What Are Taxes? Types and Who Pays Them

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Taxes are mandatory payments that a government (national, state or local) requires individuals and businesses to make, set by law and collected without any direct exchange of goods or services in return. A tax applies a rate or a fixed charge to something the law defines as taxable, such as income, a sale, a property’s value, an import or an estate. The revenue funds public spending: roads, schools, defense, courts, and programs such as Social Security and Medicare.

How Taxes Work

Every tax has the same basic parts:

• Tax base: what is being taxed, such as wages, profits, the price of a purchase or the assessed value of a home.
• Tax rate: the percentage or fixed amount applied to the base.
• Taxpayer: the person or entity the law makes responsible for the tax.
• Collection method: how the money reaches the government, whether through withholding, a filed return, a charge at the register or a bill from the county.

The core calculation is simple:

Tax owed = Tax base × Tax rate

A few taxes are fixed amounts instead of percentages, such as a charge per gallon of fuel or a set fee per imported item. Taxes calculated as a percentage of value are called ad valorem taxes, from the Latin for “according to value.” Property taxes and many tariffs work this way.

Most governments assign collection to a dedicated agency, such as the Internal Revenue Service at the U.S. federal level. States and localities run their own revenue departments and tax offices.

Flat, Progressive and Regressive Taxes

The way a rate relates to the size of the base determines how a tax spreads its burden:

• Flat (proportional) tax: one rate applies regardless of the amount. The U.S. federal corporate income tax is a flat 21% of taxable income.
• Progressive tax: the rate rises as the base grows. U.S. federal income tax is progressive, with seven brackets ranging from 10% to 37%.
• Regressive tax: the tax takes a larger share of income from lower earners than from higher earners, even if the rate itself is the same for everyone. A sales tax on necessities is the standard example, because lower-income households spend a larger fraction of their income on taxed goods.

Marginal vs. Effective Tax Rates

A progressive income tax uses marginal rates. Each rate applies only to the slice of income that falls within its bracket, not to all of your income. Moving into a higher bracket raises the tax on the additional dollars only.

Your effective rate is your total tax divided by your total taxable income. Because the lower slices are taxed at lower rates, the effective rate is always below the top marginal rate you reach.

Types of Taxes

The categories below describe the U.S. system, though most have close equivalents elsewhere.

Income Tax

Income tax is a percentage of income paid to the federal government and, in most states, to the state as well.

Several factors affect how much income tax a person owes:

• Filing status: single, married filing jointly, married filing separately, or head of household. Each status has its own bracket thresholds, so the same income can produce different tax bills under different statuses.
• Type of income: wages, interest, dividends and capital gains are not all taxed the same way.
• Starting point of the calculation: taxes are figured on taxable income, which begins with gross income and is reduced by adjustments and deductions. Some tax benefits are tied to modified adjusted gross income instead.

Capital gains tax is a tax on the profit from selling an asset that has risen in value. The holding period determines the rate:

• Short-term gains (assets held one year or less) are taxed at your ordinary income tax rate.
• Long-term gains (assets held more than one year) are taxed at lower capital gains rates, a policy intended to encourage long-term investment.

Because the holding period sets the capital gains tax rate, investors need records of when each asset was bought and sold.

Payroll Taxes

Payroll taxes are withheld from an employee’s paycheck by the employer and sent to the federal government to fund Social Security and Medicare. In the U.S., these are often referred to as FICA taxes.

The employee pays:

• 6.2% for Social Security, applied only up to an annual wage base limit that is adjusted each year for inflation. Wages above that limit are not subject to the Social Security portion.
• 1.45% for Medicare, applied to all wages with no cap.

The employer pays a matching amount: another 6.2% for Social Security up to the wage base and another 1.45% for Medicare on all wages. Combined, that is 15.3% of covered wages.

An Additional Medicare Tax of 0.9% applies to earnings above $200,000 for single filers and $250,000 for married couples filing jointly. Only the employee pays this; there is no employer match.

Self-employed people pay both halves through the self-employment tax, which funds the same programs. They can deduct the employer-equivalent half when calculating their income tax.

