Basics of Taxation, Income tax and working principles.

Header Image: Income Tax Fundamentals

Brief history of Taxing

Unlike what we know today, the US used to be income-tax-free. This was mainly because of the absence of the federal government in its infancy years. The US was under a British colony, so it imposed a few taxes on its citizens. Some of these taxes were the head tax, a tax imposed on each adult male, the realty tax, a tax on land and buildings, and the legendary tea tax that ignited the historic Boston Tea Party.

The American Revolutionary War, a significant event in the history of the United States, began in 1775 and lasted till 1783. This war, a military contention between George Washington-led American patriots and the British colony, marked a turning point in the nation’s history. The independence of the American people, achieved through this war, led to the imposition of income tax on the American people, a significant step in the nation’s financial system. 

The United States follows the trend of other developed nations by having high-earning citizens pay a more significant percentage of their income in taxes to the government. In a progressive tax system, higher rates are levied on those who can afford it. Income taxes at the federal level are between 10% and 37%  as of 2023.

What is a tax on income?

Income tax is a tax that governments levy on the income earned by firms and people within their sphere of influence. This tax is used to cater to public services, fund government responsibilities, and provide basic amenities for its citizens. It is a crucial source of revenue for the government, which is then used to fund various public services, such as healthcare, education, and infrastructure development. Individuals’ wages, salaries, and other income are subject to a Personal Income Tax. In contrast, gains earned by small firms, self-employed, companies and partnerships are subject to a Business Income Tax.

How Income Tax Works

The Internal Revenue Service (IRS) is a crucial entity in the United States. It is the recognised agency responsible for collecting taxes and ensuring tax compliance among US citizens and businesses. The IRS collects taxes on various forms of income, such as wages, salaries, investments, business earnings, and commissions, playing a vital role in the nation’s financial system. 

The US employs a progressive tax rate, a taxing policy that increases the tax rate of citizens or businesses as their income increases. A flat Income tax rate, or proportional tax, employs a uniform tax rate for all income classes. The rich and the low-income earners pay the same tax percentage to the government. The third tax policy, uncommonly employed, is a regressive tax. This is a tax that takes a larger percentage of income from low-income earners than from high-income earners. It is considered unfair because it places a heavier burden on those who can least afford it.

Also Read: THE ROLE OF BUDGETING IN FINANCES

Three key types of Income tax

  • Individual Income Tax 

Also known as personal Income tax, the state levies an individual’s wages, salaries and income stream. The IRS provides a variety of tax deductions and credits that individuals can use to reduce their taxable income. 

The IRS offers tax breaks for various expenses, such as medical expenditures, investments, and some education-related costs. For instance, if a person earns $100,000 and is approved for $20,000 in deductions, their taxable income falls to $80,000. Some common deductions include mortgage interest, student loan interest, and charitable contributions. These deductions can significantly reduce your taxable income, thereby lowering your tax liability. 

Governments use tax credits, a form of tax relief, to promote particular behaviours or activities or to offer financial assistance to specific categories of taxpayers. Unlike tax deductions, which lower your taxable income, tax credits directly reduce the taxes you owe. In other words, they reduce your tax obligation dollar for dollar, providing a significant benefit to taxpayers.

  • Business Income Tax

Income taxes must be paid on business earnings. The IRS collects income taxes from corporations, partnerships, independent contractors, and small businesses. Depending on the firm’s form, the company, owners, or shareholders report profits. They report profits before deducting operational expenses and capital investments. The difference between revenue and expenses constitutes taxable company income. For example, if a business has a revenue of $ 200,000 and operational expenses of $ 50,000, its taxable income would be $ 150,000. 

For example, if a business started with a hundred thousand dollars and closed on a profit of fifty percent at the end of the month. That makes a total of a hundred and fifty thousand dollars. If the operational cost is twenty thousand dollars, then the business will pay a tax off the thirty thousand dollars and not the hundred and fifty thousand dollars. 

$100,000 – Capital

$50,000 – Profit

$150,000 (Total) 

$20,000 (Operational cost) 

($150,000-$20,000) = $30,000 (Taxable Income)

  • Payroll Tax 

A payroll tax is a tax that both employers and workers pay based on how much the worker makes. Its primary purpose is to pay for health care and social security programmes, like Medicare and Social Security, in the US. Employers deduct a portion of these taxes from their workers’ paychecks and contribute an additional amount themselves. In the U.S., FICA requires workers and employers to contribute to Social Security and Medicare. Payroll taxes fund social welfare programs. They ensure seniors, disabled people, and others in need can receive benefits.

The Income Tax

Image by freepik

Average tax rate and how to calculate

Your average tax rate is the proportion of your total income that you pay in taxes. In theory, the more you earn, the more tax you pay. The federal income tax rate is commonly between 10% to 37%. To calculate your average tax rate, you must add all sources of taxable income earned in a tax year. The next step is to compute your adjusted gross income (AGI). After that, remove any deductions you are entitled to from your AGI. The resulting amount is your taxable income, on which you will be taxed at the applicable tax rate.

Previous

Five Crucial Questions To Ask Before Considering a Loan

Next

Building Financial Security: An Easy Guide to Building Your Emergency Fund

1 Comment

  1. Hello,

    The information provided is beneficial.

    Thanks.

Leave a Reply

Your email address will not be published. Required fields are marked *

Theme by Anders Norén & Customized by Karol K