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Americans pay various types of taxes, and most people discuss taxes in routine conversations. But how many people really know what even the most basic terms and concepts mean?
As one indication of confusion and uncertainty, most people don’t prepare their own returns, relying on and paying for help.
“Most Americans lack a basic understanding when it comes to tax policy,” the Tax Foundation said. “Taxes are complex and politicized.”
That’s why the foundation this month unveiled a free online “Tax Basics” guide at taxfoundation.org to help people make sense of common terms and concepts, alert them to common misconceptions and provide other insight.
It comes at a good time, when the presidential election campaign shifts into high gear, along with those for scores of Senate and House races — ripe environments for candidates to misquote tax fundamentals and for cheering crowds to nod along.
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Here are some key terms discussed in the Tax Foundation’s guide as they pertain to individuals (rather than businesses). Two or three related terms are grouped to help distinguish their meanings and to pack in more definitions.
Average tax rates vs. marginal rates
In the federal income-tax system and those of many states, people pay taxes at successively higher rates as they make more money. On federal returns, the first dollars you earn in a year are taxed at a 10% rate, followed by 12% on additional income and so on, up to a top 37% rate, which few people trigger. These are marginal rates.
If you divide your total tax bill by your taxable income, then you get the average rate, “the overall share of income paid in taxes,” the foundation explained. The marginal rate, by contrast, is the tax rate that applies on the next, or last, dollar earned.
Marginal rates come in handy if you’re thinking about taking on a second job or if you’re contemplating various investments. For example, the interest paid on municipal bonds typically is tax exempt. Consequently, those tax-free yields are more valuable for people who pay tax at high marginal rates than they are for those at lower marginal rates.
Deductions vs. credits vs. refundable credits
A deduction is a rule or provision that allows you to reduce your taxable income, possibly by making an expenditure or taking other action (like paying property taxes on a home).
Most taxpayers choose to take one standard deduction, as allowed in the federal tax code, rather than track and report all of their costs separately as itemized deductions. But if you have a lot of deductible expenses — mortgage interest costs, charitable donations or state income taxes, for example — it might be wise to claim them separately.
Credits are more valuable than deductions because they cut your tax bill outright, dollar for dollar, rather than just the amount of income subject to tax. Credits also are less common than deductions, meaning there are fewer tax-shaving credit opportunities to choose from compared with deductions.
Refundable credits, such as the earned income tax credit, are more valuable still. With them, you can receive the full dollar amount of the credit even if it exceeds your tax bill. With a nonrefundable credit, by contrast, you receive the benefit only until your tax liability drops to zero.
Deductions and credits both are typically passed into law with the aim of furthering some social or economic cause such as homeownership (mortgage-interest and property-tax deductions) or low-emission transportation (credits to buy electric vehicles). Deductions and credits thus subsidize certain products or behaviors.
Sales taxes vs. tariffs vs. VATs
All three of these levies raise the cost of purchases. Sales taxes, levied by most states and thousands of municipalities but not the federal government, apply to many retail goods and some services. Ideally, sales taxes should apply equally to all products, the Tax Foundation argues, but governments usually carve out exemptions for political or social reasons. For example, groceries often aren’t taxed.
You might think of tariffs as an entirely different type of animal, but they, too, are taxes that raise costs for consumers, businesses or both. Tariffs are imposed by the federal government on foreign imports. Their impact is less transparent to end users because middlemen absorb some of the cost and because sales receipts don’t list tariff amounts.
Value-added taxes are another consumption tax. “The worldwide average VAT rate is around 15%, with regional averages ranging from about 12% in Asia to 20% in Europe,” the foundation said. It described the U.S. as “unique among major countries in that it levies state and local sales taxes instead of a nationwide VAT.”
The average combined state and local sales tax rate in the U.S. is 6.6%, the foundation said, but it can exceed 9% in high-rate areas such as metro Phoenix and states including Tennessee and Louisiana.
Estate taxes vs. inheritance taxes vs. wealth taxes
Three categories of taxes are or could be levied on the property of rich individuals. Estate taxes are pegged to a person’s net worth (assets less liabilities) at the time of death and are paid before assets are distributed to beneficiaries. Inheritance taxes are similar but typically are paid directly by beneficiaries. The federal government imposes an estate tax but few people face it, thanks to a current $11.6 million exemption per person. There’s no federal inheritance tax, though there has been in the past.
Various states impose these taxes, which can affect the willingness of wealthy people to live in those locations and thus a state’s economic competitiveness.
Twelve states, including New York, Illinois, Oregon and Washington, plus the District of Columbia, had an estate tax as of 2019, according to the foundation. Six, including Pennsylvania and New Jersey, had an inheritance tax. However, most states have been moving away from these taxes or have raised exemption amounts so that fewer people are taxed.
Wealth taxes are levies on a person’s net worth while they are alive, with highly affluent individuals targeted. The U.S. has never had a wealth tax, according to the foundation, but the idea arises occasionally during election campaigns. Past Democratic presidential contenders Elizabeth Warren and Bernie Sanders, for example, each floated the idea of levying a wealth tax on multimillionaires and billionaires.
Reach Wiles at firstname.lastname@example.org.
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