An income tax is a tax that the government levies on the income of businesses and individuals within its purview. By law, taxpayers file an annual income tax return to determine their tax liability.
Income taxes are a source of government income. Government income is needed to pay for public services, government obligations, and to provide citizens with goods.
Some investments are not taxable. For example, housing authority bonds.
How Income Tax works
Many countries use a progressive income tax system. It means that people with higher incomes pay a higher tax. The first tax on income in the United States was implemented in 1862 to finance the Civil War. It was canceled after the war and returned in the early 20th century.
There is an Internal Revenue Service (IRS) in the U.S, collecting taxes and passing tax laws. The IRS has a large set of rules and regulations for taxable income and other financial motions. All types of income (wages, salaries, investments, business income) are taxed.
The government income tax helps pay for government programs and social services, such as Social Security, Homeland Security, schools, and roads.
Types of income tax
Individual income tax (personal income tax) is collected by the state on an individual's salaries, wages and other income types. Not all people’s income is taxed due to exemptions, deductions and credits.
The IRS has a number of tax deductions and credits that allow taxpayers to reduce their taxable income. A deduction can reduce taxable income and tax rate. A tax credit reduces the income tax by giving a larger refund of taken tax.
The IRS has tax credits for health care expenses, deposits, and education expenses. For example, a taxpayer's income is $100 and he or she has a tax deduction of $20, his or her taxable income would be $80 ($100 - $20 = $80).
Tax deductions are needed to reduce a taxpayer's liability or owed amount. They were created for middle- and low-income families. For example, if an individual's tax debt is $20 and he or she has a tax deduction eligibility of $4.5, his or her tax liability is reduced to $15.5 ($20 - $4.5 = $15.5).
Corporate income taxes. Companies, businesses, and self-employed contractors also pay income tax. The IRS takes the information about income from corporations, then deduct expenses. The difference between business income and expenses is taxed as corporate income.
State and local Income taxes. Individuals in the U.S. also pay taxes except for 8 states: Alaska, Florida, Nevada, South Dakota, Texas, Tennessee, Washington, and Wyoming. Tennessee canceled the dividend and interest tax on January 1, 2021. The New Hampshire state also has no income tax, but does have a 5% tax on any dividends and interest. In 2018, New Hampshire passed a bill that would cancel the interest and dividend taxes of 5% on January 1, 2024. So, in 2024, there will be 9 states without income tax.
The cost of living in a state with no income tax is not cheaper. States often have other taxes or lack of services for income supplementation. There are other factors that affect the cost of living in a state (living expenses, health care, employment opportunities). For example, Florida has a 6% sales tax on goods and services, and Tennessee has a 7% sales tax.
Main findings about Income Tax
- A tax on the business and individual income within their purview is an income tax.
- Social services and good provision are made with money from the income tax.
- Income tax applies to an individual's wages, salaries, and other income.
- Businesses and self-employed people pay business income tax.