Federal taxes

What Are Federal Taxes?

Federal taxes are mandatory financial contributions levied by a nation's central government on individuals and entities within its jurisdiction. These taxes represent the primary source of revenue for funding national expenditures, including public services, infrastructure, defense, and social programs. As a fundamental component of taxation and public finance, federal taxes play a critical role in shaping a country's economic landscape and fiscal policy. The types of federal taxes vary, but commonly include taxes on income, corporate profits, and certain goods and services.

History and Origin

Before the early 20th century, the United States federal government primarily relied on tariffs and excise tax for revenue. This system was often perceived as regressive, disproportionately affecting lower-income individuals. The shift towards a modern income-based federal tax system began to take shape with the ratification of the Sixteenth Amendment to the U.S. Constitution. Passed by Congress in 1909 and ratified on February 3, 1913, this amendment granted Congress the power to "lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration."⁸

This change effectively overturned an 1895 Supreme Court decision in Pollock v. Farmers' Loan & Trust Co., which had declared an earlier federal income tax unconstitutional by classifying it as a "direct tax" that required apportionment among states based on population.⁷ The Sixteenth Amendment paved the way for the Revenue Act of 1913, which established the first permanent federal income tax system in the U.S., fundamentally altering the government's ability to finance its operations and programs.

Key Takeaways

• Federal taxes are financial charges imposed by the central government to fund national operations and public services.
• They are the primary source of government revenue.
• Major types of federal taxes include individual income tax, corporate income tax, and payroll tax.
• The U.S. federal income tax system was enabled by the Sixteenth Amendment to the Constitution, ratified in 1913.
• Federal taxes have a significant impact on individuals, businesses, and the overall economic growth of a nation.

Interpreting Federal Taxes

Federal taxes are interpreted in various ways depending on the perspective—individual taxpayers, businesses, or policymakers. For individuals, federal taxes represent a mandatory deduction from their earnings, reflecting their contribution to public services and social welfare programs. The amount of federal tax an individual pays is typically determined by their taxable income, filing status, and applicable deductions or credits, often falling into different tax brackets.

For businesses, federal taxes, particularly corporate income tax, impact profitability and investment decisions. Policymakers view federal taxes as a crucial tool for implementing fiscal policy, managing the national budget deficit, and influencing economic activity. Changes in federal tax rates or policies can be used to stimulate or cool down the economy, redistribute wealth, or incentivize certain behaviors like saving or investing.

Hypothetical Example

Consider Jane, a single individual earning an annual gross income of $70,000. For the current tax year, assume the federal income tax system has the following simplified marginal tax rate structure:

• 10% on income up to $10,000
• 12% on income from $10,001 to $40,000
• 22% on income from $40,001 to $80,000

First, Jane's taxable income is determined after any standard or itemized deductions. Let's assume Jane takes the standard deduction of $14,600 (hypothetical for a single filer).

Taxable Income = Gross Income – Standard Deduction
Taxable Income = $70,000 – $14,600 = $55,400

Now, calculate the federal income tax based on the brackets:

• First $10,000: $10,000 * 0.10 = $1,000
• Next $30,000 ($40,000 - $10,000): $30,000 * 0.12 = $3,600
• Remaining income ($55,400 - $40,000): $15,400 * 0.22 = $3,388

Jane's total federal income tax liability would be:
$1,000 + $3,600 + $3,388 = $7,988

In addition to income tax, Jane would also pay federal payroll tax (Social Security and Medicare taxes) withheld from her wages, which fund specific social insurance programs.

