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US Tax

Chances are you've heard a lot of different things about taxes in the United States, from high taxes killing businesses to calls for taxes on polluting industries. We always hear that politicians do nothing, so where do our taxes go? Why do we have to file our taxes every year when the government already knows what we owe? Keep on reading this explanation, and we will answer all those questions and more!

Types of Tax Systems in the US

There are three types of tax systems that vary across different structures in the US. The three types are proportional, progressive, and regressive taxes.

A proportional tax rate is a flat tax that affects varying tax bases.

A tax base is a term for the dollar value of money that is going to be taxed.

If you have $10,000 and $4,000 of it won't be taxed, then your tax base is $6,000.

If a proportional tax was applied to income, which it isn't, then if you earn a very high income or low income, the percent of your income taxed is the same. Sales tax in the United States is proportional; it charges an additional percentage based on the cost of the goods.

A proportional tax of 20% is applied to two citizens, Jeff and Liz. Liz has $200,000, and Jeff has $20. They both pay 20% of their taxable base, so Liz pays $40,000, and Jeff pays $4. While the numbers are drastically different, both citizens have 80% of their money left to spend.

A progressive tax rate is one that increases as the taxable money increase.

This occurs in the United States for income tax, where those with low income pay a lower rate than those on higher incomes.

Liz was caught by the IRS trying to avoid her taxes through a foreign entity; now, her income is subject to a progressive tax. Her first $100,000 is charged at 20%; however, her second $100,000 is charged at 50%. So Liz pays $70,000 in total if her income is $200,000.

A regressive tax rate is one that decreases as the taxable money increase.

Regressive taxes, however, aren't explicitly written to say that, as it would be publicly frowned upon. Instead, regressive taxes occur through implicit means of controlling the taxable money. Payroll taxes, for example, can be considered regressive as they are levied on wages.

Jeff owns the bootstrap factory, where Steve works on the payroll. Steve's income is subject to payroll taxes such as medicare and social security. Jeff chooses not to pay himself an income to set an example for his company, so he pays no payroll taxes. However, Jeff is an avid investor that receives hundreds of thousands each year in dividends, which are not subject to payroll taxes. Steve wishes to do the same but doesn't have enough accumulated capital to have substantial dividend payments.

In the example above, we see that the regular employee Steve has his only income source taxed by payroll taxes. His boss Jeff, however, doesn't pay any payroll taxes as he earns his income through dividends.

Because individuals with high capital accumulation can avoid payroll taxes, they are considered regressive. When the option is available, individuals will avoid progressive taxation in favor of regressive taxation. Individuals who receive bonuses, income from rent, and income from qualified dividends don't pay standard income tax or payroll taxes. They are subject to different taxes, which are at a lower tax rate.

US Tax Rate

The US tax rate depends on the scenario in which a tax is being imposed. Taxes come in all different shapes and sizes, and their effects can vary too. There are numerous types of taxes, but all fall into three general categories: income, property, and sales taxes.

Sometimes a tax can shift and affect others than it intended. Who bears the burden of the tax is called the incidence of tax.

If property taxes on homes increase, in the case of renters, landlords will increase the rent by the exact cost of the tax to maintain their profits. Therefore, the landlords lose no money despite being the target of the tax, and renters who don't own a property to be taxed, are paying the property tax.

Incidence of tax is who ends up paying the tax, regardless of how it was imposed.

  • Personal income tax is a fee charged to applicable forms of labor; when a business pays you a wage, income tax is deducted. The incidence of income tax does not shift, as it directly changes the amount of money going into your pocket.

    Payroll taxes are taxes levied on the paying of wages; they are called the federal contributions insurance act or FICA. These taxes were established to fund social security and medicare. The Social Security tax is regressive, as it caps an income of $118,500, after which point tax on additional income isn't charged. Because the tax is levied on wages, it doesn't apply to non-wage income such as dividends and rent.

    Corporate income tax is a flat 35% on large businesses' earnings. This tax tends to affect a company's owners or shareholders. However, it can also slow long-term growth. Firms that are producing a profit-maximizing price and quantity will not be better off changing price or quantity. Therefore the tax is paid from the corporation's profits and retained earnings, which make up dividends.

