How the US Tax System Actually Works: A Beginner’s Guide

Our Tax System

Understanding how the US tax system works can feel daunting. Many people find the topic complicated, and stressful – mostly around filing and filling out your taxes and the deadlines and threat of penalties and fees. However, taxes are much more than filing, they are what support all the services and functions of government and they have very real impacts on the lives of every American. This guide provides an overview of our Tax the system. It breaks down key components, including the different levels of government involved, types of taxes, and alternative revenue sources.

Why Understanding the US Tax System Matters

Understanding the tax system empowers you to make informed financial decisions. Understanding allows you to participate effectively in civic discussions about. In fact, Americans spend around 13 hours and $290 each year just filling out and filing their taxes each year (1). When you consider that for most Americans their largest purchase in life will be a house, and the 2nd or 3rd largest will be a car or your taxes. Some people spend much more time thinking and researching the car they’ll purchase than their taxes. If you buy a car every 5 years, its like you will spend less time making your purchasing decisions than the 65 hours over the 5 years on average that Americans spend each year on taxes.

Complexity and Three Levels of Government and Taxation

The United States has an extremely complex tax code comprising several volumes of Tax Law with many carve outs, exceptions, deductions, etc. (See our Article on Tax Complexity) Additionally, the US tax system operates on three primary levels: Federal, State, and Local. Each level has its distinct revenue needs and employs various taxation methods, similar but distinct. So for example if you live in California or Florida while your Federal taxes will be the same you may have VERY different tax structures for the state you live in. On top of that there are a slew of taxes in various forms (many indirect) that are passed on to the consumer.

Federal Taxes

The Federal government relies on several key taxes to fund national programs and services. The Federal tax code is uniform across the country. To get an estimate and see where your tax dollars are spent, get an itemized Federal Tax Receipt from the Tax Project.

• Income Tax: This is the largest source of federal revenue. It is levied on individuals’ and corporations’ taxable income. The US employs a progressive income tax system, where higher income levels are taxed at higher rates.
• Payroll Taxes: These are the second largest source of federal revenue and fund Social Security and Medicare. They are split between employers and employees.
• Corporate Income Tax: Levied on the profits of corporations. The corporate tax rate has varied significantly throughout US history.
• Excise Taxes: These are taxes on specific goods, such as alcohol, tobacco, and gasoline.
• Estate and Gift Taxes: Applied to large estates passed on after death and significant gifts given during a person’s lifetime.

Interesting Fact: The 16th Amendment to the US Constitution, ratified in 1913, allowed Congress to levy an income tax without apportioning it among the states or based on the Census. This was the beginning of income taxes outside a brief period during the Civil War. It has allowed for the Progressive taxation (i.e. Non Apportioned) system we have today.

State Taxes

State governments use taxes to fund education, infrastructure, healthcare, and public safety. Each state has their own unique tax code.

• Sales Tax: This is a percentage of the purchase price applied to most goods and services at the place of purchase. Sales tax rates vary widely among states. Some states, like Oregon, Montana, New Hampshire, and Delaware, have no sales tax.
• Income Tax: Many states also levy an individual income tax on top of Federal Income taxes, often based on federal taxable income with some adjustments.
• Corporate Income Tax: Similar to the federal level, states tax corporate profits.
• Property Tax: While primarily a local tax, states often set guidelines for property tax assessment and administration.

Local Taxes

Local governments, such as cities, counties, and school districts, rely heavily on property taxes. Each municipality has their own unique tax code.

• Property Tax: This tax is based on the assessed value of real estate and is used to fund local schools, fire departments, and other essential services.
• Sales Tax: Some localities add their sales tax on top of the state sales tax.
• Local Income Tax: A few cities and counties impose a local income tax on residents and those working within their boundaries.

Interesting Fact: Property taxes are a stable revenue source for local governments. They are less susceptible to economic downturns compared to sales or income taxes.

Other Government Taxes (Revenue)

Now it may sound strange, understandably, for your taxes to be described in business terms as revenue, but the government categorizes taxes as revenue. The Government consider all sources of funding Revenue, but only a portion as Taxes. This is because they do collect fees, and other revenue for services rendered like Fishing licenses, or Car registration, Building permits, etc. There are several sources of government revenue funding for public services.

