Types of Taxation in the United States

United States: Types of Taxes

By Brian Roach

Federal Income Taxes

The federal income tax is the most visible, complicated, and debated tax in the U.S. The federal income tax was established with the ratification of the 16th Amendment to the U.S. Constitution in 1913. It is levied on wages and salaries as well as income from many other sources including interest, dividends, capital gains, self-employment income, alimony, and prizes. To understand the basic workings of federal income taxes, you need to comprehend only two major issues. First, all income is not taxable – there are important differences among “total income,” “adjusted gross income,” and “taxable income.” Second, you need to know the distinction between a person’s “effective tax rate” and “marginal tax rate.”

Total income is simply the sum of income an individual or couple receives from all sources. For most people, the largest portion of total income comes from wages or salaries. Many people receive investment income from three standard sources: interest, capital gains, and dividends. Self-employment income is also included in total income, along with other types of income such as alimony, farm income, and gambling winnings.

The amount of federal taxes a person owes is not calculated based on total income. Instead, once total income is calculated, tax filers subtract some expenses as non-taxable. To obtain adjusted gross income (AGI), certain out-of-pocket expenses are subtracted from total income. These expenses include individual retirement account contributions, moving expenses, student loan interest, tuition, and a few other expenses. AGI is important because much of the tax data presented by the Internal Revenue Service (IRS) are sorted by AGI. However, taxes are not calculated based on AGI either. Taxable income is basically AGI less deductions and exemptions. Deductions are either standard or itemized. The standard deduction is a fixed amount excluded from taxation – in 2003 the standard deduction was $4,750 for single individuals and $9,500 for married couples.

Tax filers have the option of itemizing their deductions. To itemize, a tax filer adds up certain expenses made during the year including state taxes, real estate taxes, mortgage interest, gifts to charity, and major medical expenses. If the itemized deductions exceed the standard deduction, then the itemized total is deducted instead. Exemptions are calculated based on the number of tax filers and dependents. A single tax filer with no dependent children can claim one exemption. A married couple with no children can claim two exemptions. Each dependent child counts as one more exemption. Additional exemptions are given for being age 65 or over or blind. In 2003, each exemption excluded a further $3,050 from taxation.

Taxable income is obtained by subtracting the deduction and exemption amounts from AGI. This is the amount a taxpayer actually pays taxes on. However, the amount of tax owed is not simply a multiple of taxable income and a single tax rate. The federal income tax system in the U.S. uses increasing marginal tax rates. This means that different tax rates apply on different portions of a person’s income. The concept can be illustrated with an example using the 2003 tax rates. For a single filer, the first $7,000 of taxable income (not total income or AGI) is taxed at a rate of 10%. Taxable income above $7,000 but less than $28,400 is taxed at a rate of 15%. Taxable income above $28,400 but less than $68,800 is taxed at a rate of 25%. Income above $68,800 is taxed at higher marginal rates – 28%, 33%, and 35%.

Not all income, however, is taxed at the same marginal rates. Investment income from capital gains has generally been taxed at a lower rate than income from labor. Dividend income used to be taxed at the same marginal rate as labor income but the Jobs and Growth Act of 2003 also taxes dividends at the lower capital gains rate. While the top marginal rate on labor income in 2003 was 35%, the top rate on capital gains and dividend income was only 15%. Given that the vast majority of investment income is earned by wealthy taxpayers, the lower rates on investment income has important implications for the progressivity of the federal income tax.

Social Insurance Taxes

Taxes for federal social insurance programs, including Social Security, Medicaid, and Medicare, are taxed separately from income. Social insurance taxes are levied on salaries and wages, as well as income from self-employment. For those employed by others, these taxes are generally deducted directly from their paycheck. These deductions commonly appear as “FICA” taxes – a reference to the Federal Insurance Contributions Act. Self-employed individuals must pay their social insurance taxes when they file their federal income tax returns.

Social insurance taxes are actually two separate taxes. The first is a tax of 12.4% of wages, which is primarily used to fund Social Security. Half of this tax is deducted from an employee’s paycheck while the employer is responsible for matching this contribution. The other is a tax of 2.9% for the Medicare program. Again, the employee and employer each pay half. Thus, social insurance taxes normally amount to a 7.65% deduction from an employee’s wage (6.2% + 1.45%). Self-employed individuals are responsible for paying the entire share, 15.3%, themselves.

