Taxes are payments from the citizens of a country to the government. Those payments fund government projects and other expenses that serve the public interest. By definition the taxes are legislated and unavoidable. Failure to pay is punishable by law.
The purpose of this article is to give general definition of taxes and the different types of taxes from economic and investment point of view. It also illustrates the difference between employees and corporations when it comes to taxes. And last but not least, it tries to argue why being a business owner of a corporation is better than being an employee, from taxation point of view.
There are more and more people that quit their daytime job in order to work as self-employed, business owners or investors. There are many reasons for such a big step and one of them is the truth about those payments to the government. Our goal in this article is to help you open your eyes and see the huge potential and opportunities of owning a business or working as a self-employed.
Time to read
Time to read: 12 minutes (based on 150 wpm).
This article is based on one of the chapters of one of the best books about self-improvement out there: Rid Dad Poor Dad. I was lucky to read this book years ago, when I was young enough, but it is never late for anybody.
Why are taxes important?
Taxes are important because of many reasons. Here we are going to cover only the economic, investment and general ones.
Taxes are important in Economics mostly because of their impact on consumption. Generally speaking, the higher the taxes are, the lower the consumption is (because less money reach the peoples).
Taxes could also have effect on supply and demand. For example, when the tax on a good with many alternatives is increased, the price of the good would generally increase and the buyers will look for alternatives.
They are also important when huge corporation consider where to create their subsidiaries in foreign countries. For example, because of a special law that permitted the government to negotiate special tax levels for selected corporations, some major companies founded their European headquarters in Ireland. More on the topic here: Double Irish arrangement.
Taxes are also important in the investing world. Some transactions trigger tax liabilities and others do not. This is a major consideration for buying and selling certain investments and for the timing of those actions. This is why one of the most important subject in MBA programs in finance.
In general taxes are important, because they are one of the major sources of funds for the governments. Therefore paying them is considered civic duty, even though it is already required by law.
History of taxes
Originally, there were no taxes. At least not like we know them today. Taxes were mainly used to pay for wars and governments imposed them temporarily in times of war. The leader of the country (or kingdom, or whatever) would (usually by force) ask everybody to take their part and set aside money in order to help the war effort. So in that sense, taxes were first temporary and did not last for too long, because otherwise the citizens rebelled.
Income tax was first implemented in the United Kingdom in 1798 by William Pitt the Younger. The reason was to pay for weapons and equipment in preparation to the Napoleonic Wars. He began to levy progressive income tax of 2 old pence in the pound on incomes over 60 pounds and increased up to a maximum of 2 shillings on incomes of over 220 pounds. Source: History of Taxation in the United Kingdom (Wikipedia).
Taxes in the US spread relatively late (in 1913), because Americans were generally against taxes. The famous Boston Tea Party (one of the prerequisites of the Revolutionary War) was caused because the UK government tried to increase the taxes on its colonies. In that sense, it took the American government almost 50 years more than the UK government to introduce income tax.
Who pays taxes?
In the beginning (for both the UK and the US), only the rich people paid taxes. The main idea that the governments marketed, was that upper and middle class citizens would pay them. And the income from taxes will benefit everybody, by investing in infrastructure, institutions and so on.
Once governments saw how much money they can gather from taxes, they started expanding the reach and soon imposed taxes on almost everybody. In reality even with the most fair progressive system of taxation, the ones that end up paying the most tax are the lower and middle classes.
The upper class reacted by starting to put their money in corporations, which always followed different rules of taxation. We will examine this subject in detail later on.
What is the difference between the government and a corporation in terms of spending?
An interesting comparison of government and corporate spending gives more information about taxes. The main income of the government is taxes (income tax, taxes on trade and import and so on). The different institutions in a government have budgets for each year, calculated based on the spending of the previous years. The government encourages the people responsible for the budgets at these institutions to optimize (in other words spend) their whole budget, or otherwise they might receive less money for the next year.
On the other hand, the primary income of a corporation is the difference between sales and expenses. The finance people, working for a corporation also work with budgets, also calculated based on the previous year(s). However, corporations penalize their finance employees, if they spend too much of the earnings and encourage them to optimize by spending less.
What are the corporations?
The corporations were invented after the Age of Exploration when the European countries saw rise in sea trade. The trade voyages were a risky business and someone could lose his or hers whole fortune by investing in a single voyage. This is why the rich created corporations in which more than 1 person invested and which could afford to send many overseas voyages. If they lost a ship, it only meant a loss of investment on that particular ship.
So technically, the corporations owned the money of the rich and they did not have to pay income tax. Governments countered with creating corporate taxes and taxing the income from the corporations. But in truth a corporation and an employee differ in that the corporation pays taxes on the difference between sales and expenses and the employees pays tax on their income. But more on that will follow later.
Types of taxes
There are many types of taxes, but the most relevant to this article are the following:
- Income tax – levied on individuals or corporations as a percentage of net profits from business, net gains or other income.
- Personal income tax – often collected on a monthly bases, with small corrections after the end of the year. Those corrections can either be further payments (if you had not paid enough) or refunds (if you paid too much).
- Negative income tax – a payment from the government for those, who do not earn enough.
- Capital gains tax – some governments impose income tax on gain of sales of capital assets.
- Corporate tax – taxes imposed on corporations. The rates may differ from those of individuals.
- Social security contributions – publicly funded health care and/or retirement services.
- Payroll tax – imposed on employers based on total payroll.
- Property tax – the owner of a property has to pay that tax based on the value of the property.
What is the difference for employees and corporations
Probably you already see the difference between employees and corporations, but in any case here it is.
Employees earn salaries, pay taxes and then spend the rest
The situation for the employees is self-explanatory. They work for a corporation and they earn a salary. The employer pays the income tax on behalf of each employee, by subtracting it from their salary. And the employee receives that is left. In summary, employees:
- Earn their salaries.
- Pay taxes monthly.
- Spend the rest.
With his or hers monthly salary (after tax), they should pay for rent, food, transportation and everything else. At the end of the year, each employee could file a tax declaration and receive a tax refund if they paid too much to the government.
Business owners earn from sales, spend next and finally pay taxes on the difference
A corporation lives by selling its products or services. Its customers pay and those payments are called sales. The corporation has expenses for raw materials, advertising, payroll and so on. Finally, at the end of the year, representatives from the corporation file a tax declaration. The company has to pay tax on the difference between its income and expenses. So in order to summarize it, companies:
- Earn by selling products or services.
- Spend for raw materials, advertising and other.
- Pay tax on the difference of earnings and expenses.
This could be very beneficial for the business owners, because the corporation could own their car, apartment. And their costs are expenses for the company. He or she could also higher smart financial and accounting professional, who could help further reduce payments to the government.
One of the goals of our blog is to help our readers to prepare for the upcoming shift in the workforce climate. As I already said, there are so many people that decide to stop working as employees and either start a business or as self-employed contractors. The model from the past where people used to work for 20+ years for the same company and bet all their saving on that company, is over.
In this article we tried to explain what taxes are. And to show the main difference between an employee and a business owner when it comes to taxes. We showed why they were invented in the first place and who pays more. My hope for all those who read the article is to open their eyes and make them rethink all options.