It is said that there are only two things certain in life: death and taxes. It’s fair to say that we don’t really like to talk about either of them! Taxes may be unpleasant, but they affect many aspects of life, from your take-home pay through to what you spend. It is therefore important to understand a bit about them.
Being ‘tax-literate’ is an important aspect of financial literacy. This page explains the basics about income taxes, tax bands or brackets, and other taxes such as sales tax. It should therefore help you to understand and interpret the tax regime where you live.
What are Taxes?
tax, noun. A compulsory contribution to state revenue, levied by the government on workers’ income and business profits, or added to the cost of some goods, services, and transactions.
Source: Oxford Languages
There are therefore two main types of taxes: income taxes and sales taxes.
Income tax is levied on your income and/or business profits. In the UK, National Insurance is also a form of income tax. The level varies with your income.
Sales tax (known as value-added tax or VAT in the UK and European Union) is charged on goods or services. This means that everyone is charged at the same rate, but you only pay tax on goods or services that you buy.
Progressive and Regressive Taxes
There are two terms that it is worth understanding with taxes: progressive and regressive.
A progressive tax is paid at a higher rate or percentage by those with higher incomes. That is, those who can afford to pay more make a higher (relative) contribution to the state. The US and UK income tax systems are both progressive.
A regressive tax is charged at the same rate to everyone, regardless of ability to pay. Sales taxes are therefore regressive.
In any given regime, there may also be taxes on particular purchases, sales or events.
For example, in the UK, these include:
Inheritance Tax, which is charged on the estate of someone who has died;
Capital Gains Tax (also known as a windfall tax), which may be charged if you buy something, and later sell it for a large profit. This is most likely to apply to shares, property or other investments. It does not apply to your ‘main residence’ (your home), although it may apply to a second home. It is basically a tax on unearned income.
Stamp Duty and Land Tax when you buy a property or piece of land.
It is hard to argue with income tax, especially with its progressive nature. It is also hard to argue with capital gains tax, because it is only charged when you make a very large profit on a purchase (hence the alternative name of ‘windfall tax’). After all, governments have to tax something.
However, inheritance tax and stamp duty are both extremely controversial. Both have also been tweaked considerably in recent years to increase the perceived ‘fairness’ of the tax and make them more acceptable.
As a rule, governments prefer taxes to be perceived as fair and reasonable.
All these taxes are levied at standard rates, and may vary between jurisdictions. They may also vary with particular circumstances. For example, stamp duty is different when you are buying a new main residence, and when you are buying a second home. It also varies with the price of the property.
These differences and variations are one very good reason to employ professionals when you make a large purchase or sale: they will ensure that you have paid the right amount of tax.
Understanding Income-Based Taxes
Income-based taxes are often, though not always, progressive. They are therefore charged in bands, or brackets.
In the UK, for example, there are four bands.
The first band is tax-free, and is known as your Personal Allowance. You therefore pay no tax at all on any income up to the top of that band.
You pay basic rate tax on all income in the second band, that is, from the top of the Personal Allowance (or nil-rate band) to the top of the Basic Rate Band.
You pay higher rate tax on all income in the third band, that is, from the top of the Basic Rate Band to the top of the Higher Rate Band.
You pay an additional rate on all income above the top of the higher rate band.
The precise tax bands and tax rates change regularly, but the principle remains the same.
Taxes on income
In any tax regime, there may be more than one form of income-based tax, or tax taken from your income at source.
For example, in the UK, both income tax and National Insurance are taken from your income at source if you are employed. Both also vary with income. However, National Insurance only has two bands: a nil rate, and a band above this threshold. Those who earn below the threshold do not have to pay.
The threshold is lower for National Insurance than for the income tax Personal Allowance.
This means that those on lower incomes have to pay National Insurance before they are required to pay income tax. This is one reason why many people oppose changes to National Insurance rates, because they tend to disproportionately affect those on lower incomes—and are therefore regressive.
Capital gains tax is also a tax on income—but on unearned income. It is not taken at source, but liable to be paid following submission of your tax return.
States may also choose to levy income-based taxes only on the income that you earned in that state. Others, however, levy taxes on all income, regardless of sources.
For example, the US government requires its citizens to pay taxes on all income from anywhere in the world—and this applies even if they do not live in the US.
A Note of Caution
It is wise to ensure that you fully understand the tax system or systems that you are under.
This is particularly important because paying the right tax is an individual responsibility.
In other words, it is not up to the state to pursue you and make sure that it charges the right amount. It is up to you to provide the right information to ensure that you pay the right tax. If you don’t, you could be landed with a large bill. Ignorance is no defence.
Understanding Sales Tax
Sales taxes are levied on goods or services that you buy. They are levied at the point of sale.
In some places and cases, you may not even be aware that you are paying taxes. They may simply be included in the prices on the items. This is the case for VAT in the UK. However, in other places, the prices on the items may not include sales tax (particularly if it only applies to residents, for example). You may therefore find that the total at the till is rather more than you were expecting.
Sales taxes are generally charged at a standard rate. However, this may vary for:
Different goods or services. For example, for a while, VAT on fuel in the UK was only 5%, even though the standard rate was considerably higher.
Different places. For example, sales taxes are set by states in the US, and travellers may therefore be caught out by different rates.
Different people. Some states may only charge sales taxes to residents, and others charge them to everyone.
TOP TIP! Check before travelling!
To avoid being caught out when travelling, it is a good idea to do some research before you go.
In particular, check whether sales tax is usually included on price tickets, what it is levied on, and also whether it varies across the places you plan to travel. This will ensure that you are not taken by surprise.
A Final Thought
The US Internal Revenue Service (IRS) has published an educational website for teachers who have to teach the basics about tax. It provides 38—yes, 38—separate lesson plans. The section on the ‘Hows’ of taxes contains 14 separate modules, and the section on ‘Whys’ runs to 24 lessons.
Taxes are complicated. It is no wonder that people find them hard to understand.
This means that completing tax returns is also complicated. This is why many people pay accountants and other tax experts to do this work for them. This may seem like overkill if your income is relatively small. However, it avoids any concerns about whether you have completed the form correctly, and declared all your tax liabilities.