What You Need To Know About The American Tax System 

american tax system

It’s no secret that the American tax system is incredibly complex. Many people think it is incomprehensible and unfair, only benefiting corporations and big businesses and not the mass working population.  

To help you understand the American tax system better, we’ll go over how the system works and highlight some major issues that arise in this vast, complicated setup in this post. 

Let’s get to it!

How does the American tax system work?

Once you make over a certain amount of money, you must pay taxes, so it’s crucial to get a general understanding of how the tax system works in the United States.

Overview

The federal government can only function financially through collecting taxes and fees from many different sectors of the economy, and you might not be surprised to learn — the largest sources of government revenues are individual income taxes and payroll taxes.

While nearly all American citizens have to pay taxes, the type and amount of taxes paid are individually different. Well-off Americans pay a larger share of their income in individual income taxes, corporate taxes, and estate taxes compared to lower-income groups. However, lower-income groups pay a greater portion of their earnings to payroll and excise taxes than wealthy Americans.

Overall, the U.S. tax code is progressive, with higher-income taxpayers paying a larger share of their income in taxes. That is true, but high-income Americans can benefit disproportionately from tax breaks, which are also known as tax expenditures. Some find this extremely unfair, and we’ll take a look at that later in this post. 

How it’s managed

The Internal Revenue Code (IRC), generally known as the tax code, is written by Congress, the legislative part of the United States government. The tax code governs tax collection, the application of federal tax laws, and the issue of tax refunds, rebates, and credits. These functions are carried out by the Internal Revenue Service (IRS), a government department of the United States Department of Treasury.

What are the different types of taxes?

There are so many different types of taxes in the U.S. But don’t worry, not all taxes apply to everyone. Below are some examples of the most common taxes:

Income tax 

The U.S. federal income tax is a tax imposed by the Internal Revenue Service (IRS) on the annual earnings of individuals, corporations, trusts, and other legal entities. Federal income taxes apply to all forms of earnings, including wages, salaries, commissions, bonuses, tips, and investment income.

In the U.S.tax system, federal income tax rates for individuals are progressive. As taxable income increases, so does the tax rate. Federal income tax rates range from 10% to 37% and are staggered at specific income thresholds. These are called tax brackets, and income that falls within each bracket is taxed at the corresponding rate.

Capital gains tax 

The tax on the profits generated from an investment after it has been sold is known as capital gains tax, so please note that no taxes are due on stock shares until they are sold, regardless of how long they are kept or how much their value increases. 

The capital gains tax rate in the United States now applies exclusively to income on the sale of assets held for more than a year, also known as long-term capital gains. The current rates are 0%, 15%, or 20%, depending on the taxpayer’s tax bracket for the current year. The short-term capital gains tax is applied to assets that are sold within one year of their purchase date. Ordinary income is taxed on this profit. For most low-to-middle-income taxpayers, this is a higher tax rate than the capital gains rate.

Payroll tax 

A payroll tax is a percentage withheld from an employee’s pay and paid to the government on the employee’s behalf by their employer. Federal payroll taxes are subtracted from an employee’s wages and remitted to the Internal Revenue Service (IRS).

Sales tax 

A sales tax is a government-imposed consumption tax on selling goods and services. The majority of sales taxes are collected by retailers and passed on to the government. Depending on the regulations in the jurisdiction, a business is liable for sales taxes if it has a link or connection to that area, which can be a store or office, an employee, an associate, or some other presence.

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What are the different types of taxpayers? 

We can divide taxpayers into two main categories: 

1. Individuals

Individual taxpayers go into one of 2 groups: citizen or immigrant (an alien is a person who resides within a country’s borders and is not a national of that country). A citizen can also be classed as a resident or a non-resident.

2. Corporations 

Domestic, foreign, and partnership corporations are the three types of corporations. There are two types of foreign corporations: resident foreign corporations and non-resident foreign corporations. 

A foreign corporation engaged in trade or business in the country is referred to as a resident foreign corporation. A foreign corporation that is not engaged in trade or business within the country but receives income from sources within the country is known as a non-resident foreign corporation. 

A partnership is a business arrangement in which two or more people share a company’s ownership and management responsibilities. Because a partnership is not a legal entity apart from its owners, it does not pay taxes.

What Does the Government Actually Do With The Taxes It Collects?

The U.S. government collects income taxes and payroll taxes from individuals and corporate income taxes from companies. The government then distributes the money to different government agencies for specific purposes that benefit or protect the nation and its citizens. Social Security and welfare programs, the education system, national parks, police departments, and the maintenance and development of public infrastructure are all funded by U.S. tax dollars.

What are the main issues with the American tax system? 

Most taxpayers agree that some form or amount of taxation is necessary to fund the government. However, there are many differing views about the size of government and its corresponding funding, the optimal structure of a tax system that’s fair to all, the system’s effective rates, and its impact on different groups in society.

As with all systems, individuals and corporations will do their best to find workarounds and loopholes to use to their advantage. And it is who can take advantage of these loopholes that seems to be unfair, with most taxpayers believing the U.S. tax system favors the wealthy and doesn’t benefit the majority of the population.

Most U.S. taxpayers consider an income tax system that applies higher rates on higher income levels to be fair. At the moment, it doesn’t seem to be that way especially when it comes to businesses, particularly large corporate businesses.

Let’s look at some of these issues in more detail.

1. Higher Benefits for Higher Tax Brackets

Although tax rates on taxable income are progressive, which means big businesses should be paying more, there are ways for these corporations to pay a lesser rate. Ways that lower-income individuals can’t. Let’s have a look at some below:

Exemptions and exclusions for certain types of income—for example, tax-exempt interest paid on state and local government bonds.

Special, lower rates for some income categories, such as capital gains and dividends

Deductions for a wide range of expenditures, including some business expenses

These adjustments can result in much lower effective tax rates on the incomes of high-income, wealthy individuals, which lower incomes miss out on. These deductions can also enable taxpayers with extremely high earnings and investment returns to avoid any tax liability at all.

2. Deductions and tax credits

Deductions benefiting taxpayers by lowering their taxable income are regressive. To calculate how much deductions you can take, multiply the amount of your deductible expenses by your marginal tax rate. For instance, if your income is in the top 37 percent tax bracket, every $100 saved from income that would otherwise be taxed at this rate saves the taxpayer $37. If the appropriate rate is 24%, a $100 reduction in income would result in only $24 in savings. 

Meanwhile, with a tax credit, a taxpayer can only save a flat rate that is equal for everybody. Regardless of income level or tax category, a 20% tax credit will save taxpayers $20 in tax liability for every $100 spent.

However, most tax credits are non-refundable. If your tax credits are higher than your tax liability, you won’t be able to take advantage of the credits’ benefits fully. 

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3. Corporate Tax Avoidance

Currently, the tax law generally applies a corporate income tax of 21%. However, many U.S. corporations pay far lower rates or no tax at all because of substantial business write-offs and aggressive tax planning. Once again, these write-offs just aren’t available to the vast majority of U.S. taxpayers.

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Special Corporate Tax Deductions That You Need to Know

The bottom line 

Most Americans would like to see a less complex and fairer tax system. The tax code is constantly being updated, which can be even more confusing. New guidelines, new forms, and new criteria are always being introduced. Stay on top of your taxes and up-to-date with the latest tax changes by subscribing to the Shoeboxed blog. We’re here to help!

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