Ch1. Introduction to Taxes — Types and Structure of US Taxes

What Is a Tax?

A tax is money that government — federal, state, or local — compels individuals and businesses to pay by law, primarily to fund public services. Three defining characteristics of taxes are compulsion (you must pay), non-reciprocity (you receive no direct benefit in exchange), and legal authority (set by statute).

The US tax system is classified along two main dimensions. The first is the collecting authority: federal vs. state/local. The second is the payment method: direct vs. indirect.

Federal vs. State/Local Taxes

Classified by collecting authority:

Federal Taxes — collected by the IRS
├─ Income taxes
│   ├─ Direct: Individual income tax, Corporate income tax,
│   │           Estate tax, Gift tax
│   └─ Indirect: Excise taxes (fuel, alcohol, tobacco, air travel)
├─ Customs duties (on imported goods)
└─ Payroll taxes: Social Security (12.4%), Medicare (2.9%)

State & Local Taxes — collected by state/county/city
├─ State income tax (most states; WA, TX, FL have none)
├─ Sales tax (state + local combined; varies 0%–10%+)
├─ Property tax (county/municipal; on real estate and personal property)
├─ Estate/inheritance tax (some states have lower exemptions than federal)
└─ Vehicle registration, fuel tax, etc.

Federal taxes are administered by the IRS; state/local taxes are administered by state Departments of Revenue or county tax assessors. The income taxes withheld from your paycheck are federal (and often state) income tax plus FICA payroll taxes. Property taxes on your home are assessed and collected locally.

Direct vs. Indirect Taxes

Classified by payment method:

Direct Tax
└─ Taxpayer = Economic burden bearer
   Example: Individual income tax — you earn the income and you pay the tax
   Example: Corporate income tax — the corporation earns and pays
   Feature: Ability-to-pay principle (progressive — higher income, higher rate)

Indirect Tax
└─ Taxpayer ≠ Economic burden bearer (tax shifting occurs)
   Example: Sales tax — retailer remits to state, but consumer bears the cost
   Example: Excise tax — manufacturer pays, but passes cost to buyer in price
   Feature: Regressive (same dollar amount regardless of income; hurts lower earners more)

Major US Tax Categories at a Glance

Individual Income Tax

The federal income tax on income earned by individuals during the calendar year. Progressive marginal rates from 10% to 37% apply to taxable income.

Types of taxable income:
├─ Wages and salaries (W-2 income): withheld by employer → settled at filing
├─ Self-employment income: reported on Schedule C, subject to SE tax
├─ Interest and dividends: <$1,500 ordinary dividends — Schedule B
├─ Qualified dividends and long-term capital gains: 0% / 15% / 20% preferential rates
├─ Pension / retirement income: taxed as ordinary income (traditional) or tax-free (Roth)
├─ Other income: freelance fees, alimony (pre-2019), prizes
└─ Capital gains: from selling property, stocks — separate rate schedules

Corporate Income Tax

The tax on income earned by C-corporations.

Corporate Tax Rate (post-TCJA):
All taxable income → 21% flat rate

S-Corporations, Partnerships, LLCs:
Pass-through entities — no entity-level tax
Income flows to owners and taxed at individual rates
Qualified Business Income (QBI) deduction may apply (up to 20%)

Payroll Taxes (FICA)

Federal taxes funding Social Security and Medicare.

FICA Tax Rates:
Social Security: 6.2% employee + 6.2% employer = 12.4% total
  (wage base: $176,100 in 2025)
Medicare: 1.45% employee + 1.45% employer = 2.9% total
  (no wage base cap)
Additional Medicare Tax: 0.9% on individual wages > $200,000 (employee only)

Self-employed individuals:
Pay both sides = 15.3% SE tax (but deduct half above-the-line)

Property Tax

An annual tax on real property value, assessed by local governments.

Property Tax Example (US average rate ~1.07% of assessed value):

Home assessed at $400,000 in a county with 1.2% effective rate:
Property tax = $400,000 × 1.2% = $4,800/year

Note: Rates vary widely — New Jersey averages ~2.2%; Hawaii ~0.3%
Assessment ratio and millage rates set locally

Capital Gains Tax

Federal tax on profits from selling capital assets (real estate, stocks, businesses).

