What are taxes and why do people talk about them all the time? The answer is simple: taxes are the money paid by people to fund their government. Taxes are used to fund all the actions of government, including salaries of government officials and services provided by government agencies. Taxes are collected from citizens or residents in a number of ways, including income taxes (i.e. the government taking a certain percent of an individual’s wages) and sales taxes (i.e. the government adding an additional percentage to the cost of goods or services).
Total taxes owed to the government are difficult to calculate. The “tax burden”, or amount of taxes one owes to the government, is a function of many factors, including total income (including a spouse’s income), number of dependents (i.e. children), where someone lives, charitable contributions, and much more.
Each year, taxpayers have to file a “tax return”, which is an end-of-year summary of the total amount of taxes they owe to the government and the total amount of taxes that they have paid so far in the year. If they paid more in taxes during the year than they owe, taxpayers will receive a refund check from the government – this is effectively returning the money that the taxpayer over-paid. If they did not pay enough money in taxes and they owe more to the government, the taxpayer will have a certain period of time to pay the government what they owe in “back taxes.”
What is the purpose of taxes?
Taxes pay for all the functions of government. In order for government agencies to pay salaries and provide services to, they need to have some form of income. A small amount of government revenue comes from fees on imported products and other marginal revenue sources, but the vast majority comes from tax revenue.
The money collected from taxes are used to pay for everything the government oversees:
- Schools
- National defense
- Police & fire departments
- Healthcare services
- Public transportation
- Social Security
- And much more
What are the different types of taxes?
When people think of taxes, they usually think of one of two common taxes: income tax or sales tax. These are the most visible taxes and are easiest to see in your daily life. However, there are three broad categories of taxes:
- Taxes on what you earn
- Taxes on what you already have
- Taxes on what you buy
Taxes on what you earn include charges for money as you earn it, in the form of wages for working, distributions from investments, and sales of property or investments. Some taxes on earnings include:
- Individual income taxes – when people pay a certain percentage of their income they receive from working a job
- Capital gains taxes – when people pay a certain percentage of the income they receive from selling something they own (e.g. a car, a house, shares of stock, etc.)
- Corporate income taxes – when business pay a certain percentage of their profit in taxes
- Payroll taxes – additional taxes on wages paid to employees of a business, which are partially paid by the business and partially paid by employees
Taxes on what you already own allow the government to extract revenue from what citizens possess. Some taxes on what you own include:
- Property taxes – when home owners pay the government taxes based on the value of their property. This is most commonly associated with taxes on land and buildings.
- Tangible personal property taxes – when the government charges taxes based on the value of large personal possessions (e.g., cars).
- Estate taxes – when a certain percent of the estate (the money and property of someone who dies) is paid to the government instead of going to a beneficiary.
Taxes on what you buy are a way of taxing consumption. Some consumption taxes are used to nudge people away from behaviors the government wants to minimize. By taxing something, the government makes that thing more expensive and discourages people from buying it. Some taxes on things you buy include:
- Sales taxes – when the government adds a few percent to a purchase price of all goods and services bought by consumers
- Excise taxes (also known as “sin” taxes) – when the government adds specific fees for purchasing products with negative societal impacts, such as cigarettes or alcohol.
Who is in charge of taxes?
In the United States, the government agency responsible for collecting federal taxes is the Internal Revenue Service (IRS). The IRS enforces tax laws and does spot checks called audits on individuals and businesses to make sure they are paying the full amount of taxes owed. There are individual state comptroller offices to collect state-specific taxes (e.g. state income tax) and serve as smaller versions of the IRS at the state level. An example of this is the Texas Comptroller of Public Accounts.
The IRS does not, however, write tax laws. The US Congress determines federal taxes and tax rates, and writes the laws that the IRS has to enforce. Similarly, state legislatures write the state tax codes that the state tax collector offices enforce.
How do taxes impact prices?
At a very basic level, taxes increase the price of a product. Let’s use an example: you want to buy a $10 sandwich. At that $10 price level, a certain number of people would be willing to pay for that exact sandwich and others would be unwilling. If the local government imposed a 80% tax on that sandwich, the cost that the shop would charge becomes $18 ($10 x 1.8). At a $18 price level, fewer people would be willing to pay for that sandwich. In other words, adding a tax on that sandwich decreased the number of people who would be willing to buy it.
What about the flip side? If the local government wanted more people to purchase sandwiches, they would subsidize those purchases. The local authorities may provide a $5 per sandwich subsidy, which makes the effective price of the sandwich $5 ($10 price – $5 subsidy). At a $5 price level, more people would be willing to pay for that sandwich compared to the original $10 price. By subsidizing the sandwich, the local government will likely encourage purchases of sandwiches.
This is the central tenet of taxes: by changing the price of a product or service, taxes can influence behaviors. If a governing authority wants to discourage a certain behavior, they should apply a tax. This is exactly what happens with “sin taxes” in the U.S., where certain products (e.g., tobacco) are subject to additional taxes to increase the price and decrease demand.