• Direct Taxes: These are levied directly on individuals or entities and cannot be shifted to someone else. Examples include income tax, corporate tax, and property tax.
• Indirect Taxes: These are initially paid by one entity but can be passed on to the consumer. Sales tax and excise taxes are examples of indirect taxes.
• Non-Tax Revenue Sources: Governments have other funding sources that are not considered taxes. These include fees, licenses, and borrowing.
• Fees and Charges: These are payments for specific services provided by the government. Examples include park entrance fees, trash collection fees, and tolls.
• Licenses and Permits: Governments charge fees for licenses and permits to regulate activities and raise revenue. Examples include driver’s licenses, business licenses, and building permits.
• Borrowing: Governments borrow money by issuing bonds to fund projects or cover budget shortfalls. While borrowing is not a tax, it creates an obligation to repay the pay off his debts</span></span></div><div class=term-number>3.</div><div class='dd'><span class=definition>a state of owing - <span class=example>deeply in debt</span></span></div><div class=term-number>4.</div><div class='dd'><span class=definition> the common-law action for the recovery of money held to be due</span></div></div><!-- mw-group end --><div class=break></div></div><!-- mw container end --></div><div class=glossaryTooltipMoreLinkWrapper><a class=glossaryTooltipMoreLink href=https://taxproject.org/glossary/debt/ rel=&quot;nofollow&quot; >Term details</a></div>" data-mobile-support="0" data-gt-translate-attributes='[{"attribute":"data-cmtooltip", "format":"html"}]' tabindex='0' role='link'>debt. Much like a loan, the debt is repaid through future tax revenue.

Interesting Fact: A branch of economics known as Keynesian Economics proposes that Government spending can stimulate the economy through increased demand. Borrowing can increase spending to allow for investments in infrastructure and public services. However, not all spending and circumstances lead to positive returns or economic stimulation and excessive borrowing can lead to long-term financial challenges.

• Asset Sales: Governments can sell assets, such as land or buildings, to generate revenue. This is typically a one-time source of income.
• Indirect Expenses and Hidden Taxes: Beyond explicit taxes, various indirect expenses and hidden taxes can affect individuals and businesses.
• Inflation: Inflation erodes the purchasing power of money. This effectively increases the cost of goods and services. Inflation is not a tax per se, however many people consider the rapid expansion of currency a direct cause of dollar devaluation and inflation. Therefore, Government policies can influence inflation rates.
• Regulations: Complying with government regulations imposes costs on businesses. These costs are passed on to consumers through higher prices. While not a tax, in essence it creates a cost burden that is often passed to the consumer.
• Mandates: The government mandates that businesses provide certain benefits to employees. These include health insurance or paid leave. These costs can translate to lower wages or higher prices.
• Opportunity Costs: Resources spent on one activity are not available for another. Government spending decisions involve opportunity costs. Spending on defense means less available for education.

In general, our Government at each level has become very adept at adding Revenue sources in too many ways to count. In these categories above you will find fees that show up everywhere you look. TSA fees added to your airport tickets, Universal Service Fees added to Internet bills, Telecom and 911 Fees added to your phone bill, Renewable Energy Charges on your Energy bill, Public Utility Fees, Waste Management Fees, Hotel Occupancy Fees, Tourism Fees, School Bonds, Fire Districts, Mosquito Abatement, etc. When it comes to revenue generation, our Government has become very innovative. (See our Article on The Art of Taxation)

Interesting Fact: Some Regulatory cost estimates in the US are estimated to be in the trillions of dollars annually. (2)

Potential Reforms

Our tax system continues to evolve in an attempt to address the changing landscape of services and needs of constituents. Here are a number of reforms that are discussed at various degrees of intensity.

• Consumption Tax: Replacing the income tax with a consumption tax.
• Carbon Tax: Taxing carbon emissions to aimed to address climate change.
• Flat Taxes: Fixed rate simple tax for all individuals replacing a number of taxes, reducing complexity, and burden.
• Wealth Tax: Taxing the net worth of the wealthiest individuals vs income, especially for those that derive most of their income from investments not salary.

The US Tax System: A Closer Look at Key Taxes

Diving deeper, here is the composition of US revenue and what they include.

