Taxation

What is Taxation?

Taxation refers to the fees and financial obligations imposed by a government on its residents. Income taxes are paid in almost all countries around the world. However, taxation applies to  all payments of mandatory levies, including on income, corporate, property, capital gains, sales, and inheritance.

Taxation is involuntary; hence it does not require consent from the residents. Therefore, the government may resort to the use of force and threats to implement successful taxation.

Levies generated through taxation are not bound to any specific service delivery, and they are legally recognized because the compelling establishment is a government authority and not a private institution. Taxation procedures vary across governing structures and periods.

In modern times, taxation is also applied to physical assets and specific contracts, such as business transactions. However, modern tax policies are greatly influenced by political forces.

Understanding Taxation

Taxation is a form of financing of government activities in almost every country. The International Centre for Tax and Development (ICTD) estimates that 80% of overall government funding in half of the countries around the world is accounted for by tax revenues. Governing authorities are able to increase taxation levels by changing taxation rules and expanding tax bases.

Primarily, the revenue collected is utilized for the welfare of taxpayers; this means that the specific benefit received is independent of the individual payment. However, there are some exceptions, such as payroll taxes, where the taxpayer will directly benefit from medical coverage and retirement benefits.

Taxation patterns differ greatly among developing and developed countries. Higher tax revenues are collected in developed countries than in developing countries due to efficient taxation compliance mechanisms and effective tax collection methods.

However, both of these factors are directly affected by the competency of the political system. Generally, developed countries rely more on income taxation to realize most of their national output, more so than developing countries who rely heavily on consumption and trade taxes.

Types of Taxation

The following are the different types of levies imposed on residents by the government:

1. Income Taxes

Income taxes are levies imposed on the total financial income of an individual, such as wages, investments, and salaries. Most income taxes increase with the rise in the taxpayer’s earnings. This means that higher-income earners pay more taxes than low-earners. This is also referred to as progressive taxation.

2. Corporate Taxes

Corporate income tax is levied on business income. The burden of corporate tax is shared between the business, its consumers, and the employees through setting higher prices and paying low wages. To encourage business growth, most governments levy businesses a corporate tax rate of below 30%.

3. Payroll Taxes

Payroll taxes are levies imposed on employees’ income to finance social security funds. Normally, the payroll tax amount is automatically deducted from the income and paid by the employer on behalf of the employee.

For example, in the United States, the highest payroll taxes are 12.4% tax to finance Social Security and 2.9% tax to pay Medicare, accounting for a 15.3% total tax rate. In this case, the employer remits 7.65% of the tax rate, which amounts to half of the payroll taxes. The other half is automatically deducted from the employee’s income.

4. Capital Gain Taxes

Capital gains taxes are levied on capital assets, which include personal properties and investments like stocks, homes, bonds, cars, or jewelry. When an asset increases in value, such as rising stock prices, it is referred to as capital gain.

Therefore, when an individual benefits from a capital gain, tax is paid on the profit earned.

5. Property Taxes

Property taxes are generally imposed on physical property, such as land and buildings. They are the primary revenue source for local state governments. Property levies account for over 70% of local tax revenues. Property taxes finance key public services, such as fire departments, schools, roads, security, and rapid medical services.

Classes of Taxes

Taxes are classified into different criteria ranging from the mode of payment, the subject bearing the tax burden, and the extent of shifting the burden.

1. Direct Taxes

Direct taxes are levies subjected to individuals based on the taxpayer’s net wealth, expenditure, or personal net income. Levies on net worth are based on the taxpayer’s assets value minus total liabilities, while expenditure taxes are paid on income that is not directed to savings.

2. Indirect Taxes

Indirect taxes are taxes imposed on transactions such as imports and exports and the production and consumption of goods and services. Examples include value-added taxes, legal transaction taxes, manufacturing taxes, and custom taxes on import duties.

Learn More

CFI offers the Financial Modeling & Valuation Analyst (FMVA®) certification program for those looking to take their careers to the next level. To keep learning and advance your career, the following resources will be helpful:

• Ad Valorem Tax
• How the Government Makes Money
• Corporate vs. Personal Income Tax
• How to Use the IRS.gov Website
• See all accounting resources