Income Tax

What Is Income Tax?

Income tax is a type of tax that governments impose on income generated by businesses and individuals within their jurisdiction. By law, taxpayers must file an income tax return annually to determine their tax obligations.1 2 Income taxes are a source of revenue for governments. They are used to fund public services, pay government obligations, and provide goods for citizens.

Certain investments, like housing authority bonds, tend to be exempt from income taxes.5

How Income Tax Works

Most countries employ a progressive income tax system in which higher-income earners pay a higher tax rate compared to their lower-income counterparts.6 The U.S. imposed the nation's first income tax in 1862 to help finance the Civil War. After the war, the tax was repealed; it was reinstated during the early 20th century.7

In the U.S., the Internal Revenue Service (IRS) collects taxes and enforces tax law.8 The IRS employs a complex set of rules and regulations regarding reportable and taxable income, deductions, credits, et al.9 The agency collects taxes on all forms of income, such as wages, salaries, commissions, investments, and business earnings.3

The personal income tax the government collects can help fund government programs and services, such as Social Security, national security, schools, and roads.10

Types of Income Tax

Individual Income Tax

Individual income tax is also referred to as personal income tax. This type of income tax is levied on an individual's wages, salaries, and other types of income. This tax is usually a tax the state imposes. Because of exemptions, deductions, and credits, most individuals do not pay taxes on all of their income.11

The IRS offers a series of income tax deductions and tax credits that taxpayers can make use of to reduce their taxable income. While a deduction can lower your taxable income and the tax rate that is used to calculate your tax, a tax credit reduces your income tax by giving you a larger refund of your withholding.12

The IRS offers tax deductions for healthcare expenses, investments, and certain education expenses. For example, if a taxpayer earns $100,000 in income and qualifies for $20,000 in deductions, the taxable income reduces to $80,000 ($100,000 - $20,000 = $80,000).12

Tax credits exist to help reduce the taxpayer's tax obligation or amount owed. They were created primarily for those in middle-income and low-income households. To illustrate, if an individual owes $20,000 in taxes but qualifies for $4,500 in credits, their tax obligation reduces to $15,500 ($20,000 - $4,500= $15,500).12

Business Income Taxes

Businesses also pay income taxes on their earnings; the IRS taxes income from corporations, partnerships, self-employed contractors, and small businesses.4 Depending on the business structure, either the corporation, its owners, or shareholders report their business income and then deduct their operating and capital expenses. Generally, the difference between their business income and their operating and capital expenses is considered their taxable business income.13 14

State and Local Income Tax

Most U.S. states also levy personal income taxes. As of 2020, there are seven states with no income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. In addition, two other states–New Hampshire and Tennessee–do not tax earned income; however, they do tax dividends and interest.15

However, Tennessee is set to eliminate those taxes on dividends and interest (an effort to repeal the tax in New Hampshire failed in 2018) and it is projected that the number of states in the U.S. with no income tax will reach eight in 2021.16 17

For taxpayers, it may not necessarily be cheaper to live in a state that does not levy income taxes. This is because states often make up the lost revenue with other taxes or reduced services. In addition, there are other factors that determine the affordability of living in a state, including healthcare, cost of living, and job opportunities.