Individual Income Tax

The Federal income tax is a progressive system on the income of individual tax payers. Meaning that the tax burden rises with income generally, in essence the more you make the more they take. Income is divided into tax brackets, each with a different tax rate. As income rises, it is taxed at higher rates. (See our Article on Fair Share of taxation and where the income tax burden falls.)

• Taxable Income: This is the income subject to tax after deductions and exemptions.
• Deductions: These reduce taxable income. Common deductions include the standard deduction, itemized deductions for mortgage interest, charitable contributions, and state and local taxes (SALT).
• Tax Credits: These directly reduce the amount of tax owed. Examples include the child tax credit, earned income tax credit, and education credits.
• Alternate Minimum Tax (AMT): The AMT is a tax applied to high income earners that serves as a way to ensure that a minimum tax is collected. When your taxes are filed, two separate calculations must be made. The standard tax calculation, whether you itemize or use the EZ form, and your AMT tax. If your AMT tax is higher than your standard tax calculation, you must pay the AMT amount.

Corporate Income Tax

The corporate income tax is levied on the profits of corporations. Taxes on corporations influence business investment and economic growth. The Federal tax rate on corporations in the US is a flat rate 21% and between 23.5% to 23.85% when you include State and Local corporate taxes compared to the OECD Corporate tax rate of 25.6% to 25.8% (3). The effective Corporate tax rate can be significantly lower in the US based on a number of deductions. In 2022 as part of the Inflation Reduction Act a Corporate Alternative Minimum Tax (CAMT) of 15% was imposed.(5) Corporate taxes are the 3rd highest tax revenue source after Individual Income Taxes, and Payroll Taxes. For many countries, including the US and many European nations, these are a lower source of tax revenue. Many consider these mostly pass through costs and they are passed on to the consumer in the form of higher prices, the investor as lower returns, or the employee in lower wages and/or benefits. (4)

Interesting Fact: The Tax Cuts and Jobs Act of 2017 (TCJA) reduced the corporate income tax rate from 35% to 21% bringing the US Corporate tax rate into a more competitive level with OECD countries.(3)

Payroll Taxes: Funding Social Security and Medicare

Payroll taxes are automatic deductions taken from your paycheck by your employer and matched by your employer to fund Social Security and Medicare. Payroll taxes are the 2nd largest source of revenue for the Federal Government. Social Security and Medicare are the two largest, and mandatory, components of the Federal budget expenses.

• Social Security: This provides retirement, disability, and survivor benefits. Social Security is taxed at 6.2% each for the employee and employer (12.4% total) up to a maximum of $176,100 as of 2025.
• Medicare: This provides health insurance for seniors and some people with disabilities. Medicare is taxed at 1.45% each for the employee and employer (2.9% total) with no maximum. An additional 0.9% increase is added at certain income levels.

Sales Tax: A Consumption-Based Tax

Sales taxes are based on a percentage of the purchase price. They are consumption-based taxes collected by States and Localities. As a consumption tax, the more you consume the higher your sales tax total will be. Consumption taxes are considered to be a regressive tax meaning those with lower incomes pay a high percentage of their income for this tax than those with a higher income, although it is also likely that those with higher incomes consumer more and therefore pay higher sales taxes. Sales taxes are collected at the point of purchase by the end consumer, unlike a Value Added Tax (VAT) often used in Europe and other parts of the world that are taxed at different intermediate stages.

• Tax Base: This refers to the goods and services subject to sales tax. In general, most purchased goods and services other than essentials defined under exemptions are taxed.
• Exemptions: Some items, such as groceries and prescription drugs, are often exempt from sales tax.

State Controlled Monopolies or Heavy Price Influence

States and Local Municipalities in several states control either outright monopolies where they control the distribution, and regulate the sale, and price of goods and services directly, or heavily influence the prices. Some areas of control/influence:

• Alcohol: Several states currently operate and control state run wholesale and distribution of Alcohol within their state.
• Cannabis: While still illegally Federally, several states now offer either Medicinal or Recreational state sponsored Cannabis distribution controlled like Alcohol or heavily regulated.
• Tobacco: Similar to Cannabis, several states have state controlled distribution or heavily regulated.
• Lottery: These are state sponsored lottery gambling that is setup, run and controlled by the States.
• Gasoline/Fuel: While most are not directly priced and controlled, several states impose heavy excise takes that influence prices substantially, for example California.
• Utilities: Many states either run, or heavily regulate through mechanisms like Public Utility Commissions that set rates and pricing on a number of utilities like Power, Water, and Waste.