    Sales and excise tax share some similarities; they are both taxes charged at the point of consumption. Sales tax is a general proportional tax applied to most goods. Excise tax is applied to specific commodities to achieve various goals, think gasoline and cigarette taxes. Excise taxes are applied to commodities to raise revenue as their demand tends to be inelastic. The tax can also be used to discourage negative externalities in the case of cigarettes.

    Property taxes are levied on land, buildings, and homes. The incidence of tax can depend on the property; for rental scenarios, the property tax is added to the rental fee. This makes the tenant responsible for the property tax for a property they do not own. Property taxes are considered regressive as the strength of the tax depends on property value rather than income, so a higher income can pay the tax easier. This occurs because property taxes don't take an individual's income into account. Homeowners with incredibly high incomes will feel the burden of the tax less as it is a smaller proportion of their wealth.

US Income Tax Rates

The US income tax rates depend on the quantity of income earned, and qualifying deductions filed. In the United States, citizens are required to file their taxes in a complicated and unclear system. Many other developed nations file their taxes to the government automatically. In the case of the United States, there is no clear answer as to why. Some argue it's sustained by lobbying from invested tax filing industries. Others claim that individual filing allows people to minimize how much taxes will be paid. Lastly, some claim that it creates anger against taxation in general, which is politically favorable to some.

The United States uses a marginal tax rate for personal income. The taxation is divided based on set increments. The way this works out is you pay fewer taxes on your first $10,275, and then the tax rate increases for money made after that level. This is referred to as a progressive tax, where the average tax burden increases as income increases.

In the table below are the official tax brackets for the 2022 United States filing classification 'single'. The tax brackets are different for married, head of household, and qualifying widows with dependents. The benefits of filing for a joint married status only occur when one member has a significantly higher income than the other.

The average tax rate is cumulative of total taxes paid, based on the sum of the marginal tax rates paid.

Taxable Income Brackets(single)
Average Tax Rate(on highest income)
Total Tax Possible
(highest income)
$0 to $10,275
10%
10%
$1,027.50
$10,276 to $41,775
12%
11.5%
$4,807.38
$41,776 to $89,075
22%
17%
$15,213.16
$89,076 to $170,050
24%
20.4%
$34,646.92
$170,051 to $215,950
32%
22.9%
$49,334.60
$215,951 to $539,900
35%
30.1%
$162,716.75
$539,901 or more
37%
≤ 37%

Table 1 - 2022 Tax Brackets Filing Status: Single. Source: Bankrate.com1

As seen in the table above, income that falls between the tax brackets is charged at the corresponding marginal tax rate. Consider this example below for clarification.

This example doesn't factor in tax deductions; they will be featured in the following section.

Matt made $65,000 in 2021, training cats how to formally waltz. He files as single without dependents as the state does not count his 4 cats, no matter how cute they are.

Matt's income is broken down according to the tax brackets. His $65,000 is split into:

His first $10,275 he made is taxed at 10%, which is $1,027.50

The income he made between $10,276 to $41,775 which is $31,499 is taxed at 12% which is $3,779.88

The income he made between $41,776 to $65,000 which is $23,224 is taxed at 22% which is $5,109.28

\(\hbox{Total Taxes Paid}=$1,027.50+$3,779.88+$5,109.28=$9,916.66\)

In the example above, we can see Matt paid three different tax rates on his income. On average, he paid 15.26% of his total income. The marginal tax brackets are designed to let low-income earners keep more of their income, which is also good for the economy as it keeps demand up.

US Tax Deductions

What are US tax deductions, and how can we use them to pay no taxes, you might ask? The United States income tax has a system where filers can deduct specified expenses and losses that lower their taxable income base.

Tax deductible items range from mortgage interest, charitable contributions, child tax credit, and even labor expenses. Individuals can choose the standard deduction rate or itemize their expenses if they believe they can reduce them by more than the standard. The standard deduction rate is $12,550; for clarification, check this example below.

Kathy only works part-time as a tree whisperer; she is paid $13,000, for which the government already took $3,000 in taxes throughout the year. Kathy files with the standard deduction rate of $12,550, which is used to reduce her taxable income base. So her taxable income goes from $13,000-$12,550=$450. She is charged 10% tax on these $450, so she owes $45. However, since she paid $3,000 throughout the year, she is returned what she paid minus what she owes $3,000-$45=$2,955.

