Taxation

Updated on January 4, 2024
Article byGayatri Ailani
Edited byRaisa Ali
Reviewed byDheeraj Vaidya, CFA, FRM

Taxation Meaning

Taxation refers to the practice of levying the tax. The government levy taxes on their citizen to generate income, known as tax revenues. The income generated is then used to fund government expenditures. 

Taxation

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Tax revenues are important for national development. Most countries in the world collect taxes, but the structure varies. For example, the personal income tax rates in Japan, Austria, Sweden, and Denmark are more than 50%. At the same time, countries like Monaco, the Bahamas, and the United Arab Emirates (UAE) do not have personal income taxes. 

Key Takeaways

  • Taxation is the process of imposing and obtaining compulsory charges known as taxes from citizens by government entities to fund government expenditures.  
  • There are two types of taxes: direct and indirect taxes. The former is imposed directly on individuals and businesses, whereas the latter is levied indirectly by applying it to goods and services.
  • Examples of direct taxes include income tax and corporate tax. In addition, import tax and sales tax are examples of indirect taxes.
  • It is different from auditing because auditing is the process of examining the financial records of an entity.

Taxation Explained

Taxation refers to the charges and financial responsibilities that a government imposes on its citizens. Almost every country in the world collects taxes. However, taxation differs substantially from country to country and between emerging, developing, and developed economies

Due to effective tax compliance processes and collecting methods, developed countries collect higher tax revenues than developing countries. The standard of living and rising middle and upper-class income also contribute to the higher tax collection percentage in the developed economy. Since taxes are compulsory, the government may use various laws and penalties to collect them if someone refuses to pay the tax.

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Types of Income Tax Explained in Video

 

History

The first federal income tax was introduced in 1861 to raise money for the Civil War. Additionally, the Internal Revenue Act of 1862, introduced by the Bureau of Internal Revenue, the forerunner to the current Internal Revenue Service, was approved by Congress. However, the income tax was abolished in 1872 because it received little support after the Civil War.

Even though the first income tax was implemented in the United States due to the Civil War, the federal income tax emerged again and was officially imposed in 1913. Between 1920 and 1980, taxation as a percentage of national income rose sharply. The government’s spending on public services, especially healthcare and education, increased while taxes were raised. President Franklin D. Roosevelt ratified the Social Security Act in 1935, and the government began collecting Social Security taxes in January 1937.

Types

Taxes are generally classified into direct and indirect taxes.

1. Direct Taxes

Direct taxes are levied on individuals or organizations for their income or profits. Examples include gift tax, corporate tax, income tax, wealth tax, and capital gains tax.

  • Corporate Tax: The amount charged by the government on a corporation’s profits or net income is referred to as a corporate tax. It is a critical source of income for the government and an example of taxation for corporations.
  • Income Tax: Income taxes are levied on an entity’s annual income. Most income taxes rise in tandem with the taxpayer’s earnings. It means that those with higher incomes pay more taxes than those with lower incomes. 
  • Wealth Tax: It is also known as net wealth tax. It is levied on an entity’s net wealth, the market value of their total owned assets minus liabilities. The base for a wealth tax can vary depending on the income and various other sources as per rules.
  • Capital Gains Tax: Capital gains taxes are levied while selling off a non-inventory asset or capital asset for a higher price than its actual price. 
  • Gift Tax: A gift tax is a federal tax paid by an individual who transfers something valuable to another person without receiving something of equivalent value in return. It can include large sums of money or real estate.

2. Indirect Taxes 

Indirect taxes are applied on goods and services, and the customer purchasing the goods and services pays it indirectly as a part of the price of goods and services.

  • Import Duty and Tax: A government-imposed tax on goods from other countries is an import duty. Each country’s import duties are different. 
  • Sales Tax: Tax applied by the government on selling specific goods and services.

Examples

Let us look at taxation examples to understand the concept better. 

Example #1

John makes a taxable income of $9,950 in a year. If the income is not over $9,950, then the tax rate applicable is 10% of the taxable income. Therefore, John pays $ 950 as income tax to the government. 

Example #2

In September 2022, U.N. Secretary-General Antonio Guterres said that developed economies should put an additional tax on the profits of fossil fuel firms. This goal is to tax the windfall profits or unexpected increased earnings of fossil fuel companies in developed economies. Additionally, the tax money should help households experiencing a cost-of-living crisis due to rising food and energy costs and nations affected by climate change.

Example #3

Another example is the double taxation practice. It occurs when tax is collected twice from different entities for the same source of income. For instance, in the case of stock dividends taxation, they are taxed twice at the corporate and personal levels. The first occurs when the tax is obtained against a company’s earnings. Then, shareholders also have to pay taxes on the dividends they receive.

Example #4

Another example is discerned from cryptocurrency taxation. Under IRS rules, cryptocurrencies are assets. Crypto is taxable if profitable selling or using cryptocurrency in a transaction occurs. It is taxed as business income if crypto is accepted as payment for business purposes.

Benefits

There are several benefits of taxation mentioned below:

  • First, they aid in constructing and maintaining public infrastructure. It contributes to establishing or preserving the institutions necessary for the rule of law and the smooth operation of the democratic process.
  • Taxes guard the nation’s frontiers. Increasing government revenue can enhance spending on supplies, research & development in defense, foreign military cooperation, and international peacekeeping activities.
  • The government’s law enforcement organizations, including the police, paramilitary forces, and intelligence services, are funded by taxes. Therefore, it is also advantageous to ensure security and public safety.

Taxation vs Auditing

The difference between auditing and taxation are as follows:

  • The evaluation and verification of a company’s financial records is an audit. Its purpose is to verify the fair and accurate representation of financial data. In contrast, taxation is the method by which government extracts revenue from the people by imposing financial obligation in the form of tax.
  • Tax accountants are experts in efficiently assisting institutions and individuals with tax planning and filing, while auditors verify whether accountants’ work is accurate and compliant with the law.
  • There are three different types of auditing internal, external, and IRS tax auditing, whereas there are generally two different types of taxes, direct and indirect.

Frequently Asked Questions (FAQs)

What was the “no taxation without representation” slogan?

It is a political slogan that emerged and was popularised during the American Revolution. During the mid-1760s and early 1770s, the American colonists were the first to coin the phrase “no taxation without representation!” when Britain imposed the Stamp Act, where they charged Americans to pay tax on every piece of printed paper used. 

What is the purpose of taxation?

The primary purpose is the economic development of the country. Therefore, the government can use tax revenue to invest in the productive areas of the economy, particularly the infrastructure sectors.

Is taxation voluntary?

No taxation is compulsory and not voluntary. Citizen of the country is obliged to pay taxes. In the United States, IRC section 1 imposes a tax on the taxable income of individuals, estates, and trusts, and IRC section 11 imposes a tax on corporations’ taxable income.

This has been a guide to Taxation and its meaning. We explain its history, types, examples, benefits, and comparison with auditing. You may also find some useful articles here:

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