One of the most valuable aspects of working at a public policy agency has been developing a deeper understanding of how policy systems operate and how they influence the broader economy.
Among these areas, tax policy has been especially compelling because of its wide-reaching economic and social implications.
The United States is a notable example of a country that uses its tax system not only to raise revenue, but also to pursue a wide range of policy objectives.
The U.S. tax system generates substantial funding for government operations while also influencing economic and social decisions, including retirement saving, education investment, health insurance coverage, clean energy adoption, and support for families with young children.
U.S. Capitol, Washington, D.C.
This article provides a high-level overview of the U.S. tax system as a foundation for understanding specific tax-related programs in greater detail.
1. Taxes are collected at three levels of government
A defining feature of the U.S. fiscal system is that taxes may be collected at multiple levels of government.
- The federal government collects taxes to fund national defense, Social Security, Medicare, federal programs, and government operations.
- State governments use tax revenue to pay for education, transportation, Medicaid, and many other state public services.
- Local governments, such as counties or cities, collect taxes to maintain schools, police and fire departments, libraries, parks, and other local services.
Consequently, a taxpayer’s overall tax liability can vary significantly depending on their state and locality of residence, income level, and personal circumstances.
2. Raising revenue for the government
The principal taxes that support government revenue include:
- Federal income tax
- State income tax
- Social Security and Medicare taxes, also known as payroll taxes
- Sales tax
- Property tax
- Corporate income tax
- Estate or inheritance taxes in some states
While some states do not impose a personal income tax, sales taxes and property taxes often vary substantially across local jurisdictions.
Income tax
Income taxes may be levied by the federal government, state governments, and in some jurisdictions, local governments. Several states, including Texas and Florida, do not impose a personal income tax.
The United States applies a progressive income tax structure. Under this system, income is divided into tax brackets, with each bracket applying to a specific range of taxable income.
A higher tax rate applies only to the portion of income that falls within a higher bracket. In other words, different portions of income are taxed at different rates; the taxpayer’s entire income is not taxed at the highest applicable rate.
For example, if part of a taxpayer’s income falls within the 10% bracket, only that portion is taxed at 10%; subsequent portions may be taxed at 12%, 22%, and higher rates. This distinction also explains why a taxpayer’s marginal tax rate is often higher than their effective tax rate.
This structure helps prevent taxpayers from facing a sudden jump in taxes simply because part of their income falls into a higher tax bracket.
U.S. citizens and permanent residents (green card holders) are generally subject to U.S. tax obligations on income earned both within and outside the United States.
Social Security and Medicare taxes (Payroll taxes)
Unlike income taxes, payroll taxes are withheld directly from workers’ wages to finance two major federal programs: Social Security and Medicare.
In general, both employees and employers contribute to these taxes. The revenue supports Social Security retirement benefits, disability benefits, survivor benefits and benefits for eligible family members, and Medicare coverage for individuals age 65 and older.
Sales tax
Sales tax is imposed on the purchase of goods and certain services. Unlike federal income tax, sales tax is primarily determined by state and local governments. As a result, rates can differ considerably across states and even among cities within the same state.
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Some states, including Oregon, Delaware, Montana, and New Hampshire, do not impose a state-level sales tax, while many other states have combined state and local rates that approach 10%. Sales tax revenue commonly supports public services such as education, transportation, and public safety.
Property tax
Property tax is levied on the assessed value of homes, land, and other real estate. It is one of the most important revenue sources for local governments in the United States.
Property tax revenue typically funds public schools, police and fire departments, libraries, parks, and other community services.
Because property taxes are based on assessed property values and local tax rates, the amount owed can differ substantially across jurisdictions, even for properties with similar market values.
Corporate income tax
In addition to personal income taxes, businesses operating in the United States may be subject to corporate income tax on profits generated from business activities. Depending on the business structure, profits may be taxed at the corporate level or passed through to owners and reported on their personal income tax returns.
Corporate tax provisions can also function as policy instruments by encouraging or shaping certain economic activities through deductions, credits, and investment incentives.
Taxes on inherited assets (Estate tax and inheritance tax)
After an individual’s death, their assets may be subject to estate tax or inheritance tax, depending on federal and state law. Estate tax is imposed on the total value of an estate before distribution to heirs, while inheritance tax is imposed on the recipient of inherited assets.
In practice, the federal estate tax applies only to very large estates, and state-level estate or inheritance taxes exist only in certain states. As a result, most families in the United States are not subject to these taxes.
4. Shaping economic behavior
A particularly important feature of the U.S. tax system is its use as a tool for influencing economic behavior.
Through deductions, tax credits, and tax-advantaged accounts, the government creates incentives for individuals and households to:
- offset higher education costs through the American Opportunity Tax Credit and the Lifetime Learning Credit;
- save and invest for retirement through 401(k) plans or IRAs;
- save and invest for education through 529 plans;
- save on health care costs through FSAs and HSAs;
- support families with young children through the Child Tax Credit, or help parents participate in the labor market through the Child and Dependent Care Tax Credit and Dependent FSA;
- invest or spend in certain priority areas, such as electric vehicles and environmental initiatives.
5. Why filing taxes every year matters
Two individuals with the same salary may have very different tax outcomes. Tax liability depends on many factors, including filing status, number of dependents, deductions, tax credits, investment income, and place of residence.
For this reason, paycheck withholding is only an estimate. When taxpayers file their annual returns, they may receive a refund or be required to pay additional tax.
Summary
As you may have noticed throughout the How America Works series, many government support programs are closely connected to the tax system. Together, they illustrate that the U.S. tax system is designed not only to raise revenue but also to shape long-term economic behavior.
This reflects one of the defining characteristics of the U.S. tax system. In addition to providing direct benefits, the government uses tax provisions to encourage behaviors considered beneficial to individuals and society, such as pursuing higher education, saving for retirement, investing in children, and participating in the labor force.
In this sense, the U.S. tax system serves not only as a revenue-raising mechanism, but also as a central policy tool for advancing economic and social objectives. Understanding how the system works can help taxpayers make more informed financial decisions and better navigate related government programs.