Income taxes are taxes collected by federal, state and local governments on the income of individuals and businesses. These taxes are typically applied to a percentage of the income, but the rate may vary based on the type of income, amount of income or the type of taxpayer.
What Are Income Taxes and How Do They Work?
Income taxes are one of several different types of taxes governments rely on to fund public services.
The federal government in the United States uses a progressive income tax system in which your tax rate increases as your income increases. This produces a series of tax brackets in which different blocks of your income are taxed at different rates.
- Individual Income Tax
- Individual income tax — or personal income tax — is the tax individuals pay on their personal salary, wages or other taxable earnings. Most people don’t pay taxes on all their income thanks to deductions, tax credits and exemptions.
- Business (or Corporate) Income Tax
- Business earnings from small businesses, corporations, self-employed individuals, partnerships and other business arrangements are also subject to income taxes. A business income tax typically applies to the income after subtracting capital and operating expenses from the business’ revenue.
The individual income tax produces about five times as much tax revenue for the federal government than the business income tax, according to the U.S. Department of the Treasury.
The IRS collects federal income taxes and enforces federal tax law in the United States. It manages and oversees the complex set of tax regulations created by the federal tax code.
Federal income taxes are collected on all types of income including wages, salaries, commissions, business earnings, interest and investments.
State and local governments may also impose income taxes, but rates and methods for taxing income vary between jurisdictions.
Income taxes play a major role in most people’s personal finances. So, it’s important to understand what your income tax options are when laying out your personal financial planning.
Federal, State and Local Income Taxes
Federal, state and local income taxes account for the largest portion of government revenue in the United States — 41.5 percent of all tax revenue in 2019, according to the Tax Foundation.
Federal Income Tax
The foundation of the federal income tax is that Americans are taxed based on their ability to pay. Even though taxpayers may have the same income, they may not be able to pay the same amount. This may be due to high medical bills, mortgage interest or other financial obligations or burdens.
To make the income tax more fair, people can claim tax exemptions, deductions and credits. These lower the taxable income of taxpayers in some situations making them more able to pay income tax.
The federal income tax is a voluntary system — but paying it is not optional. The IRS relies on each income earner to voluntarily report their income and calculate the taxes they owe when they file a tax return each year.
The first federal income tax was levied during the Civil War, but court rulings following the war declared the income tax unconstitutional. The federal income tax was reinstated with the passage of the 16th Amendment in 1913.
State and Local Income Taxes
In addition to the federal income tax, you may also have to pay state or local income tax depending on where you live.
Among the states, 41 of them — along with the District of Columbia — tax wages and salaries as income. California holds the top marginal rate for taxable income at 13.3 percent.
The remaining eight states do not collect income taxes.
- South Dakota
Most local governments do not collect local income taxes. But as of 2019, nearly 5,000 local governments, spread across 17 states, levied some amount of local income taxes.
Two states — Ohio and Pennsylvania — account for nearly 78 percent of all jurisdictions that levy local income taxes. This includes 3,155 cities and 671 school districts.
Income tax rates vary widely between states and localities that levy them. To find out your state and income tax rate, you should contact your state tax agency.
Who Pays the Federal Income Tax in the U.S.?
In the United States, individuals, businesses and other entities such as estates and trusts pay income taxes.
Breaking down data from the 2018 tax year, the Tax Foundation looked at the amounts people of different income levels paid in federal individual income taxes.
It found the highest earning half of taxpayers pay 97 percent of federal income taxes. The bottom 50 percent of income earners paid the remaining 3 percent. The average adjusted gross income of the bottom 50 percent was about $18,600.
Typically, more affluent Americans pay higher income taxes while people in lower income groups pay a greater percentage of their earnings toward payroll and excise taxes. Taxpayers in the bottom 90 percent of incomes in the United States pay more in payroll taxes than income taxes, according to the Peter G. Peterson Foundation.
Individual income taxes accounted for $1.6 trillion in federal revenue in 2020, according to the Congressional Budget Office. That was nearly half of all revenue the federal government took in that year. Corporate income taxes accounted for another 6 percent of federal revenue — an additional $212 billion.
11 Cited Research Articles
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- Congressional Budget Office. (2021, April 30). Revenues in Fiscal Year 2020: An Infographic. Retrieved from https://www.cbo.gov/publication/57173
- Congressional Research Service. (2020, November 10). Overview of the Federal Tax System in 2020. Retrieved from https://crsreports.congress.gov/product/pdf/R/R45145
- Enache, C. (2021, February 17). Sources of Tax Revenue: U.S. vs. OECD. Retrieved from https://taxfoundation.org/us-tax-revenue-2021/
- Library of Congress. (n.d.). Income Tax Day. Retrieved from https://guides.loc.gov/this-month-in-business-history/april/tax-day
- Loughead, K. (2021, February 17). State Individual Income Tax Rates and Brackets for 2021. Retrieved from https://taxfoundation.org/publications/state-individual-income-tax-rates-and-brackets/
- Peter G. Peterson Foundation. (2021, April 6). Who Pays Taxes? Retrieved from https://www.pgpf.org/budget-basics/who-pays-taxes
- U.S. Department of the Treasury. (2010, December 5). Economics of Taxation. Retrieved from https://www.treasury.gov/resource-center/faqs/Taxes/Pages/economics.aspx
- U.S. Internal Revenue Service. (n.d.). Understanding Taxes. Retrieved from https://apps.irs.gov/app/understandingTaxes/student/glossary.jsp
- U.S. National Archives. (n.d.). 16th Amendment to the U.S. Constitution: Federal Income Tax (1913). Retrieved from https://www.ourdocuments.gov/doc.php?flash=false&doc=57
- Walczak, J. (2019, July 30). Local Income Taxes in 2019. Retrieved from https://taxfoundation.org/local-income-taxes-2019/
- York, E. (2021, February 3). Summary of the Latest Federal Income Tax Data, 2021 Update. Retrieved from https://taxfoundation.org/publications/latest-federal-income-tax-data/