What Are Federal Taxes and How Do They Work?

Federal taxes are mandatory payments individuals and businesses make to the United States government. The U.S. Constitution’s 16th Amendment authorizes Congress to collect taxes on income. This revenue is the government’s primary funding source, paying for public services and operations ranging from national defense and infrastructure to social programs supporting citizens and the economy.

The Primary Types of Federal Taxes

Individual Income Tax

The individual income tax is the largest source of revenue for the U.S. government. This tax is levied on a person’s total earnings from sources including wages, salaries, and bonuses, as well as investment income like interest, dividends, and capital gains. U.S. Code Title 26 defines taxable income as earnings from all sources.

All U.S. citizens and residents meeting certain income thresholds must pay this tax. The amount owed depends on filing status—such as single, married filing jointly, or head of household—and total taxable income.

Corporate Income Tax

Corporations in the United States pay federal income tax on their profits. A company’s profit is its revenue minus business costs, like operating expenses, depreciation, and employee salaries. Legally defined corporations are responsible for paying this tax, calculating their net earnings and paying a percentage of those profits to the government.

Payroll Taxes (FICA)

Payroll taxes, mandated by the Federal Insurance Contributions Act (FICA), are dedicated contributions that fund Social Security and Medicare. These funds are earmarked specifically for these social insurance programs. FICA taxes are split evenly between employees and employers.

For Social Security, both parties pay a percentage of an employee’s wages up to an annual limit, which is $176,100 for 2025. The Medicare tax has no wage limit and is paid on all earnings. Self-employed individuals are responsible for paying both the employee and employer portions of FICA taxes.

Excise Taxes

Excise taxes are levied on the sale of specific goods, services, or activities, and are often included in the product’s price. These taxes can generate revenue or discourage the consumption of certain items. The tax is paid by the producer or seller, who then passes the cost to the consumer. Common examples include federal taxes on gasoline, tobacco, alcoholic beverages, airline tickets, and certain sporting equipment.

Estate and Gift Taxes

Estate and gift taxes apply to the transfer of wealth. The estate tax is for property transferred after death, while the gift tax is for wealth transferred during life. These taxes affect only very large transfers, and most Americans are not subject to them.

The tax is levied on the value of an estate or gift that exceeds a high exemption amount. For 2025, the federal exemption is $13.99 million per individual. A person can transfer up to this amount without incurring the tax. Gifts exceeding the annual exclusion ($19,000 for 2025) must be reported, but tax is only owed if lifetime transfers surpass the exemption.

Customs Duties and Tariffs

Customs duties, or tariffs, are taxes on goods imported into the United States. These taxes protect domestic industries by making foreign goods more expensive and also serve as a source of government revenue. Importers pay the duty, which is a percentage of the product’s value and varies by the good and its country of origin. This cost is often factored into the final retail price paid by consumers.

How Federal Taxes Are Assessed and Paid

Tax Assessment Concepts

The United States uses a progressive tax system for individual income taxes, where higher income levels are taxed at higher rates. This system is organized into tax brackets, with rates for 2025 ranging from 10% to 37%. A person’s income is not all taxed at their highest bracket; instead, portions of income falling into each bracket are taxed at that specific rate.

Taxpayers can lower their tax liability using deductions and credits. A tax deduction, such as for student loan interest, lowers the amount of income subject to tax. A tax credit directly reduces the amount of tax owed on a dollar-for-dollar basis. A $1,000 tax credit lowers the final tax bill by $1,000, making credits more impactful than deductions of the same amount.

Methods of Payment

The primary method for paying federal income tax is withholding. Employers deduct an estimated amount of tax from an employee’s paycheck and send it to the IRS. The amount withheld is based on information the employee provides on their Form W-4, which includes filing status and dependents.

Individuals who are self-employed or have significant non-wage income must pay estimated taxes. This requires calculating their expected tax liability and making quarterly payments to the IRS, due on April 15, June 15, September 15, and January 15. This pay-as-you-go approach for both withholding and estimated taxes helps prevent a large bill and underpayment penalties.

If these payments do not cover the full tax owed, the balance is due when the annual tax return is filed. The deadline for filing Form 1040 is April 15, unless it falls on a weekend or holiday. Payments can be made electronically through the IRS website or by mail.

The Role of the Internal Revenue Service (IRS)

Tax Administration and Collection

The Internal Revenue Service (IRS) is the federal agency that administers and collects federal taxes. Its main function is to process millions of tax returns filed annually by individuals and businesses, including income, corporate, payroll, and excise tax forms. The agency ensures returns are processed accurately and the correct tax is assessed. The IRS then collects the revenue owed through withholding, estimated payments, and balances due at filing.

Enforcement of Tax Laws

The IRS is also responsible for ensuring compliance with the nation’s tax laws as outlined in the Internal Revenue Code. The agency encourages voluntary compliance but has the authority to enforce these laws. Enforcement activities include conducting audits to verify the accuracy of tax returns. If an audit finds a discrepancy, the IRS can assess additional taxes, penalties, and interest. For non-payment or fraud, the agency may take collection actions like levying bank accounts or, in serious cases, pursuing criminal charges.

Taxpayer Services

The IRS provides services to help taxpayers meet their obligations. The agency develops and distributes tax forms, instructions, and publications on its website, covering a wide variety of topics. The IRS also offers direct assistance through its website’s interactive tools and FAQs. Further help is available via toll-free telephone lines and in-person Taxpayer Assistance Centers, all designed to encourage voluntary compliance.

How Federal Tax Revenue Is Used

Mandatory Spending

A large portion of federal tax revenue is designated for mandatory spending, which is required by existing laws. The largest of these programs are Social Security, Medicare, and Medicaid, which provide benefits to retirees, individuals with disabilities, and low-income families. Spending on these programs is determined by eligibility rules, meaning the amount spent each year depends on how many people qualify for benefits.

Discretionary Spending

Discretionary spending is the part of the federal budget that Congress approves annually through the appropriations process, allowing policymakers to set priorities. The largest category is national defense, which funds the U.S. military and related security operations. Other major categories include education, transportation, scientific research, and veterans’ benefits. The amount allocated to each area can change yearly based on the priorities of Congress and the President.

Interest on the National Debt

A portion of federal tax revenue pays interest on the national debt, which is the total money the U.S. government has borrowed to fund operations when spending exceeded revenues. This borrowing is done by issuing securities like Treasury bonds. The interest paid is a legal obligation, and the amount depends on the debt’s size and interest rates on the issued securities.