Corporate Taxes

Corporations pay tax on their taxable income, not on their revenue. In simplified form, taxable income is worked out in three steps:

1. Sales revenue − cost of goods sold (COGS) = gross profit
2. Gross profit − operating expenses (general and administrative costs, selling and marketing, research and development, depreciation and similar items) = earnings before interest and taxes (EBIT)
3. EBIT − interest expense = taxable income

The U.S. federal corporate rate is a flat 21%, down from 35% before the Tax Cuts and Jobs Act of 2017. The Inflation Reduction Act of 2022 added a 15% corporate minimum tax that applies only to very large companies, such as U.S. corporations with three-year average book income of $1 billion or more. Many states levy their own corporate income taxes on top of the federal one.

Sales Taxes

Sales tax is charged at the point of sale on certain goods and services. The customer pays it, and the business collects and remits it. There is no federal sales tax in the U.S. Each state sets its own rules, and cities and counties can often add their own rates within state limits. The total rate on the same purchase can therefore differ from town to town, and some items, such as groceries, are taxed differently or exempt in some states.

Many other countries tax consumption at each stage of production rather than only at the final sale, through a value-added tax (VAT) or a goods and services tax (GST).

Excise Taxes

Excise taxes apply to specific products or activities rather than to purchases in general. Common examples include taxes on gasoline, tobacco and alcohol. They are often a fixed amount per unit (per gallon or per pack) and are usually built into the price instead of being added at the register. Besides raising revenue, some excise taxes are meant to discourage the consumption they target.

Property Taxes

Property taxes are mainly local and a major funding source for schools and local services. The most common U.S. form is the real estate ad valorem tax, based on a property’s assessed value. A local government assessor sets that value, and reassessments typically happen every one to five years.

Real estate taxes are often expressed as a millage rate: the tax per $1,000 of assessed value. One mill equals $1 per $1,000.

Property tax = (Assessed value ÷ 1,000) × Millage rate

Rates vary considerably by jurisdiction, and many states also tax tangible personal property such as cars and boats.

Tariffs

A tariff is a tax a country imposes on imported goods. By raising the price of foreign products, tariffs are meant to make domestic alternatives more competitive. There are two main forms:

• Specific (fixed-fee) tariffs: a set amount per item or unit, based on the type of good.
• Ad valorem tariffs: a percentage of the item’s value, calculated the same way as a property tax.

The importer pays the tariff to customs, but part or all of the cost can be passed on to buyers through higher prices.

Estate and Inheritance Taxes

The federal estate tax applies to the value of a person’s property at death, but only to estates larger than an exclusion amount set by law. Only the portion above the exclusion is taxed:

Taxable amount = Estate value − Exclusion amount

Federal estate tax rates are progressive, starting at 18% and rising to 40%. The 40% rate applies to the portion of the taxable estate (after any lifetime taxable gifts are added back) that exceeds $1 million. Property left to a surviving spouse generally passes free of estate tax through the marital deduction.

Some states levy their own estate tax, often with a lower exclusion than the federal one, though no state taxes estates worth less than $1 million. An inheritance tax is different: it is paid by the beneficiary who receives the assets, rather than by the estate before assets are distributed. There is no federal inheritance tax, and only a few states impose one.

Ways to Classify Taxes

Beyond the categories above, taxes are often grouped by what triggers them:

• Transaction taxes arise when something is bought, sold or imported. Sales taxes, excise taxes and tariffs fall here.
• Taxes on net results apply to income or profit over a period, after allowable costs. Individual and corporate income taxes are examples.
• Event-based taxes arise from one-time or occasional events, such as an estate tax at death or a capital gains tax when an asset is sold.
• Holding taxes apply because you own something, regardless of whether it changes hands. Property tax is the main example.

Economists also distinguish direct taxes, paid by the person on whom they are levied (income tax, property tax), from indirect taxes, which a business collects or pays and then passes on through prices (sales tax, excise taxes, tariffs).

Example of Taxes

The hypothetical example below follows one person through several types of tax. Figures not stated in law above are invented for illustration.

Income tax. Assume a simplified progressive system with three brackets: 10% on the first $20,000 of taxable income, 20% on the next $30,000 (from $20,000 to $50,000) and 30% on everything above $50,000. Our taxpayer has $70,000 of taxable income.

The marginal rate is 30%, because that is the rate on the last dollar earned. The effective rate is $14,000 ÷ $70,000 = 20%. If this person earned another $1,000, only that $1,000 would be taxed at 30%, adding $300 to the bill.

Payroll taxes. Using the actual FICA rates, suppose the person’s wages are $60,000 and fall below the year’s Social Security wage base:

• Social Security: $60,000 × 6.2% = $3,720
• Medicare: $60,000 × 1.45% = $870
• Employee total withheld: $4,590

The employer pays a matching $4,590, so $9,180 (15.3% of wages) goes to Social Security and Medicare in total. These amounts are separate from income tax withholding.

