Types of Taxes
Taxes are often classified as to what they tax and how the tax is figured. Types of taxes include income taxes, property taxes, transaction taxes, and gratuitous transfer taxes.
Income taxes are levied on income by the federal government, most states, and some local governments and are imposed on individuals, corporations, and some fiduciaries, such as estates and trusts. Income taxes are also usually the most burdensome taxes assessed by a government. Consequently, most of these taxes are collected by pay-as-you-go procedures, which include withholding by employers and estimated tax payments by self-employed taxpayers. Individuals have several deductions and exemptions, such as a standard deduction and personal exemption, which lowers their taxes, but corporations can only deduct business expenses.
The federal income tax, as well as income taxes assessed by many states, is based on a progressive marginal tax rate, meaning that the tax rate increases in steps as income increases, but each marginal rate only applies to the income earned within that step. For instance, a 10% rate might apply to the 1st $10,000 earned, a 15% rate might apply to all income earned that exceeds $10,000, but is less than $30,000, at which point a higher marginal tax rate would apply. So if a taxpayer earned $25,000, then the income tax would equal 10% of $10,000, or $1000 +15% of the additional $15,000, or $2,250, for a total income tax of $3,250.
In addition, many localities impose a local income tax, which is applied to everyone who works or lives within the locality. Generally, these income taxes are imposed by major cities with large expenses and where corruption is often rampant. Some local income taxes can actually exceed the state tax. For instance, the local income tax rate for Philadelphia was 3.928% while the state income tax was only 3.07%.
Employers must pay employment taxes based on the wages paid to its employees. Employment taxes consist of the Federal Insurance Contributions Act (FICA) tax, which consists of the Social Security and Medicare taxes, and the Federal Unemployment Tax Act (FUTA) taxes.
The Social Security tax is 12.4% of income below the inflation-adjusted Social Security wage base limit (2020: $137,700), while the Medicare tax rate is 2.9% on all earned income. If the taxpayer is self-employed, then she must pay the entire tax. If the taxpayer is an employee, then the employee pays ½ and the employer pays the other half. However, the employee generally suffers the full burden of the tax in the form of lower wages. (See Tax Incidence: How The Tax Burden Is Shared Between Buyers And Sellers for an explanation.)
FICA taxes combined with income taxes on earned income make working income the most highly taxed of transactions. The FICA taxes are a flat tax where a fixed rate is applied to all taxpayers who earn less than the Social Security wage base limit. It is a tax rate that is especially burdensome to the poor and lower middle-class, although the poor can use the Earned Income Credit and the Child Tax Credit to offset some of their FICA tax liability. Otherwise, there are very few deductions that go against FICA taxes. Children under age 18 who are employed in their parent's trade or business are exempted from the FICA taxes, but not the spouse.
Both the federal and state governments impose taxes to finance unemployment compensation. Under the federal program, it is called the Federal Unemployment Tax Act, or FUTA. The FUTA tax rate is 6.2% of the first $7,000 of covered wages during the year for each employee. The federal government does give credit for any taxes that are also paid to the state. However, the credit cannot exceed more than 5.4% of the covered wages. Generally, unemployment taxes are administered by both the state and federal governments.
Most states also have a policy of reducing the unemployment tax on employers who have little turnover of employees, since they lessen the unemployment burden on the state, which helps to reduce layoffs by employers. The FUTA tax is assessed entirely upon the employer. However some states do levy a special tax on employees to provide either disability benefits or supplemental unemployment compensation or both.
Ad Valorem Taxes
Ad valorem taxes are imposed on and are based on the appraised value of property, and are most commonly assessed on realty or valuable personal property, such as motor vehicles. Ad valorem taxes on realty are generally imposed by state governments or municipalities, but most are assessed by cities, counties, and school districts.
