As we learned in the previous tutorial, ideally all government spending is funded by taxes,
or required payments to the government from every citizen in a society. Even if many of
us complain about paying them, most citizens accept that taxes are a necessary way to fund
the government. However, governments need to make the important decision of deciding what to tax.
Literally anything can be taxed, and some things can seem arbitrarily taxed. In his influential
book, The Wealth of Nations, Adam Smith argued that a tax should have four characteristics:
simplicity, certainty, fairness, and efficiency. In other words, it should be easy and convenient
for taxpayers to pay, it should be certain to taxpayers that they know how and why the taxes
are being collected, it should be compatible with taxpayers’ conditions, including their
ability to pay and still pay their own bills, and it should be efficient for governments to collect.
While Smith offers a welcome guide, governments around the world still tax in different ways.
So what should be taxed? In this tutorial we’re going to look at all the major types
of taxes that governments typically collect, starting with consumption taxes, or taxes on
the purchase of stuff. #1: Sales Taxes
A sales tax is a tax you pay when you buy something. Usually, whoever is selling you
something can collect those sales taxes the moment you make the purchase. This is
why when you buy a hat for $9.99, you actually end up paying around $10.79 when you check out.
That additional 80 cents is the sales tax. It’s important to note that this is on final goods,
or goods meant to be sold to your average consumer, as opposed to immediate goods,
or goods that are bought to produce other goods. Nearly every country in the world has some form of
a sales tax, but it’s important to recognize that there are different types of sales taxes. Some
examples of sales taxes include turnover taxes, which are taxes on the sale of the aforementioned
immediate goods, or vendor privilege taxes, which are taxes on retailers for the privilege of doing
business in a certain area. There are also taxes on the sale of specific types of items,
like the wholesale sales tax, which is a tax on the sales of wholesale goods before the goods
are sent to retailers, or luxury taxes, which are taxes on stuff that is not considered essential.
#2: Value-Added Taxes A value-added tax, or VAT, is a tax on the price
of a good or service at every stage of production or distribution. It’s similar to a sales tax,
but instead of just being applied to the stuff sold to the consumer, it is applied repeatedly for
every point of sale at which value has been added to the stuff. Let’s look at an example. Say a
farmer sells wheat to a baker. The value has been increased after the baker buys it, so a VAT is
collected by the farmer. Next, the baker sells his bread to a wholesale bakery supply distributor.
The value has once again been increased, so an additional VAT is collected by the baker. Finally,
the wholesale bakery supply distributor sells packaged bread to restaurants and supermarkets
across the country. The value has once again been increased so yet an additional VAT is collected
by the wholesale bakery supply distributor. The vast majority of countries in the world
have a value-added tax, but a glaring exception is the United States, which relies on sales
taxes instead. Governments often prefer the VAT over the sales tax, however, since it encourages
more specialization and discourages vertical integration, which is when one company completely
owns and controls the supply chain. #3: Excise Taxes
An excise tax is any tax on stuff when it’s produced, as opposed to when it’s sold. The
main thing that makes a tax an excise tax is that businesses pay them, not consumers. They
are usually a fixed amount for each unit of a good or service sold, and governments
also apply them to a narrow range of goods. Excise taxes are often sin taxes, or excise taxes
placed on things that some people view as harmful to society in one way or another. This would
include cigarettes, alcohol, marijuana, gambling, prostitution, gasoline, or even sugary beverages.
Both excise taxes and value-added taxes are often called “indirect taxes”, since consumers
end up paying them indirectly, as producers and retailers will end up simply raising their prices
when they have to pay excise and value-added taxes. Regardless, most people are fine with
excise taxes, as long as they are sin taxes, because they think if something is bad for you
or society as a whole, then it should be more expensive to discourage people from buying it.
To review, the three main types of consumption taxes are sales taxes, value-added taxes,
and excise taxes. Critics often say consumption taxes are the most regressive form of taxation,
since people who have the least amount of wealth end up paying a larger portion of their wealth
in taxes than wealthier individuals do. One way governments have attempted to solve the
problem of sales taxes being regressive is by allowing sales tax exemptions, meaning certain
organizations like schools or nonprofit hospitals don’t have to pay sales taxes. Additionally,
governments may make the sale of certain goods tax exempt, like clothing, groceries, and other items
that are important for survival. #4: Property Taxes
A property tax is a recurring tax paid based on the value of the property we own. Typically, it’s
on real estate, like land and buildings, but also personal property like vehicles and equipment. At
minimum, we usually pay property taxes once a year, and if the value goes up on our property,
then we pay more property taxes. Governments may also collect property taxes when the property
changes owners. In the United States, property taxes are the single biggest source of state and
local revenue, funding things like schools, roads, the police, and other very important services.
