What Is Income Tax?
The term “income tax” refers to a type of tax that governments impose on the income generated by businesses and individuals within their jurisdiction. By law, taxpayers must file an income tax return annually to determine their tax obligations.
Income taxes serve as a substantial revenue source for governments, enabling them to fund public services, pay government obligations, and provide essential goods for citizens. In the United States, the federal government, many states, and local jurisdictions each levy their own income taxes. Some investments, like housing authority bonds, are sometimes exempt from income taxes.
Key Takeaways
- Income tax is imposed on earnings generated by individuals and businesses.
- This tax supports public services, government obligations, and citizen welfare.
- Both federal and many state/local jurisdictions impose income taxes.
- Personal income tax pertains to individual earnings such as wages, salaries, and other forms of income.
- Business income taxes apply to corporations, partnerships, small businesses, and the self-employed.
How Income Tax Works
The Internal Revenue Service (IRS) is responsible for collecting taxes and enforcing tax law in the United States. The IRS has a complex set of rules dictating reportable and taxable income, allowable deductions, credits, and more. It collects taxes from various forms of income including wages, salaries, commissions, investments, and business earnings.
Personal income tax collected helps fund numerous government programs and services such as Social Security, national security, education, and infrastructure.
History of Income Tax
The United States first imposed an income tax in 1862 to finance the Civil War. Initially repealed post-war, it was reinstated with the Revenue Act of 1913, along with the introduction of Form 1040. Today, the U.S. follows a progressive income tax system where higher earners pay a higher tax rate. Federal income tax rates range from 10% to 37%.
Types of Income Tax
Individual Income Tax
Individual or personal income tax is levied on an individual’s wages, salaries, and other income categories. Owing to various exemptions, deductions, and credits, most people do not pay taxes on all their earnings.
The IRS offers taxpayers a range of deductions and credits. Deductions lower your taxable income, and credits reduce your tax liability. For example, if an individual earns $100,000 and has deductions amounting to $20,000, their taxable income reduces to $80,000. On the other hand, a tax credit directly lowers the amount of tax owed.
Business Income Tax
Businesses also have to pay income taxes on their earnings. Depending on the business structure, income may be reported by the corporation, its owners, or shareholders. After deducting operating and capital expenses from their income, the difference is considered taxable business income.
State and Local Income Tax
Many U.S. states levy personal income taxes, although eight states do not: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. Tennessee repealed its Hall tax on dividends and interest in 2021. New Hampshire still taxes dividends and interest but will phase out this tax by 2024, which will bring the total number of states without income tax to nine.
What Percent of Income Is Taxed?
The tax percentage depends on your income and filing status. Generally, higher earners pay a higher percentage due to the progressive tax system. Federal income tax rates range from 10% to 37%.
How Can I Calculate Income Tax?
To calculate income tax, aggregate all taxable income earned in a tax year. Next, calculate your Adjusted Gross Income (AGI) by subtracting eligible deductions from your total income. This results in your taxable income and eventual tax obligation.
Which States Have No Income Tax?
States without any state income taxes include Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. New Hampshire will phase out taxes on dividends and interest by 2024, making it another state without income tax.
The Bottom Line
All U.S. taxpayers are required to pay federal income tax, and depending on the state, they may need to pay state and local income taxes as well. The progressive tax system ensures higher earners pay a proportionately higher tax rate, and various exemptions and deductions mean most taxpayers do not pay tax on their entire income.
Related Terms: Adjusted Gross Income (AGI), Taxable Income, Tax Deduction, Tax Credit, Standard Deduction, Itemized Deductions.
References
- Internal Revenue Service. “Qualified Residential Rental Property — Multifamily Housing Bonds”.
- Internal Revenue Service. “The Agency, Its Mission and Statutory Authority”.
- Internal Revenue Service. “About Publication 17, Your Federal Income Tax (for Individuals)”.
- Internal Revenue Service. “Tax Topics: Types of Income”.
- U.S. Department of the Treasury, Office of Tax Analysis. “Tax Expenditures (2023)”. Pages 22-24.
- Internal Revenue Service. “Historical Highlights of the IRS”.
- Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2024”.
- Internal Revenue Service. “Federal Income Tax Rates and Brackets”.
- Internal Revenue Service. “Credits and Deductions for Individuals”.
- Internal Revenue Service. “Definition of Adjusted Gross Income (AGI)”.
- Internal Revenue Service. “Topic No. 407 Business Income”.
- Internal Revenue Service. “What Is Taxable and Nontaxable Income?”
- Internal Revenue Service. “Publication 535, Business Expenses”. Pages 3-6.
- Tennessee Department of Revenue. “HIT-4 — Hall Income Tax Rate”.
- New Hampshire Department of Revenue Administration. “Frequently Asked Questions — Interest & Dividend Tax”.
- Tax Foundation. “New Hampshire Could Become the Ninth Income Tax-Free State”.
- Tax Foundation. “Taxes in Tennessee”.
- Tax Foundation. “Taxes in Florida”.
- Tax Foundation. “State Tax Changes Taking Effect January 1, 2024”.
- New Hampshire Department of Revenue Administration. “Frequently Asked Questions — Interest & Dividend Tax: What Is the Interest and Dividends Tax (I&D Tax)?”