Realty Property Taxes
Realty is defined by state property law, and includes real estate and capital improvements that are classified as fixtures, which is something permanently attached to the real estate where removal would cause damage. Hence, capital improvements of property generally increase property taxes. In addition, when non-income producing property is converted into income producing property, the appraised value of the property generally increases.
Property owned by governments, including the federal government, state and local governments, and certain charitable organizations, are generally exempt from property tax. Many states also assess lower property taxes on land dedicated to agriculture or other special uses that do not produce income, such as wildlife sanctuaries. Some states also have a homestead exemption which exempts some of the property value from taxation for property used as a home. The homestead exemption also protects some or all its value against creditors. Many states also assess lower property taxes on taxpayers who are 65 or older, since they generally live on fixed incomes. Many states and localities also exempt all or portions of property taxes for businesses willing to relocate there.
A key advantage of ad valorem taxes on realty for the tax authorities is that it is difficult to avoid, since real estate and its fixtures are easily identified. Therefore, many taxpayers try to lower their bill by challenging the assessment of the property, since ad valorem taxes depend on the value of the property. There are generally 4 methods to assess the value of real estate:
- actual purchase or construction price,
- market prices of actual sales or construction costs of comparable properties,
- cost of reproducing a building minus allowances for depreciation and obsolescence,
- capitalization of income from the property.
Usually a combination of these methods is used to assess property taxes, since it can lead to inequities otherwise. For instance, if real estate values are rapidly rising, recent buyers of real estate would pay more in real estate taxes than earlier buyers for comparable properties if taxes were based on actual purchase or construction price.
Personalty Property Taxes
Personalty includes all assets that are not realty. Although ad valorem taxes on personalty are usually on tangible property, some states also tax intangible property, such as stocks, bonds and other securities. Personalty can be used for either personal reasons or for business, sometimes they are used for both, which the IRS classifies as listed property, which is subject to special tax rules. Examples include telephones, computers, and motor vehicles. Generally, ad valorem taxes on personalty are hard to enforce, since there is very little compliance among the population. However, if the personalty is used in business, there is usually greater compliance, because the business can deduct both the cost of the property and the property taxes from other taxes, such federal income taxes. Since businesses need to list the property on their tax forms to deduct costs, taxes, and depreciation, this notifies tax authorities about the property.
Transaction taxes are taxes assessed on the transfer of property in exchange for consideration, usually money. Generally the transaction tax = the value of the property multiplied by the percentage rate of the transaction tax. Transaction taxes are regressive, because they are more burdensome to the poor.
Excise, Sales, Use, and Value-Added Taxes
The major types of transaction taxes are excise taxes and sales taxes. The federal government does not assess a sales tax but does assess many excise taxes. However, most states do impose a sales tax as do many localities within the states.
Both the excise tax and the sales tax are equal to a percentage of the property value when the transaction occurs. The excise tax differs from the sales tax in that the excise tax is generally applied to special types of property, such as alcohol or tobacco, while the sales tax is a tax that applies to a wider variety of items. Because of the regressive nature of sales taxes, many states do not impose a sales tax on groceries, clothing, or other necessary items.
Excise taxes are assessed to pay for specific expenses, such as using the gasoline tax to pay for the expense of providing roads and bridges, or to discourage undesirable behavior, such as drinking and smoking, which are discouraged by assessing excise taxes on alcohol and tobacco. The items that are generally subject to excise taxes are taxed both by the state and federal government.
Often, excise taxes are higher than general sales taxes and are often imposed on items that are mostly purchased by out-of-state visitors, such as for hotel occupancy or car rentals. (States obviously believe in taxation without representation!) Excise or sales taxes are also assessed on property that is transferred where documentation is required to record the transfer, since compliance is generally much higher, such as the transfer of real estate.
