Decoding Taxation: An Introductory Guide To Understand Your Taxes Better
There are a few things that are universally considered scary–the Annabelle Doll, the idea of a Zombie Apocalypse, and Taxes. While there isn’t much we can do about the first two, we can definitely help you stop those tax management nightmares.
First of all, if tax jargon scares you and sounds like a foreign language to you, believe us, you’re not alone. As a matter of fact, only 3.5 billion people, that is, one-third of the world population understand the fundamentals of tax management. So, if you get lost in the tax jargon–so do more than 65 percent of the world.
To do that, we’re right here. Here’s our quick guide that has simplified the basics of taxation for you–to help you know the tax jargon without getting confused. Let’s dive right in!
What is Taxation?
A long time ago–around 3000 BC–an Egyptian Pharaoh (ruler) decided to make the people contribute a portion of their wealth to serve the leader (government). That was the first instance of regulated taxation. Back then, there was no money–so the pharaoh took his share in the form of labor and grain. Not just that, people’s wealth was calculated based on harvests and property.
This process of sharing what you own or have, with the ruler or the authority to fund their needs and aid their administration is called taxation. In other words, taxation is the imposition of mandatory taxes by governments on people or corporations. What started in Egypt is now a norm worldwide–every Government in the world imposes to fund its expenditures.
In fact, tax revenue accounts for 80 percent of total government spending in half of the world’s countries. Initially (in Egypt), taxes were levied just on harvest and property. However, today you’ve to pay tax on your income, business gains, property, capital gains, sales, and even.
That’s not all. Taxation is involuntary, there’s no consent that you give to pay taxes–it’s a mandate. Needless to say, to administer this mandate, every government has to use the power of law where failure to pay taxes, tax evasion, or resistance to taxation, is illegal and punishable by law.
Since taxes are defined, modified, collected, and administered by the government, taxes in every nation vary. Every nation has its own norm, rates, and standards. That being said, you’d find that some kinds of taxes are common everywhere–their rate and inclusions may vary but they’d be present in some form in every country.
However, before we get into the classification and types of taxes, let’s talk about why you need them in the first place.
Why do we need a tax system?
A quick and dirty version of the answer to why we need taxes is to pay for all government expenses. Whether the government spends on a new scheme, a new infrastructural development, a new international deal or to pay its employees–a major part of the cost is borne by the taxpayers and their contribution. While the government may have other sources of income like privatization deals, licenses, exports but none of them hold a bigger share than taxes. Not just that, taxes are the only regular source of income–all others vary based on the market, demand, and other factors.
So, it wouldn’t be incorrect to say that your government would not be able to function properly if there wasn’t a tax system. In fact, taxes take care of some of the most common government expense verticals including:
- Infrastructure funding
- Welfare and development projects
- State and government employees’ salary
- Public transportation
- Unemployment compensation
- Pension plans
- Enforcement of the law
- Public health, education, and insurance
- Water, energy, and waste management systems
Now that you’re convinced that having a tax system is crucial for any nation, let’s talk about the different taxes that exist.
Direct and Indirect Taxes
Taxes are of different types based on who pays for them, who bears the ultimate weight of them, the extent to which the load shifts, and a variety of other factors. Taxes are generally divided into two main categories: direct or indirect.
In simple words, taxes that are levied directly on you are direct taxes. The amount you pay to the government directly based on your income, consumption, or net wealth fall under this type of tax. Needless to say, you cannot transfer these to another person or legal body. Corporate and income taxes are the most common examples that fall under this category. For instance, any tax that you pay on your salary–is a direct tax. The government will directly take it from you.
Indirect taxes are taxes imposed if you manufacture or consume products and services, as well as do transactions such as imports and exports. Some examples of indirect taxes are sales taxes, both general and selective, value-added taxes (VAT), taxes on any component of manufacturing or production, taxes on legal activities, any customs or import duties. For instance, the tax that you pay at a restaurant on your bill is an indirect tax. Here the restaurant collects the tax and then pays it to the government as a cumulative of their earning.
All in all, a direct tax applies to you as an individual while an indirect tax applies to your activities (commercial, recreational and more!). Moreover, you pay direct taxes to the government and indirect ones to a third party.
Source: Aditya Birla Capital
While that’s the most common categorization when it comes to taxes, experts also divide taxes into progressive and regressive taxes.
Progressive and Regressive Taxes
Progressive and regressive taxes are defined based on how your wealth and income impact them. If your tax liability increases with an increase in income, then that’s a progressive tax. These work well for equitable distribution of wealth. Here, the richer pay higher taxes.
On the other hand, regressive taxes is where your tax liability as your income rises–since they’re independent of how much you earn. That means regressive taxes levy a higher burden on the lower-income people than the wealthy. Needless to say, they’re not ideal. Sales tax, for instance, is a regressive tax because no matter how rich or poor you may be, you’d have to pay the same amount of tax on the purchase of goods. So, this amount may feel like peanuts to the wealthy but can be extremely high for those who’re on the lower pay scale.
Assuming that you now understand the major categories of taxes, let’s talk about some common kinds of taxes.
Types of Taxes
Government imposes income taxes on your overall financial income, which includes earnings, investments, and salaries. Most income taxes rise in tandem with your earnings. As a result, higher-income earners pay more taxes than lower-income earners (it’s a progressive tax!).
Corporate taxes apply to your business profits. Your corporation, customers, and employees bear the burden of corporation tax by raising prices and paying low wages. To foster economic growth, most governments impose a corporate tax rate of less than 30%.
Your contributions to healthcare, social security, disability, and survivor benefits, and federal unemployment benefits are all covered by payroll taxes. In addition, federal (and maybe state and local) income taxes get cut from your salary.
Capital Gain Tax
Capital gains taxes apply on your investment income once you get capital gain by selling a part of your investment. Dividends and interest earned from a bank account, as well as dividends and earnings from investments, are all taxed.
Property taxes apply to your residences, land, and commercial real estate. Property tax payments, unlike mortgage payments, do not amortize. You must continue to pay them for the duration of your residence unless you qualify for property tax exemptions for seniors, veterans, or handicapped citizens.
To sum up
Evidently, you may not be paying all of these taxes. In fact, most people are often concerned just with their income tax or corporate tax. However, having a basic idea about all the types of taxes, how they’re imposed, and how they impact or get impacted by your income helps you in managing your finance better. Not just that, you’re not surprised by a sudden tax liability every time you buy an asset or get a land–you know you’d be taxed for it. So, you’re always better prepared. Hope you have some clarity on the fundamentals of taxation because you never know when they might come in handy!