Practical Applications

Federal taxes are broadly applied across the economy and touch nearly every individual and business. Their practical applications are extensive:

• Funding Government Operations: The most direct application is to finance government spending. In fiscal year 2024, individual income taxes accounted for approximately 49% of total federal revenue, while payroll taxes contributed about 35%. The U⁶.S. Treasury Department provides detailed data on where federal revenue comes from.
• ⁵Social Programs: Payroll taxes, specifically those mandated by the Federal Insurance Contributions Act (FICA), are dedicated to funding Social Security and Medicare. These programs provide retirement benefits, disability insurance, and healthcare for eligible individuals. The Social Security Administration provides details on how the program is financed through dedicated payroll taxes.
• ⁴Economic Stabilization: Federal tax policy is a key component of macroeconomic management. During economic downturns, tax cuts can be implemented to stimulate consumer spending and business investment. Conversely, tax increases might be used to curb inflation or reduce national debt.
• Income Redistribution: Through a progressive tax system, where higher earners pay a larger percentage of their income in taxes, federal taxes can help reduce income inequality. Data from the Tax Policy Center shows how the U.S. federal tax system impacts the distribution of income.
• ³Incentivizing Behavior: Tax credits and deductions are often used to encourage certain activities, such as homeownership, education, or charitable giving.

Limitations and Criticisms

Despite their necessity, federal taxes are subject to various limitations and criticisms. One significant concern revolves around their potential impact on economic growth. Some economists argue that high marginal tax rates can disincentivize work, saving, and investment, potentially slowing down economic expansion. Conve²rsely, tax cuts, especially those not offset by spending reductions, can lead to increased federal borrowing and a larger national debt, which may have negative long-term growth implications. The Brookings Institution has explored the effects of income tax changes on economic growth.

Anot¹her critique often centers on the complexity of the federal tax code. The extensive rules, deductions, and credits can make filing a tax return challenging for average citizens and businesses, often requiring the assistance of tax professionals. This complexity can also lead to unintended loopholes or create opportunities for tax avoidance.

Furthermore, the fairness of the federal tax system is a recurring debate. While the U.S. system is designed to be progressive, meaning higher earners generally pay a larger share of their income, some argue that certain provisions or capital gains taxation rules may disproportionately benefit the wealthy, while others contend that the overall tax burden is too high or unfairly distributed across different income groups.

Federal Taxes vs. State Taxes

While both federal taxes and State taxes are levied on individuals and businesses within the United States, they differ significantly in their scope, purpose, and administration. Federal taxes are imposed by the U.S. government and are uniform across all states, funding national initiatives like defense, federal social programs, and interstate infrastructure. The collection and enforcement of federal taxes are primarily handled by the Internal Revenue Service (IRS).

In contrast, state taxes are imposed by individual state governments, and they vary widely from state to state in terms of types of taxes levied, rates, and exemptions. State taxes fund state-specific services such as public education, state roads, and local law enforcement. Common types of state taxes include state income tax, sales tax, and property tax, which may or may not exist or be structured differently in each state. For example, some states have no state income tax, while others have relatively high rates. The distinct systems mean that a taxpayer's total tax burden is a combination of both federal and state (and often local) obligations, each with its own set of rules and administrative bodies.

FAQs

What are the main types of federal taxes in the U.S.?

The main types of federal taxes in the U.S. are individual income tax, corporate income tax, and payroll taxes (Social Security and Medicare taxes). Other federal taxes include excise taxes, estate taxes, and gift taxes.

How does the federal government use the revenue from federal taxes?

The federal government uses revenue from federal taxes to fund a wide range of public goods and services. This includes national defense, healthcare programs (like Medicare and Medicaid), Social Security benefits, infrastructure development, education, scientific research, and interest payments on the national debt.

Is the U.S. federal income tax system a progressive tax system?

Yes, the U.S. federal income tax system is generally considered a progressive tax system. This means that as an individual's taxable income increases, they are subject to higher marginal tax rates, resulting in a larger percentage of their income being paid in taxes.

Who is responsible for collecting federal taxes?

The Internal Revenue Service (IRS), a bureau of the U.S. Department of the Treasury, is primarily responsible for collecting federal taxes and enforcing tax laws.

What is the difference between federal income tax and federal payroll tax?

Federal income tax is levied on an individual's or corporation's earnings and is used to fund general government operations. Federal payroll tax, on the other hand, is specifically earmarked to fund social insurance programs like Social Security and Medicare. Both employees and employers contribute to federal payroll tax.