A tax is a compulsory financial charge or some other type of levy imposed upon a taxpayer by a governmental organization. Taxes are used to fund a number of public expenditures, such as roads, public transportation, education, and others. When expenditures exceed tax revenue, the government goes into debt.
Taxes have two effects:
- An income effect because they reduce purchasing power to taxpayers (income tax)
- A substitution effect when taxes cause a substitution between taxed goods and untaxed goods (sales tax)
Federal income tax is the tax levied by the United States Internal Revenue Service (IRS) on the earnings of individuals and legal entities. However, most states collect state income and sales taxes in addition to the federal income tax. State taxes are given little attention compared to federal income taxes.
States take one of three approaches when it comes to state income taxes:
- The state does not collect income tax
- The state imposes a flat tax, taxing all income (or only dividends and interest) at the same rate
- The state imposes a progressive tax which taxes higher income at higher rates
First, there are seven states that do not collect a state income tax. While these states do not have an additional income tax, other taxes, such as property or sales taxes, could be higher in these states. The seven states are:
Second, there are eleven states with flat income tax rates. In New Hampshire and Tennessee, the tax rate applies to dividends and interest income and regular income is typically not subject to state tax. These states are:
- Colorado (4.63%)
- Illinois (4.95%)
- Indiana (3.23%)
- Kentucky (5%)
- Massachusetts (5.05%)
- Michigan (4.25%)
- New Hampshire (5%)
- North Carolina (5.25%)
- Pennsylvania (3.07%)
- Tennessee (2%)
- Utah (4.95%)
The remaining states and the District of Columbia have state income tax brackets. The higher an individual’s income, the higher the tax bracket he/she will be placed into. California has the highest potential state income tax bracket of 13%.