Why You Have to Pay Taxes & Where the Money Goes

Governments collect taxes to fund public services and infrastructure that benefit everyone in society. This revenue supports a wide array of collective needs, including roads, schools, public safety, and national defense. Taxes represent a shared responsibility among citizens to contribute to the maintenance of a functioning society. It ensures the provision of goods and services that would otherwise be difficult or impossible for individuals to acquire on their own.

Tax on Income from Work

Individuals typically pay taxes on their earnings from employment or self-employment, as this income represents a significant and consistent source of government revenue. This broad tax base allows governments to fund their extensive operations and public services.

For those employed by an organization, income tax is applied to their gross wages and salaries. Employers are generally responsible for withholding a portion of an employee’s pay for federal income tax. The federal income tax system is progressive, meaning higher earners pay a larger percentage of their income in taxes. Taxable income is determined by subtracting certain deductions and exemptions from gross income.

Individuals who work for themselves, such as freelancers or small business owners, also pay income tax on their net earnings. Since there is no employer to withhold taxes, self-employed individuals are generally required to make estimated tax payments throughout the year. These payments are typically made quarterly to cover their income tax obligations. The requirement for estimated payments ensures that self-employed individuals contribute to the tax system on an ongoing basis, similar to how employed individuals have taxes withheld from their paychecks.

Tax on Investment and Property Gains

Taxes are also levied on gains derived from investments and the ownership of real property, recognizing these as forms of wealth accumulation or benefits from valuable assets. This taxation contributes to funding public services at various levels of government.

Investment income, such as dividends from stocks and interest earned from savings accounts or bonds, is generally subject to taxation. When an asset like stocks, mutual funds, or real estate is sold for a profit, these capital gains are also taxed. The tax rate on capital gains can vary depending on how long the asset was held; profits from assets held for one year or less are typically taxed at ordinary income tax rates, while those held for more than a year may qualify for lower long-term capital gains rates.

Local governments, including cities and counties, typically levy property taxes on real estate, such as homes and land. These taxes are based on the assessed value of the property, which is regularly evaluated by local tax assessors. Property taxes are a primary source of revenue for local services, directly funding essential community functions like public schools, police and fire departments, and local road construction and maintenance. The amount of property tax owed is calculated by multiplying the property’s assessed value by the local tax rate, which can vary significantly depending on the jurisdiction.

Tax on Goods and Services

Taxes are also added to the price of goods and services purchased, serving as a way for governments to generate revenue from economic activity and consumption. These consumption taxes are collected at the point of sale.

Sales tax is a common example, imposed by most state and local governments on the retail price of many goods and some services. This tax is collected by the seller at the time of purchase and then remitted to the appropriate government entity. Sales tax rates vary significantly across different states and even within localities, as cities and counties may add their own sales taxes. Certain essential items, like groceries or prescription medicine, are often exempt from sales tax depending on state regulations.

Excise taxes are another type of consumption tax, but they are levied on specific goods or services, often those considered non-essential or with associated social costs. Common examples include taxes on gasoline, tobacco, and alcoholic beverages. The revenue generated from excise taxes can be used for general government funding or, in many cases, earmarked for specific purposes, such as gasoline taxes contributing to road maintenance and improvements. These taxes can also serve to discourage certain behaviors by increasing the cost of the taxed items.

Taxes Supporting Social Programs

Specific payroll taxes are collected to fund social welfare programs, creating a social safety net for eligible individuals. These taxes are distinct from general income tax and are typically withheld directly from paychecks.

A portion of earnings is dedicated to the Social Security tax, which funds the Social Security program. This program provides crucial financial benefits for retirement, disability, and survivors of deceased workers. The Social Security tax rate is typically split between the employee and the employer, with self-employed individuals responsible for both portions. There is an annual wage base limit on the amount of earnings subject to Social Security tax, meaning income earned above this limit is not taxed for Social Security.

Another portion of earnings is allocated to the Medicare tax, which supports the Medicare program. Medicare provides health insurance primarily for individuals aged 65 or older, as well as younger people with certain disabilities. Unlike the Social Security tax, there is no income limit for the Medicare tax; all earned income is subject to it. Additionally, higher-income earners may pay an extra Medicare tax on earnings above certain thresholds.