Property tax. The person owns a home assessed at $250,000 in a hypothetical jurisdiction with a 20-mill rate: ($250,000 ÷ 1,000) × 20 = $5,000 per year.

Corporate tax. The same person owns shares in a small corporation with hypothetical figures of $10 million in revenue, $6 million in COGS, $2.5 million in operating expenses and $0.5 million in interest expense. Gross profit is $4 million, EBIT is $1.5 million and taxable income is $1 million. At the 21% federal rate, the federal tax is $210,000, before any state tax or the many adjustments real tax returns involve.

Estate tax. If an estate is worth $15.7 million and the exclusion were $15 million (a hypothetical figure), federal estate tax would apply only to the $0.7 million above the exclusion.

Why Do We Pay Taxes?

Taxes are the main source of government revenue. They pay for public goods that private markets provide poorly, such as roads, defense, courts and schools, and they fund social insurance. In the U.S., Social Security and Medicare have taken a growing share of federal spending as baby boomers have aged. Taxes also serve policy goals, such as encouraging long-term investment or shifting more of the burden to higher earners, and the trade-offs between fairness and growth keep tax policy under constant political debate.

Who Has to Pay Taxes?

Who pays depends on the specific tax and the law behind it:

• Federal income tax generally applies to people whose income exceeds a filing threshold, which depends on filing status, age and the type of income.
• Payroll taxes apply to employees and employers on covered wages, and to self-employed people on net self-employment earnings.
• Corporate taxes apply to companies incorporated in, or doing business in, the taxing jurisdiction.
• Sales, excise and property taxes fall on buyers of taxable goods and owners of taxable property, while sellers collect and remit sales taxes.
• Estate taxes apply only to estates above the exclusion amount.

Nearly every tax comes with exceptions, exemptions and special rules about who is covered.

Paying Taxes and Tax Delinquency

Each tax has its own payment schedule. Sales taxes and tariffs are collected at the transaction. Income and payroll taxes are mostly collected during the year through withholding or estimated payments, with an annual return to settle the difference. Property tax due dates are set by the local government and vary by county.

Failing to pay on time can lead to several consequences:

• A one-time penalty or fee
• Interest charges that grow the longer the balance remains unpaid
• A lien on the taxpayer’s assets
• Denial of access or service for transaction-based taxes such as tariffs (for example, goods held at customs)
• Seizure of business property or a lien on it for unpaid business taxes

Distinctions People Confuse

Tax evasion vs. tax avoidance. Evasion is deliberately failing to pay taxes you legally owe, for example by hiding income, and it is a crime. Avoidance means arranging your finances within the law to reduce your tax, such as contributing to tax-advantaged retirement accounts, holding investments long enough to qualify for long-term rates, or harvesting investment losses to offset gains.

Payroll tax vs. income tax. Both are withheld from your paycheck, but payroll taxes fund Social Security and Medicare specifically and use flat rates. Income tax goes into general government revenue and uses progressive brackets.

Statutory vs. economic burden. In economics, a tax falls on whoever ultimately bears its cost, which may differ from whoever the law requires to pay. A business that pays a tax may pass some of it to customers through higher prices, to workers through lower wages, or to owners through lower profits.

Taxes vs. fees. A fee, such as a park entrance charge or a passport fee, is paid in exchange for a specific service. A tax is owed regardless of whether you use any particular government service.

Limitations of Taxes

Taxes raise revenue, but they come with costs and complications:

• Behavioral distortions: higher taxes on an activity tend to reduce it, which is the intent for excise taxes but a side effect for taxes on work, saving or investment.
• Uneven burden: sales and excise taxes can be regressive, and the exemptions and credits that address this add complexity.
• Complexity and compliance costs: brackets, deductions, filing statuses and holding-period rules mean time and money spent on record-keeping and tax preparation.
• Jurisdictional variation: rates and rules differ across countries, states and localities, so a familiar tax may work differently or not exist at all in a new place.

The Bottom Line

Anyone who earns wages, runs a business, owns property or plans an estate deals with several kinds of tax at once, each with its own base, rate and payment schedule. Knowing the difference between marginal and effective rates helps you read your own tax bill accurately. Keeping purchase and sale records and paying on time help you avoid penalties, interest and liens.