Interesting Fact: Excise Gas Tax can add as much as $0.90 to $1.21 per gallon

California Example:

• California Excise Tax: $0.596 per gallon
• Federal Excise Tax: $0.184 per gallon
• State Sales Tax: 2.25% plus applicable district taxes (for gasoline)
• Low Carbon Fuel Standard (LCFS): Estimated to add significantly to the price (7)
• Cap-and-Trade Program Costs: Also adds to the price (6)
• Underground Storage Tank (UST) Fee: $0.02 per gallon
• Local Sales Taxes: Vary by jurisdiction

Progressive vs. Regressive Taxes

The discussion on Progressive versus Regressive taxes is a philosophical one based on not what is taxed, or where it something is taxed, but how something is taxed. In general, at the point of tax, the difference between Progressive and Regressive taxes is about whether or not different people charged different rates for the same service. The concept is that those earning more, pay more. Many states, particularly liberal states, have moved to push more and more of the tax burden on wealthier, higher income individuals with the use of Progressive Taxes. This is a Tax Policy area with particularly high debate with many arguing for Progressive Taxation, where a relative few pay a significant portion of the tax burden versus Regressive where everyone pays the same rate but that equates to those earning lower incomes to pay a higher proportion of their incomes versus wealthier individuals. (See our Article on Fair Share to get a more in depth discussion on how these taxes work).

• Progressive Taxes: Higher-income earners pay a larger percentage of their income in taxes. The federal income tax is an example.
• Regressive Taxes: Lower-income earners pay a larger percentage of their income in taxes. Sales taxes can be regressive, as lower-income individuals spend a larger portion of their income on taxable goods.
• Proportional Taxes: Everyone pays the same percentage of their income in taxes.

Conclusion: US Tax System and Civic Duty

The US Tax system has evolved, and will continue to evolve over the life of our country. Taxes are a necessary component of any Government in order to provide all the essential services required by Government for citizens. Through the nature of the US Federated States, and changing service and revenue needs of the country our Tax Policy has evolved into a unique set of policies. When looking at the overall US Tax system, instead of a top down well thought out tax system it may appear as a series of bolt on parts that may not make a lot of sense when looked at as a whole. In California there is a house called the Winchester Mystery house owned by the family that created the Winchester rifle. Sarah Winchester believed that if she stopped building she would die, so additions and construction were continuous which led to an odd byzantine architecture including stairs to nowhere and doors and windows opening to nothing. To an outside observer, the US tax system may appear analogous to the Winchester mystery house. It works, but it doesn’t always look pretty, and it may not always be the most efficient.

The US tax system will likely continue to evolve to address challenges such as the national debt, income inequality, fairness, social welfare, and economic competitiveness. Understanding the US tax system is crucial for every citizen. By learning how taxes work, you can participate in policy debates. You can make informed financial decisions that impact the long term health of our country. The tax system is complex. However, understanding it empowers you to contribute to a more prosperous future.

Sources

1. NTU https://www.ntu.org/foundation/detail/taxpayers-will-spend-71-billion-hours-464-billion-on-tax-compliance-in-2025
2. Competitive Enterprise Institute https://cei.org/studies/ten-thousand-commandments-2023/
3. OECD https://www.oecd.org/en/data/datasets/corporate-income-tax-rates-database.html
4. Investopedia https://www.investopedia.com/terms/c/corporatetax.asp#:~:text=While%20corporations%20do%20pay%20taxes,of%20return%2C%20customers%20through%20higher
5. Congress https://www.congress.gov/crs-product/R47328
6. CA.GOV https://lao.ca.gov/Publications/Report/4811
7. University of Pennsylvania https://kleinmanenergy.upenn.edu/research/publications/californias-low-carbon-fuel-standard/#:~:text=Policy%20Insight&%240.85%2FGallon,and%20100%25%20cost%20pass%2Dthrough