Now the next few taxes are all taxes on assets. #5: Estate Taxes
An estate tax is a tax on your right to transfer wealth at your death. It’s automatically taken out
of your estate, or all the stuff that you own at the time of your death. Typically,
governments collect estate taxes on estates with assets worth at least tens of millions of dollars.
Critics often nickname them “death taxes.” Related to estate taxes are inheritance taxes,
which are taxes the beneficiary, or person inheriting the wealth, has to pay when they
receive the inheritance. Inheritance taxes also revolve around the idea that if you’re getting
free money from a dead relative, it’s fine for the government to take some of it since you didn’t
earn that inheritance. #6: Wealth Taxes
A wealth tax is a tax on a person’s total net worth. To figure out a person’s net worth,
we look at the value of their assets minus their debt. For example, if a person has $5 million
in assets and $500,000 in debt, their net worth would be $4.5 million. Similar to property taxes,
a wealth tax is recurring. Wealth taxes are not common around the world, primarly due to the fact
that most of the countries which have tried it have had a difficult time raising money from them,
since people have either hidden their assets or taken their assets to other countries.
Additionally, some assets are difficult to evaluate, particularly intangible ones. Therefore,
most governments prefer taxes on earned wealth in a given year, rather than accumulated wealth.
#7: Income Taxes An income tax is a recurring tax on your income,
or the money you earn. However, it’s not just on wages or salaries. It can also be on other forms
of investments an individual or household earns. There can be expenses and deductions that lower
the amount of income that is taxed, which is why filing your income taxes can become complicated.
The vast majority of income taxes are “progressive,” meaning tax rates increase
as a person’s income increases. Typically a progressive tax system has tax brackets,
so different portions of your income are taxed at different rates. The rate you pay on the last
dollar you earn is often higher than what you pay on the first dollar you earn. Governments
always start at zero when calculating. In the United States, there are currently
seven different tax brackets at percentage rates of 10, 12, 22, 24, 32, 35, and 37.
Some places have a proportional income tax, in which the tax rate is fixed,
so you pay the same percentage no matter what your income is. If you are self-employed,
you often have to calculate your own income and pay the government directly. Employers often
collect what’s known as payroll taxes. Critics of the income tax say it
disincentivizes people to earn money or even punishes them for earning money. Indeed,
many wealthy individuals just report a lower income in order to pay less in taxes.
#8: Capital Gains Taxes A capital gains tax is a tax
on the profit on the sale of an asset. Often this is through the sale of stocks, bonds,
precious metals, or cryptocurrency. Even antiques can be subject to a capital gains tax if you make
enough money from them. The capital gains tax rate depends on how much profit you gained in
a given year. It is much more common than a wealth tax, since it is easier to keep track of. However,
wealthy individuals often simply hold on to assets. In other words, they don’t sell them,
and this is why some argue a wealth tax might be a better way to generate more money for governments.
#9: Gift Taxes A gift tax is a tax on
money or property simply given to another person. Related to the gift tax is the generation-skipping
transfer tax, when someone wants to give money or assets to a grandchild or an unrelated
person much younger than them. #10: Corporate Income Taxes
A corporate income tax, otherwise known as simply a corporate tax, is a tax on business profits.
Typically corporate tax rates are flat. The thing about corporate taxes is that they indisputably
create tax havens, or countries that have either a low or effective 0% corporate tax rate. Companies
incorporate headquarters in these tax havens to avoid paying taxes on their annual profits.
#11: Tariffs Tariffs are
taxes on stuff crossing an international border. This can be on imports or exports,
but primarily on imports. Tariffs can be a fixed percentage of the price or change according to
the price. Historically, tariffs have been an important source of revenue for governments.
Economists who favor tariffs argue that they are a way for governments to both make money and
encourage production to stay domestic. However, the vast majority of economists argue that tariffs
have a negative effect on economic growth and economic welfare. We will look more at the pros
and cons of tariffs in a future tutorial. While we have covered the major types of
taxes in this tutorial, there are many types we didn’t have time to mention. Generally, however,
taxes fall into three categories. There are taxes on what you buy, taxes on what you own, and taxes
on what you earn. In order for citizens to have confidence in their governments, governments must
employ sensible tax policies, and being aware of the different types of taxes is crucial to making
sure that a tax is simple, transparent, efficient, and most importantly, fair.