Introduction

Taxation in the United States operates through a multi-layered system involving federal, state, and local governments, each with its own authority to levy taxes. Taxes in the U.S. cover various areas including income, payroll, property, sales, capital gains, dividends, imports, estates, and gifts, along with numerous fees. In 2020, the total tax revenue collected by these different levels of government accounted for 25.5% of the Gross Domestic Product (GDP), which is notably lower than the OECD average of 33.5% of GDP.

Progressive Tax System

The tax and transfer policies in the U.S. are designed to be progressive, meaning that tax rates generally increase as the amount of taxable income increases. This system aims to reduce effective income inequality. Lower-income workers, particularly those with dependents, often pay no income taxes and may even receive small subsidies from the federal government through credits such as the Child Tax Credit and the Earned Income Tax Credit. Conversely, taxes are imposed more heavily on labor income compared to capital income, with differing rates and subsidies for various types of income and expenditures potentially creating indirect taxation on certain activities.

Taxation Structure

In the U.S., taxes on net income are imposed on individuals and corporations by federal, most state, and some local governments. Citizens and residents are taxed on their global income, but they can claim a credit for foreign taxes paid. The amount of taxable income is determined by specific tax accounting rules rather than financial accounting principles. Notably, the Inflation Reduction Act of 2022 introduced a 15% minimum tax on large corporations based on their annual financial statement income.

Deductions and Exemptions

Business expenses generally reduce taxable income, though some expenses are subject to limits. For individuals, taxable income can be reduced by personal allowances and specific non-business expenses such as home mortgage interest, state and local taxes, charitable contributions, and medical expenses exceeding certain income thresholds. State rules for determining taxable income often differ from federal rules, with federal marginal tax rates ranging from 10% to 37% of taxable income. State and local tax rates vary widely, from 0% to 13.30% of income, with many states imposing graduated tax rates. The Tax Cuts and Jobs Act of 2017 introduced a $10,000 cap on the deduction for state and local taxes (SALT), which has increased the effective tax rate for medium and high earners in high-tax states.

Global Taxation and Foreign Income

The U.S. is unique among countries in taxing its non-resident citizens on their worldwide income at the same rates as residents. The constitutionality of this approach was upheld in the case of Cook v. Tait. However, U.S. citizens and certain residents working abroad can exclude up to $120,000 of foreign-earned income from U.S. taxation, adjusted for inflation in 2023. Additionally, payroll taxes, including Social Security and Medicare taxes, are levied by both federal and state governments at a combined rate of 15.3%, although Social Security tax is applied only to wages up to a certain limit, with additional Medicare taxes imposed on higher wages.

Property and Sales Taxes

Property taxes are primarily imposed by local governments and special purpose authorities, based on the fair market value of property. Rates vary significantly, ranging from 0.2% to 1.9% of a property's value depending on the state. Sales taxes are applied by most states and some localities to retail sales of goods and services, with rates varying from 0% to 16%. Sales tax is collected by the seller at the time of sale, or as a use tax by buyers who did not pay sales tax at the point of purchase.

Customs Duties and Estate Taxes

The federal government imposes tariffs or customs duties on the import of many goods, with rates varying from 0% to over 20% depending on the type of goods and their country of origin. Estate and gift taxes are levied by both federal and some state governments on the transfer of property through inheritance or lifetime donations. Federal estate and gift taxes apply to worldwide property and provide a credit for foreign taxes paid.

Types of Taxpayers

Taxes in the U.S. are imposed on various entities including individuals, business entities, estates, trusts, and other organizations. The tax base can vary based on property, income, transactions, transfers, imports, or other factors relevant to the taxpayer. For instance, property taxes are usually imposed on property owners, while income taxes can affect the members of a business entity based on their share of the entity’s income.

Income Tax System

Income tax in the U.S. is levied at federal, state, and some local levels. The tax system defines taxable income and applies specified rates to it. Taxable income can be reduced by credits and deductions, some of which may be refundable. The history of income tax in the U.S began with the Revenue Act of 1861 during the Civil War. Although the Supreme Court ruled a federal income tax unconstitutional in 1895, the Sixteenth Amendment to the U.S. Constitution ratified in 1913 reestablished federal income tax authority, leading to a series of Supreme Court decisions that upheld this taxation structure.

Taxation of Income

Income tax is imposed based on income levels, with different rates for individuals, corporations, estates, and trusts. Taxable income is calculated as gross income minus exemptions, deductions, and personal allowances. Gross income includes all receipts and gains from all sources and is not limited to cash received. Certain types of income, such as interest from state and local bonds or certain benefits, may be exempt from taxation. Foreign non-residents are taxed on U.S.-source income, with tax rates often reduced by treaties.

Filing Status and Tax Rates

There are several filing statuses for federal individual income taxes, including single, married filing jointly, married filing separately, head of household, and qualifying widow(er). Each status influences the deductions and credits available to taxpayers. Income tax rates are graduated, meaning higher levels of income are taxed at higher rates. Federal income tax rates for individuals range from 10% to 37%, while corporate income is taxed at a flat federal rate of 21%. State income tax rates vary, with some states imposing no income tax at all.

Conclusion

The U.S. tax system is complex, involving multiple layers of taxation at federal, state, and local levels, each with its own set of rules and rates. The progressive nature of the federal tax system, combined with the diversity of state and local tax regimes, results in a varied and intricate landscape for taxpayers. Understanding these elements is crucial for navigating the U.S. tax environment effectively.