Taxes and tax system: What are they and why are they paid?

Taxes are a fundamental part of the economic life of any nation, including the U.S. These taxes are the backbone that allows the financing of essential public services that directly impact the quality of life of citizens.

But what are taxes really, how do they work in the USA and who is obliged to pay them? In this article, we explore these key concepts and delve into the importance of taxes in American society.

From their role in the redistribution of wealth to their contribution to economic efficiency, we will discover why taxes are a fundamental pillar in the country.

Keep reading!

What Are Taxes?

Taxes are compulsory tributes that citizens are obliged to pay as a result of certain events, actions or transactions, without receiving direct compensation in return.

These taxes play an essential role in the maintenance of the State as they result in the financing of fundamental public services such as pensions, health care, education, security and the construction of infrastructure.

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Role of Taxes in the State and Society

Taxes play a crucial role in the functioning of a state and society as a whole. They are the main source of public revenue, enabling the government to:

Fund Public Services: Taxes are essential to provide basic services such as health care, education, infrastructure and security. Without tax revenues, these services would be severely affected.

Redistribute Wealth: Taxes are levied in proportion to each citizen’s income, which helps reduce economic disparities and redistribute wealth more equitably.

Promote Economic Efficiency: Taxes can be used to tax activities that generate negative impacts on people who do not participate in those activities, thus promoting a more efficient and sustainable economy.

Dampen Crises: Fiscal policy, including the ability to increase or reduce taxes, can be used as a tool to mitigate the effects of economic crises by stimulating or restraining demand.

How Do Taxes Work in the U.S.?

The United States employs a progressive tax system, meaning that tax rates for individuals and businesses vary based on their income levels. The primary form of taxation in the U.S. is the federal individual income tax, encompassing a range of tax brackets extending from 10% to 37%.

These tax rates are applied to taxable income, calculated as adjusted gross income minus the standard deduction or allowable itemized deductions. Income up to the standard deduction or itemized deductions is not subject to taxation and falls within a zero percent tax rate.

This federal income tax system operates progressively, with tax rates increasing as an individual’s taxable income rises. Distinct tax rates are imposed on different income ranges, referred to as brackets, contingent on the taxpayer’s filing status.

For instance, in 2020, the highest tax rate of 37% applied to taxable income exceeding $518,400 for single filers and $622,050 for married couples filing jointly.

There are separate tax schedules and rates for heads of household and married individuals filing separately. Additionally, capital gains and dividends are subject to their unique tax rate schedule, with tax brackets adjusted annually to accommodate inflation.

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Each tax rate is applicable only to income within its specific bracket. If a taxpayer’s income surpasses the threshold for a higher tax bracket, only the income within that bracket is taxed at the elevated rate, while the rest remains subject to lower bracket rates.

For example, if a single filer has a taxable income of $60,000, they fall within the 22% tax bracket. However, their tax liability isn’t $13,200 (22% of $60,000) but is calculated as 10% of the initial $9,875, 12% of the subsequent $30,250 ($40,125 – $9,875), and 22% of the remaining $19,875 ($60,000 – $40,125), totaling $8,990.

The U.S. tax system generally features tax brackets for married taxpayers that are twice the size of those for single individuals, though exceptions exist. This sometimes leads to a “marriage penalty” situation where certain couples face higher taxes when filing jointly instead of separately. Conversely, many married couples enjoy a “marriage bonus” because their tax brackets, being generally double the size of those for singles, enable them to pay less in taxes when filing jointly.

Who Must Pay Taxes?

In the United States, just like in many countries, the responsibility of paying taxes lies with citizens and businesses that earn income and make profits.

The U.S. tax system features various tax brackets and rates to ensure that individuals with higher incomes contribute more towards funding public expenditures and supporting societal well-being.

American taxpayers are required to file their tax returns and adhere to their tax responsibilities in line with existing tax laws and regulations. For further information you may reach out to a tax advisor.

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