A use tax is a special type of tax that the buyer is supposed to pay when purchasing an item from an out-of-state vendor who does not have a physical presence within the state, and is, therefore, not required to collect sales tax for the state. These taxes are often called Amazon taxes, because Amazon does not collect sales taxes for most jurisdictions, although that may soon change. Use taxes are generally very difficult to enforce, so they are rarely collected. The rationale for the use tax is that businesses located within the state or jurisdiction have to charge sales tax while out-of-state vendors do not, thus increasing the price of the goods and services that are sold by state vendors. This has become a particular pervasive problem with the rapid rise in online shopping.
Many states sometimes offer a tax holiday, when certain items can be purchased during a restricted period, usually a couple of days, without paying a sales or use tax, to help out the poor or to stimulate desirable activity. Most of these tax holidays seem to be in August, when items needed for the coming school year are exempted from sales or use taxes. Common tax holiday items include clothing and school supplies below a certain price, such as $100, and sometimes computers, since they are increasingly being used in the classroom but still remain expensive for many parents.
A value-added tax (VAT) is like a sales tax, in that a certain percentage is assessed on products or services. However, the value-added tax is assessed at each stage of development of a product or service and its distribution. Generally, the VAT is assessed on the price difference of the business inputs and the output. So if a furniture maker pays $100,000 for wood to produce its furniture, then sells the furniture for $300,000 to a retailer, then the furniture manufacturer must pay a VAT on the $200,000 difference between what it sold its output and what it paid for its input. Likewise if the retailer sells the furniture for $500,000, then the retailer must pay a VAT on the $200,000 difference between what it sold the furniture for and what it paid for it.
Naturally, the businesses pass these taxes on to the consumer in the form of higher prices, although the tax burden will be shared by both businesses and their customers, depending on the tax incidence. Although no jurisdiction in the United States assesses a value-added tax presently, many European countries do. Like regressive sales taxes, the VAT imposes a heavier burden on poor people. Tax authorities like the VAT, not only because it is easily enforceable, but also because it is not readily apparent to the people how much tax they are paying.
Severance taxes are sales taxes assessed on the natural resources extracted, or severed, from the state and are usually payable by the producer of the natural resource, although some states assess the tax on the first buyer of the natural resource. The tax base of the severance tax is usually based on the value or the quantity of the natural resource removed. The rationale for severance taxes is that the state has a natural interest in its natural resources and assessing severance taxes helps to lower other taxes for the general voting population. This explains why Alaska has one of the lowest tax rates in the United States, since it collects more than 50% of its income from severance taxes imposed on oil and gas, mining, and the fishery business. Alaska has the highest proportion of severance taxes in the United States. (A list of severance taxes assessed by state.) No doubt that the tax revenue generated from severance taxes will increase as gas production from fracking increases.
Gratuitous Transfer Taxes
Gratuitous transfers are the transfers of money or property from the donor to the donee for little or no consideration. Gratuitous transfers include gifts and transfers from the estates of decedents to beneficiaries.
2018 Gift Tax Update
In December 2017, the Republicans have passed their major tax plan, known as the Tax Cuts and Jobs Act, which mostly benefits the wealthy. Part of that plan includes decreasing the top estate tax rate from 40% to 35% and doubles the exemption to more than $11 million for each individual, which will allow a couple to leave more than $22 million to their heirs tax-free. This exemption is also adjusted for inflation. This new exemption also applies to gifts, but this new law for individual taxpayers reverts back to the old law in 2026. Therefore, any gifts whose value exceeds the old limit may be subject to clawback taxes if the exemption reverts to the previous law that was effective in 2017.
Death taxes take 2 forms: estate taxes and inheritance taxes. An estate tax is a tax on the value of the estate at the time of the decedent's death and is paid by the personal representative of the estate before any property is distributed to beneficiaries. Inheritance taxes are assessed on the individual receiving property from the estate.
The federal government only imposes an estate tax, and even then, it allows a large exemption of property that can be transferred tax-free, which is now more than $11 million for a single individual or $23 million for a married couple, and, in 2013, Congress augmented this gift to the wealthy by adjusting the amount for inflation. The federal estate tax is generally very low because the wealthy have extensive influence with Congress, and, of course, because most members of Congress are wealthy themselves. Many states assess either an inheritance tax or estate tax, and some, impose both.