Tax deductions can provide a massive boost to protecting income from taxation; however, the benefits of it are regressive. This means that higher-income earners tend to benefit more from deductions than low-income earners. While not an income tax example, many major businesses have come under scrutiny for their tax deduction methods.

According to Matthew Gardner at the Institute of Taxation and Economic Policy:

Amazon avoided about $5.2 billion in corporate federal income taxes in 2021.2

This sentiment is shared by many as former president Donald Trump when criticized for not paying taxes, responded:

That makes me smart. 3

- Donald Trump

Whether you agree with him or the tax system, it is smart for individuals and businesses to maximize their revenue and income. The individuals and businesses are acting within the legal framework. The only way to change this outcome is to change the legal framework of our tax system, which requires moving political mountains.

US Tax Revenue by Source

The US tax system is massive; to better understand it, we'll break down tax revenue by source. The United States federal government collects taxes through many various means. From taxing individual income, charging foreign market players fees, income tax of corporations, and many other sources.

Figure 1 below is a breakdown of tax revenue by category. In 2021 the federal government collected $4.05 trillion.4 That is a lot of money; however, it's not as much as they spent: $6.82 trillion.5

Figure 1 shows the tax revenue collected in billions of dollars, so the individual income tax collected is 2,000 billion dollars or $2 trillion, or $2,000,000,000,000.

US Tax United States Tax Revenue 2021 StudySmarterFig. 1 - United States Tax Revenue 2021

Individual income tax is a fee charged to inflows of money to citizens. This can occur as wages, capital gains, salary, investment, commissions, personal sales, and gifts.

Individual income tax is made up of direct individual income tax, which was taxed for $1.5 trillion, and other individual income taxes worth $824.1 billion4. Other individual income taxes are money collected from non-work activities, such as interest, dividends, stock options, and even prizes such as Olympic prize pools.

Social security and medicare taxes are automatically deducted from nearly every worker's pay. These are designed to fund social programs meant to benefit all citizens.

Medicare is a subsidized healthcare plan for citizens over 65; this is designed to give retirees an affordable healthcare price. Social security is a social insurance program that is meant to give retirees a base level of income to maintain themselves without work. Both of these are designed to reward citizens for a life of working and paying into the system.

The last thing we'll cover is the corporate income tax, a flat 35% tax on all profits a business realizes. However, tax deductions and credits are numerous. 'Pass through businesses' is a term for a business structured in a way that makes them exempt from corporate income tax, only requiring them to pay individual income tax. According to William Mcbride at the tax foundation

Pass-through businesses have grown dramatically such that more than 90 percent of US businesses are pass-through entities.7

Relationship between US Taxes and Economic Growth

There is a strong relationship between US taxes and economic growth. Taxation in whichever form will directly take away the available income of citizens and restrict the growth and investments of businesses.

Money held by individuals and businesses is spent on items and investments that maximize their personal utility. Taxation reduces the ability to maximize individual utility in exchange for improving social utility. However, the social utility received doesn't make up for the utility lost from the taxes in many cases.

Consider a fictional business that records revenue for one year at $10 million. The business knows that it has a 30% return on investment (ROI), which is $600,000, if it invests $2 million into its production. However, the corporate tax charges the company $2 million. This tax does provide benefits of infrastructure and human capital gains. However, these benefits are calculated to provide only $100,000 of value to the business.

Only individuals and businesses can use their money best to maximize utility and keep efficiency high. In this fictional example, the government provided only a 5% ROI, compared to the potential 30% ROI without tax.

So why is so much money stolen from us through taxes? Well, the taxes do provide social utility and benefits. The economic benefit of taxes can be viewed as direct and indirect. The benefits of taxation are usually indirect; however, industry and citizens who receive subsidies will have direct benefits.

A direct tax benefit can be seen in Boeing, one of the United States aerospace companies, which has received 15.3 trillion in state and federal grants, and tax credits.8 They also received loan guarantees and bailout assistance totaling $74.9 trillion.8

Indirect benefits of taxation would be government expenditures that provide utility to a business or aid in workers' lives that improve their productivity.