Short-term capital gains (held ≤1 year): taxed as ordinary income
Long-term capital gains (held >1 year):
  0% if taxable income ≤ $48,350 (single) / $96,700 (MFJ) — 2025
  15% for most taxpayers
  20% for highest-income taxpayers
  + 3.8% NIIT if MAGI exceeds $200K/$250K

Sales Tax

Collected at the point of sale by retailers; no federal sales tax — all state/local.

Combined state + local sales tax rates (2025 examples):
California: up to ~10.75% (state 7.25% + local)
Texas: up to ~8.25%
New York City: 8.875%
Oregon / Montana / New Hampshire: 0% (no state sales tax)

How Taxes Are Collected

Withholding (Pay-As-You-Go):
Employer deducts federal/state income tax and FICA from each paycheck
Bank deducts backup withholding on interest if no TIN provided
Final settlement: Form W-2 filed in January; taxpayer files Form 1040 by April 15

Self-Assessment (Voluntary Filing):
Taxpayer calculates own tax liability and files a return
Self-employed: quarterly estimated tax payments (Form 1040-ES)
Annual reconciliation on Form 1040 (April 15 deadline)

Assessment by Government:
IRS issues tax bill after audit or failure to file
Property tax: county mails annual bill based on assessed value
Vehicle registration: state sends renewal notice with fee

Key Concept Cards

Federal = IRS, State/Local = Dept. of Revenue ★★★★★ : Income tax, payroll tax, estate/gift tax are federal (IRS). Property tax, sales tax, vehicle tax are state/local. Memory hook: Your W-2 withholds federal; your property tax bill comes from the county

Direct Tax = ability-to-pay; Indirect Tax = regressive ★★★★★ : Progressive income tax is ability-to-pay. Sales tax is regressive — takes a larger percentage of lower incomes. Memory hook: Direct = proportional burden; Indirect = equal dollar, unequal burden

Withholding = pay-as-you-go ★★★★☆ : Taxes withheld from paychecks are prepayments. April 15 return either refunds overpayment or collects balance. Memory hook: Withholding = advance payment; Form 1040 = true-up

LTCG and Qualified Dividends = preferential rates ★★★☆☆ : Long-term investment income taxed at 0/15/20%, not at ordinary income rates up to 37%. Memory hook: Long-term capital gain = big tax break for patient investors

Practice Quiz

Q1. What is the difference between federal and state/local taxes, and who collects each?

The collecting authority is the key distinction. Federal taxes are levied and administered by the IRS and include individual income tax, corporate income tax, payroll taxes, estate tax, and gift tax. State and local taxes are levied by state Departments of Revenue (income and sales taxes) or county/municipal governments (property taxes). Most employed Americans pay both federal income tax (withheld on their W-2) and state income tax (if their state has one), plus FICA payroll taxes — all from the same paycheck.

Q2. Explain the difference between a direct and indirect tax using the taxpayer vs. burden-bearer framework.

A direct tax has the same person as both the legal taxpayer and the economic burden-bearer. Individual income tax is the clearest example: the worker earns the income, files the return, and personally bears the economic cost. An indirect tax separates these roles: the legal taxpayer (the seller) remits the tax, but the economic burden is shifted to the buyer through higher prices. Sales tax is the canonical example — the retailer sends the tax to the state, but the consumer pays it embedded in the purchase price. Economists call this “tax incidence shifting.” Indirect taxes tend to be regressive because lower-income households spend a higher proportion of their income on taxable consumption.

Q3. What taxes apply when you buy, hold, and sell real estate?

Buying real estate triggers transfer taxes (deed recording fees or state transfer taxes, typically 0.1%–2% of purchase price; plus any city/county transfer tax). Holding triggers property tax (annual, based on assessed value — ~1%–2% of market value in most areas) and potentially Alternative Minimum Tax adjustments. Selling triggers capital gains tax: if held >1 year and meets the §121 exclusion ( $250,000 single /$ 500,000 MFJ) for a primary residence with 2+ years of ownership and use, the gain is excluded from federal income tax. The gain above the exclusion is taxed at long-term capital gains rates (0/15/20%). Real estate investors may also face §1250 depreciation recapture taxed at up to 25%.

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