What Are Taxes?

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DEFINITION
Taxes are payments to federal, state, and local governments to fund their expenditures. The three main types of taxes are applied to income, wealth, and consumption.

Taxes are payments to federal, state, and local governments to fund their expenditures. The three main types of taxes are applied to income, wealth, and consumption. For example, individuals and businesses are subject to federal income taxes, and people who own real estate must pay property taxes.

Learn what taxes are, how they are assessed, and whether you need to pay them.

Definition and Examples of Taxes

Taxes are payments that individuals and businesses make to governments so that these governments can function and provide benefits to those within their jurisdiction. Other methods of paying for the government’s expenditures include issuing public debt and printing money.

For example, every year, the United States government spends trillions of dollars, and it offsets the majority of these expenses by collecting taxes from individuals, small businesses, and corporations.

Individual income taxes account for approximately 50% of the federal government’s revenue, with Social Security and Medicare taxes comprising an additional 30%. Corporate income taxes make up about 10% of the federal government’s revenue.

Other taxes—such as excise taxes and estate and gift taxes—generally account for less than 5% of the government’s revenue.

How Taxes Work

The government that imposes each tax has a particular set of laws governing the amount and collection of that tax. Those laws and the type of tax determine how different tax systems work. 

That said, some key concepts generally apply across tax systems, such as:

  • Tax base: The items or activities subject to a tax.
  • Tax rate: The percentage of a taxpayer’s tax base that is used to calculate the taxpayer’s tax liability.
  • Tax return: A form or series of forms filed by taxpayers with the government imposing the tax on which a taxpayer’s tax liability is calculated and tax payments are reconciled.

For example, for the federal income tax, the tax base is a taxpayer’s taxable income, the tax rates are set every year by the IRS, and the tax return that most individual taxpayers use is Form 1040.

Types of Taxes

There are three major types of taxes:

  1. Taxes based on income
  2. Taxes based on consumption
  3. Taxes based on wealth

Taxes Based on Income

Taxes based on income, or income taxes, are taxes assessed on an individual’s or business’s earned and unearned income. The federal government collects income taxes, as do most states and some local governments.

In the United States, both individuals and certain businesses such as corporations pay income taxes, though the federal government collects far more in personal income taxes than in corporate income taxes.

The Internal Revenue Service (IRS) is responsible for collecting federal income taxes.  Other governments—such as states and cities—have their own revenue departments responsible for the collection and administration of their respective tax systems.

Taxes Based on Consumption

Taxes based on consumption are imposed on things that people buy. Sales taxes and excise taxes are examples of taxes based on consumption.

While sales taxes are generally imposed across the board on nearly all sales of goods or services in jurisdictions that impose them (unless specifically exempted), excise taxes are imposed on the sale of specific items.

There is no federal sales tax in the United States, but many states and cities have a sales tax.

Taxes Based on Wealth

Taxes based on wealth are taxes imposed on things people own. For example, property taxes—such as those imposed based on the assessed value of real estate or other property—are the main source of revenue for many local governments.

Other examples of taxes based on wealth are inheritance, estate, and gift taxes.

Do I Need To Pay Taxes?

Whether you need to pay taxes depends on where you work, shop, earn income, and live, and how the governments of those jurisdictions tax income, consumption, and wealth.

Some taxes will be imposed on you automatically. For example, if your state imposes a sales tax, you will likely have to pay it whenever you purchase goods or services subject to the sales tax. Businesses in your state will be required to collect this sales tax from their customers to remit to the state government.

For other taxes—such as income taxes—you may be responsible for filing a tax return with the federal government, your state government, and/or your local government in which you calculate your tax liability.

If you are employed, your employer may be required to withhold income taxes, Social Security taxes, Medicare taxes, and other taxes from your paycheck.

If you are not sure if you need to pay taxes, it’s a good idea to consult with a tax professional.

Key Takeaways

  • Taxes are payments made by individuals and businesses to the government to fund its spending.
  • Federal, state, and local governments can all impose taxes.
  • The vast majority of the federal government’s revenues come from taxes, and most of the taxes the government collects are paid by individuals.
  • There are three major types of taxes: income taxes, consumption taxes, and wealth taxes.

Article Sources

  1. Data Lab. “Sources of Revenue for the Federal Government.” Accessed Dec. 15, 2021. 

  2. U.S. Department of the Treasury. “Economics of Taxation.” Accessed Dec. 15, 2021.