What is tax? Definition and meaning
Tax is a compulsory charge that a government imposes on corporate profits, land value, personal income, the sale of goods and services, and other financial assets and activities. The involuntary fee can be enforced by either national, regional or local government in order to fund their activities.
The government uses the money it gathers through taxes to fund public spending. Direct taxation refers to taxing what is earned, while indirect taxes are those levied on what is spent – levying the charge on the price of goods and services is indirect taxation.
Governments, monarchs and emperors have been collecting taxes from the people for thousands of years. The first known system of taxation was in Ancient Egypt between 3000 and 2800 BC in the first dynasty of the Old Kingdom.
Tax evaders face punishment
Paying taxes is compulsory – those who do not pay it but should are guilty of evading taxes and are liable to a penalty, and in some cases imprisonment.
Several celebrities have been caught evading taxes. Wesley Snipes, the actor of the Blade movies, was sentenced to three years in prison in 2008 – he began serving his sentence in 2010.
Italy’s iconic actress Sophia Loren served 17 days of a 30-day jail sentence in 1982 for evading taxes. In 2013, a Rome-based court ruled that she was innocent and had calculated her tax correctly.
The majority of governments use a department or agency to collect the charges they levy. In the United States, United Kingdom and Canada, the Internal Revenue Service (IRS), HM Revenue and Customs and Canada Revenue Agency (respectively) perform this function.
A tax collector’s office in 1640. Painting by Pieter Brueghel the Younger (1564-1636), a Flemish artist. Money in the form of cash was not so common in those days. People used to come into his office with goods or livestock, which they would hand over as payment. (Image: Wikipedia)
Tax: purpose and effect
The purpose of taxation is to raise income to fund government. Taxation money has been used by governments and their functional equivalents throughout history to carry out a wide range of functions.
The money spent by the state – public spending – goes on economic infrastructure (education, public safety, legal systems, sanitation, public transportation and roads), scientific research, military, culture & arts, public works, the operation of government itself, data collection and distribution, etc.
The ability of government to raise taxes is known as fiscal capacity.
When public spending (expenditure) exceeds tax revenue the government accumulates a debt. Part of the money collected through taxes may be used to service past debts.
Taxes are also used to fund public services, welfare and utilities, including the education system, pensions for retired people, public transportation, unemployment benefits, energy, water and waste management systems.
In some countries, utilities (water, electricity, natural gas) are set up and distributed by the private sector.
War tax stamps used to be common features when the country was at war. In this image you can see a (left) 5-centimo Spanish stamp dated 1875. The other two were issued in WWI, in (top right) Malta and (bottom right) Canada. A postage stamp would be added to an envelope in addition to regular postage. (Images: Wikipedia)
Types of taxes
Many jurisdictions tax the income of individual people and business entities, including large corporations. Businesses are generally taxed on net profits, net gains, and other income, while salaried employees are charged on how much they earn.
Most countries have a tax-free threshold – anything below that amount per year is not subject to income tax. This threshold is generally higher if the main earner is married – however, as a growing number of families have both parents working, some couples may find themselves better off (if they both work) if they don’t get married.
In Europe, North America, Japan and Australasia, people on higher incomes are charged a greater proportion of their earnings compared to their counterparts who are paid less – they have a vertical equity tax system.
According to Cornell University Law School, tax evasion is: “Using illegal means to avoid paying taxes. Typically, tax evasion schemes involve an individual or corporation misrepresenting their income to the Internal Revenue Service. Misrepresentation may take the form either of underreporting income, inflating deductions, or hiding money and its interest altogether in offshore accounts.”
Most salaried people have their income tax deducted at source – i.e. a pay-as-you-earn system, with small corrections made at the end of the financial year. The taxpayer will either have to pay an additional amount, or will receive a refund if he or she had been overcharged.
Businesses tend to be able to have more deductions that lessen the total tax bill for the year, compared to salaried individuals. In some countries, a part of an individual’s monthly mortgage repayments may be tax-deductible.
Negative income – this is an economics term for supplemental pay in a **progressive tax system where employees who earn below a certain amount receive supplemental pay from the government, i.e. the government pays rather than collects.
** Progressive tax is a system in which higher earners pay a greater percentage of their income in tax than lower earners.
Capital gains tax is levied on the profit when you dispose of (sell) an asset that has appreciated in value, i.e. you sell it for more than you bought it for.
The British Government says that disposing of an asset includes: 1. Selling it. 2. Giving it away as a gift. 3. Transferring it to somebody else. 4. Getting compensation for it (e.g. if you lose something you get insurance money). 5. Swapping it for something else.
The government charges you on the gain you make, not the total amount of money you receive.
Imagine you bought an antique table for $5,000 and sold it at a later date for $25,000. This means your gain was $20,000 – you would be taxed on those twenty thousand.
In some countries, a number of assets are tax-free. In every country, there is a tax-free allowance – if your profit is below that amount, you will pay no capital gains.
How much individuals will be charged depends on their tax bracket, i.e. higher earners in most countries probably have to pay higher rates of capital gains.
Corporate tax (Corporation tax in the UK) is levied on the profit of a company. In the US/Canada, it is also known as corporate income tax. Rules surrounding how much companies have to pay vary considerably around the world.
According to PricewaterhouseCoopers (PwC), a multinational professional services network, in the United States, resident corporations are taxed based on their global income.
On its website, PwC writes:
“Generally, a foreign corporation engaged in a US trade or business is taxed at regular US corporate tax rates on income from US sources that is effectively connected with that business and at 30% on US-source income not effectively connected with that business.”
Estate or inheritance tax
A levy on the transfer of the estate of a deceased person is called estate tax in the United States and inheritance tax in the UK.
The levy applies to property that is transferred through a will, an intestate estate or trust, or the payment of certain types of life insurance benefits.
In the US, if a spouse or a federally-recognized charity inherits the estate, there is not usually any tax to be paid. Up to a certain amount may be given by an individual before and/or upon death without incurring deferral estate taxes.
People who operate in the shadow economy – ‘below the radar – pay no taxes on income, sales and profits. In some countries, the shadow economy – also known as the informal sector or underground economy – represents more than half its GDP. Their governments either tax those in the formal sector more heavily to make up for the shortfall, or provide very basic services.
Video – 4 main types of taxes
This video by Education Unlocked looks at the four types of taxes that individuals have to pay – sales, property, estate and income taxes.