The rationale of the federal estate tax, first enacted by the Revenue Act of 1916, was to prevent the accumulation of wealth in families. However, because of the large number of loopholes in the tax law and because of the large exemption of property that can be passed tax-free, the wealthy have increasingly become wealthier, especially under President George W. Bush, who has increased the unified tax credit for gifts and estates, and also lowered the long-term capital gains rate and qualified dividends to 0% or 15%.
The estate becomes a separate taxable entity that must file its own tax forms. The personal representative of the estate lists the value of the property minus various deductions, including funeral and administrative expenses, debts of the decedent, expenses associated with the administration of the estate, and transfers to charitable organizations. However, the biggest deduction is the marital deduction for a married couple. If one spouse dies, any transfers to the surviving spouse will not be subject to the estate tax. The rationale behind the marital deduction is that the federal government will get to tax the property when the surviving spouse dies. However, estate planners have used the marital deduction in various ways to greatly reduce the overall taxes paid by the estates of both spouses.
State Death Taxes
In those states that assess an inheritance tax, the rate of taxation generally depends on how closely related the heir was to the decedent. Generally, the closer the relationship, the lower the tax, and in some states, transfers to the surviving spouse are not taxed at all.
Gift taxes are excise taxes levied on gifts. In the United States, the federal government applies a gift tax that is graduated according to the total value of gifts given by a donor over his lifetime. The federal gift tax was first enacted in 1932 to complement the estate tax, to prevent donors from giving away all their property while they were still alive to avoid the estate tax. Currently, the exemption for gift taxes is the same exemption for estates — more than $11 million per donor and more than $22 million for a married couple. The exemption is given through a unified transfer tax credit that can be applied to either lifetime gifts or the estate. Any tax credit that is used to offset gift tax liability reduces the credit available to offset the estate tax. The top gift tax rate is now 35%, which is the same as the estate tax.
Unlimited gifts can be given to the spouse without incurring tax liability because of the marital deduction. There is also an annual gift tax exclusion that allows the transfer of money or property tax-free, and without using any of the unified transfer tax credit, if its value is less than the annual exclusion, which is adjusted for inflation, per donee. Federal law also allows a gift to be split so that a spouse can give up to double the annual exclusion amount per donee by splitting the gift with the other spouse, even if the spouse contributed nothing to the gift. The main reason for the annual exclusion is because it would be difficult to enforce taxation of the gift, since it would rarely be reported. However, lawyers have devised many legal schemes using this exclusion to allow the wealthy to transfer much more money than the amount of the exclusion would suggest. For instance, Mitt Romney, who sought the 2012 Republican nomination for President, has used this technique to provide a tax-free $100 million trust fund for his 5 sons!
State gift taxes are imposed by some states, such as Connecticut and Tennessee, and those states that do impose a gift tax also have lifetime exemptions and annual exclusions. However, they differ from the federal gift tax in that the tax rate depends on the relationship between the donor and donee. Like inheritance taxes, the closer the relationship, the lower the tax rate, and, generally, transfers between spouses are tax-free.
Other United States Taxes
Federal custom duties, otherwise known as tariffs, are taxes that are imposed on imported goods. Custom duties provided most of the revenue for the federal government before the 20th century. Nowadays, it not only generates revenue, but is also used to protect local industries from foreign competition, which often leads to retaliation by exporting countries.
Miscellaneous State And Local Taxes
Most states impose a franchise tax, which is a tax on the right to do business in the state. However, the tax base used for the determination of the tax varies by state. Usually, the franchise tax is based on the capitalization of the corporation. Occupational taxes are like franchise taxes but are applied to specific trades or businesses and are collected in the form of licenses or tax permits, such as a liquor license or tax permits or fees to practice certain professions, such as law or medicine.