What Is Tax?

There are few things in life more complicated than taxes, with various levels of government collecting taxes at numerous levels. While taxes are not simple, understanding how they work is essential for anyone who is planning to earn income, collect interest or earn capital gains. We'll take you through some basic taxes, with plain-English explanations, to help you better understand the system.

Types of Taxes

There are many different types of taxes. In this section, we will give a brief overview of each.

Personal Income Tax

The most common taxes are taxes on income, also known as personal income tax. Personal income tax is the tax you pay on your salary or wages. The tax is collected by the government on behalf of the country, state and/or other taxing authority, and the money is used to pay for public services such as roads, schools, and police and fire departments.

The amount of income tax you pay depends on your income, your filing status and your deductions. Deductions are the expenses you take off your total taxable income to reduce your taxable income figure. You can claim deductions for mortgage interest, donations to charity, medical expenses and other items. The higher the deductions, the lower your taxable income.

Personal income tax is generally withheld from your paycheck and paid to the government by your employer. Self-employed individuals and independent contractors on the other hand must make estimated tax payments throughout the year and report the payments to the government on their income tax returns.

Personal income tax can also apply to investment income, such as interest income, rent, dividends and capital gains.

Sales Tax

Sales taxes are taxes imposed by a state or local government on certain goods and services. The tax is paid by the consumer at the time of purchase, and the tax rate depends on the type of good or service purchased.

Sales tax is typically calculated as a percentage of the purchase price or the sale price, where the sale price is the price you pay after any discounts are taken off. For example, if a store sells a computer for $1,000, and the computer is subject to a 5-percent tax rate, the store will collect $50 of tax on the purchase.

Sales tax is imposed on most tangible personal property, including food items, clothing, medicines, books, magazines, movies, music, newspapers, food, beverages, drugs, tobacco products, cars, computers, jewelry, furniture, prescription drugs, medical devices, and cars.

Property Tax

Property tax is a tax imposed by the local or state government on the value of real property, such as buildings and land. Property tax is based on the fair market value of the property and is typically due every year. The amount of property tax you pay depends on what jurisdiction you live in and the assessed value of your property.

Like other taxes, property tax is imposed to raise revenue for government services. Property tax is charged on residential, commercial and industrial properties. Property tax is usually imposed by the state, but some local governments also have the power to impose property tax.

A property tax assessment is typically conducted by an independent assessment authority. Assessment authorities are appointed to assess the value of different properties based on present-day fair market value. The resulting tax bills are then sent to the property owners.

Other Taxes

There are other types of taxes that are imposed by various levels of government. Some of these are excise tax, service tax, inheritance tax, luxury tax, capital gains tax, gift tax, estate tax, property transfer tax, sin tax, and a multitude of other miscellaneous taxes.

Why do Governments Tax?

Governments tax to raise revenue for their operations. Tax revenue pays for public services, which include firefighting, road maintenance, trash collection, police protection, schools, military defense, public transportation, environmental protection, and health care.

Governments can also tax to influence behavior. For example, taxes on cigarettes, gambling or alcohol might be collected to discourage risky and unhealthy activities.

Do You Really Have to Pay Taxes?

In general, yes. While there may be a few ways to avoid paying taxes, most individuals and businesses must report their income and pay taxes. The tax rules are very complex and can be confusing. Therefore, it is wise to consult with a professional tax advisor to assist in preparing your taxes. Failure to pay taxes can result in penalties, interest, and even criminal prosecution.