There is a very important difference between these two taxes. The Social Security tax is due only on the first $84,900 (in 2002) of income. On income above $84,900, no additional Social Security tax is paid. In other words, the maximum Social Security tax in 2002 that would be deducted from total wages is $5,264 ($84,900 × 0.062). The Medicare tax, however, is paid on all wages. Thus, the Medicare tax is truly a flat tax while the Social Security tax is a flat tax on the first $84,900 of income but then becomes a regressive tax when we consider income above this limit.

Consider the impact of social insurance taxes on two individuals, one making a salary of $30,000 and another making $300,000. The typical worker would pay 7.65% on all income, or $2,295, in federal social insurance taxes. The high-income worker would pay the maximum Social Security contribution of $5,264 plus $4,350 for Medicare (1.45% of $300,000) for a total social insurance tax bill of $9,614. Note that this works out to a 3.2% overall tax rate, or less than half the tax rate paid by the typical worker. As the high-income individual pays a lower rate of taxation, we see that social insurance taxes are regressive.

Federal Corporate Taxes

Corporations must file federal tax forms that are in many ways similar to the forms individuals complete. Corporate taxable income is defined as total revenues minus the cost of goods sold, wages and salaries, depreciation, repairs, interest paid, and other deductions. Thus corporations, like individuals, can take advantage of many deductions to reduce their taxable income. In fact, a corporation may have so many deductions that it actually ends up paying no tax at all or even receives a rebate check from the federal government.

Corporate tax rates, like personal income tax rates, are progressive and calculated on a marginal basis. In 2002, the lowest corporate tax rate, applied to profits lower than $50,000 was 15%. The highest corporate tax rate, applied to profits over $10 million was 35%. As with individuals, the effective tax rate corporations pay is lower than their marginal tax rate.

Federal Excise Taxes

An excise tax is a tax on the production, sale, or use of a particular commodity. The federal government collects excise taxes from manufacturers and retailers for the production or sale of a surprising number of products including tires, telephone services, air travel, fossil fuels (including gasoline, diesel fuel, and aviation fuel), alcohol, tobacco, and firearms.

Unlike a sales tax, which is evident as an addition to the selling price of a product, excise taxes are normally incorporated into the price of a product. In most cases, consumers are not directly aware of the federal excise taxes they pay. However, every time you buy gas, make a phone call, fly in a commercial plane, or buy tobacco products, you are paying a federal excise tax. For example, the federal excise tax on gasoline as of 2003 was about 18 cents per gallon.

Federal excise taxes initially may appear to be an example of proportional taxation – everyone pays the same tax rate on goods subject to excise taxes. However, in practice excise taxes turn out to be regressive because lower-income households tend to spend a greater portion of their income on goods that are subject to federal excise taxes. This is particularly true for gasoline, tobacco, and alcohol products.

Federal Estate and Gift Taxes

The vast majority of Americans will never be affected by the federal estate or gift taxes. These taxes apply only to the wealthiest Americans. The estate tax is applied to transfers of large estates to beneficiaries. Currently, estates valued at less than $1 million ($2 million for couples) are totally exempt from the tax. The top marginal estate tax rate is 55% but, as with individual and corporate taxes, the effective tax rates on estate tend to be lower. Provisions of the estate tax laws reduce the tax burden for the transfer of small businesses and farms.

The estate tax exemption amount is scheduled to increase over the next several years to $3.5 million ($7 million for couples) in 2009. In 2010, the estate tax is scheduled to expire but this expiration is only temporary – under current law the estate tax would be reinstated in 2011.

The transfer of large gifts is also subject to federal taxation. The estate tax and gift tax are complementary because the gift tax essentially prevents people from giving away their estate to beneficiaries tax-free while they are still alive. In 2002, gifts under $11,000 were excluded from the tax. Similar to the federal income tax, the gift tax rates are marginal and progressive, with a maximum tax rate of 50%. The gift tax is also scheduled for temporary expiration in 2010.

The estate and gift taxes are the most progressive element of federal taxation, paid exclusively by those with considerable assets. The majority of estate taxes are paid by a very small number of wealthy taxpayers. In 2000 over half of estate taxes were collected from estates worth more than $5 million, about 0.15% of all estates.

State and Local Taxes

Like the federal government, state governments also rely on tax revenues to fund public expenditures and transfer programs. Like the federal government, state governments rely on several different tax mechanisms including income taxes, excise taxes, and taxes. Thus, much of the above discussion applies to the tax structures in place in most states. However, there are some important differences that deserve mention.

Types of Taxation