Income Definition: Types, Examples, and Taxes (2023)

What Is Income?

Income refers to the money that a person or entity receives in exchange for their labor or products. Income may have different definitions depending on the context—for example, taxation, financial accounting, or economic analysis.

For most people, income means their total earnings in the form of wages and salaries, the return on their investments, pension distributions, and other receipts. For businesses, income means the revenues from selling services, products, and any interest and dividends received with respect to their cash accounts and reserves related to the business.

Economists have different definitions and ways of measuring income. Whether their studies involve earnings, savings, consumption, production, public finance, capital investment, or other related topics and subtopics, their concept of income will correspond to the purpose of their research. While the measure of income on a macro level is critical to societal and policy studies, individuals are more focused on their personal and business income.

Understanding Income

There are different terms for income, depending on the quantity being measured. Gross income means the total value of one's salary or payments, without accounting for any cash outflows. Net income refers to the income left over after subtracting taxes or fees. For individual earners, discretionary income is the amount they have available after paying for necessary expenses.

For the purposes of taxation, income refers to the types of revenues that are eligible for income tax. These definitions may vary by jurisdiction—salaries and sales are typically considered part of one's taxable income, but inheritances and gifts usually are not.

Although tax and accounting rules have similarities, each system has special rules reflecting its distinctive context and purposes. Generally, taxation and financial accounting measure income over a 12-month period. While financial accounting income is comprehensive, taxable income is calculated with special statutory exclusions, exemptions, and allowances that vary by tax status, income source, and individual and business decisions.

Taxable Income

For income tax purposes, the tax code attempts to define income to reflect taxpayers’ actual economic position. The general tax framework applies totaxpayers’ personal revenue (other than tax-exempt income) from all sources and offsets such revenue with deductions for expenses and losses to determine taxable income.

In addition, public policies may offer favorable taxation for people at certain income levels or for favored economic activities. Such policies include tax exemptions for government bonds, tax-favored treatment for retirement savings, tax credits for people below a certain income level, and promoting energy efficiency through special tax credits.

Types of Income

Three categories of income are of principal concern to taxpayers: ordinary income, capital gain, and tax-exempt income.

Ordinary Income

In the United States, the tax law distinguishes ordinary income from capital investments. Ordinary income encompasses earnings, interest, regular dividends, rental income, distributions from pensions or retirement accounts, and Social Security benefits. Ordinary income is taxed at rates ranging from 10% to 37% in 2022.

Taxpayers whose net investment income exceeds specified thresholds pay an additional 3.8% net investment income tax.

Capital Gains

Capital gains are the gains from selling assets that have appreciated in value. In the United States, the capital gains tax rates on assets held for more than one year are 0%, 15%, and 20%. Capital assets include personal residences and investments such as real estate, stock, bonds, and other financial instruments.

Qualified dividends—that is, dividends distributed with respect to the U.S. and certain foreign corporate stock holdingsthat meet statutory holding-period requirements—also are taxed at capital gains rates.

Tax-Exempt Income

Interest paid on certain bonds issued by governmental entities is treated as tax-exempt income. Interest paid on federal bonds and Treasury securities is exempt from state and local taxation.

Interest on bonds issued by state and local governments generally is not subject to federal taxation. Municipal private activity bonds are not subject to the regular federal income tax, but they are subject to the federal alternative minimum tax. Some states and local governments also exempt interest on state and local bonds from taxation.

How Is Earned Income Taxed?

Earned income is the money a person receives due to working or business activities, such as earning a salary, self-employment income, or certain government benefits. This is distinct from unearned income, such as receiving an inheritance, capital gains, or qualified dividends.

Earned income is subject to different taxes than unearned income. In the United States, earned income is subject to payroll taxes, Medicare tax, and Social Security tax, although the latter is capped at a certain level.

Business Income: GAAP Income

Most businesses, including all public companies, employ standard financial accounting methods and practices—i.e., generally accepted accounting principles (GAAP)—to determine their income and value. Audited financial statements prepared in accordance with these rules are required for public companies. Investors assess businesses’ financial statements and use them to compare the performance of companies in the same or different industries.

GAAP calculations do not incorporate the type of public policy deviations that are embodied in the tax code. The two systems employ different timing standards for recognizing revenue and expenses. Generally, the snapshot of income and business value determined using GAAP provides a picture of business income and value that is often closer to economic reality than the results of tax accounting.

The Bottom Line

Income is one of the most basic measures of economic activity. For individuals and companies, it measures the net gain of their revenues as a result of working or doing business. In public policy, income represents the basis for most forms of taxation.