The United States spends approx $81 billion annually protecting oil supplies around the world, though this estimate is thought to be conservative. For example, this number doesn't include all costs of the Iraq war, which led to the United State's ability to protect said oil supplies.9

So tax revenue is spent on indirect benefits to the supply of oil and gas. This keeps consumer prices low and stabilizes the infrastructure of extraction companies to provide it. In a way, individuals are paying taxes to lower the price of gas, as opposed to no tax and much higher gas prices.

US Tax - Key takeaways

  • There are three types of taxes: proportional, progressive, and regressive.
  • There are numerous types of taxes, but all fall into three general categories: income, property, and sales.
  • The most known tax, income tax, is progressive; the more money is made, the higher the money is taxed, and this is done marginally.
  • Tax deductions exist for individuals and businesses to list expenses and investments that then reduce one's taxable money.
  • Taxes reduce economic efficiency in exchange for social efficiency. Taxes do slow economic growth but provide more equitable growth to its citizens.

References

  1. https://www.bankrate.com/taxes/tax-brackets/
  2. https://itep.org/amazon-avoids-more-than-5-billion-in-corporate-income-taxes-reports-6-percent-tax-rate-on-35-billion-of-us-income/
  3. https://www.cnbc.com/2016/09/26/trump-brags-about-not-paying-taxes-that-makes-me-smart.html
  4. https://datalab.usaspending.gov/americas-finance-guide/revenue/categories/
  5. https://datalab.usaspending.gov/americas-finance-guide/spending/
  6. Fig. 1 - United States Tax Revenue 2021, https://datalab.usaspending.gov/americas-finance-guide/revenue/categories/
  7. https://taxfoundation.org/us-corporate-tax-revenue-low-because-high-taxes-have-shrunk-corporate-sector/
  8. https://subsidytracker.goodjobsfirst.org/parent/boeing
  9. https://www.cnbc.com/2018/09/21/us-spends-81-billion-a-year-to-protect-oil-supplies-report-estimates.html

Frequently Asked Questions about US Tax

The United States tax system uses various forms of taxation to collect money for government expenses. Some of the taxes are income tax, sales tax, and corporate income tax.

The three kinds of tax systems are progressive, proportional and regressive. Progressive system increases the tax rate for higher incomes. A proportional rate charges a fixed percentage to all its applied to. A regressive tax system occurs when high income earners pay a smaller proportion of their wealth than low income earners.

The US is one of the only countries that requires its citizens to file a tax return manually. This is done to allow individuals to minimize their tax burden if they choose.

The United States tax system is pulled in two directions. It wants to secure funding for the military and social programs; while also trying to minimize tax burden that slows economic growth. The result is that loopholes are created in the tax regulations that allow many to avoid paying the standard rate.

The United States tax system is not fair because those with greater wealth can access tax consultants and means of protecting their wealth from taxes.

Final US Tax Quiz

Question

What is a proportional tax?

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Answer

A proportional tax rate is a fixed percentage charged to different tax bases. Such as a 10% flat rate.

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Question

What is a progressive tax rate?

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Answer

A progressive tax rate is a tax rate that charges a higher percentage to high income earners

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Question

What is a regressive tax?

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Answer

A regressive tax rate is one that costs low income earners a higher percentage of their income than it does to high-income earners.

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Question

What are the three ways tax rates are categorized?

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Answer

Progressive.

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Question

What are the three general categories taxes fall into?

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Answer

Income.

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Question

What is incidence of tax?

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Answer

The one who ends up bearing the burden or paying the tax.

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Question

Where does the incidence of property taxes on rental units fall?

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Answer

On Renters.

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Question

Under the United States marginal income tax rate system, does $40,000 of income get charged 1 or 2 tax rates?

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Answer

2.

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Question

Under the United States marginal income tax rate system, 

$400,000,000 of income would get charged at how many different tax rates?

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Answer

7.

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Question

In the United States, 2021 tax brackets are categorized by family status, select all that apply.

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Answer

Single.

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Question

What is a tax deduction?

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Answer

A tax deduction lowers the amount of money that will be taxed.

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Question

Tax deductions can be standard/automatic and itemized.

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Answer

True.

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Question

Those looking to maximize efficiency should minimize their tax burden.

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Answer

True.

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Question

Why are corporate income tax revenues so low?

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Answer

Many businesses have converted to "pass-through" businesses, subject to different tax laws.

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Question

Does taxation hurt economic growth or help it?

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Answer

Hurt.

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