Taxonomy (the Taxonomy Module) gives you a way to classify your site's content. Taxonomy is composed of a Vocabulary which itself is composed of terms. Taxonomy reference fields can be added to content types or other entity bundles for categorization. For example on a website about cooking you might have a Vocabulary (remember the Vocabulary is the top-level container for Taxonomy) called Categories. Within the Categories Vocabulary you might have the terms, Recipes, Tips, Crockpot Recipes etc.
From drupal.org here are some questions that elucidate who/when/why you'd use taxonomy.
Taxonomy should be driven by the business requirements of your website, with an eye towards possible future functional expansion. Here are some questions to help you determine how you may want to use taxonomy:
- Are there subsections of your site that you would like to look different from the main theme?
- Are there content areas of your site that should be edited only by a specific part of your organization?
- Is there content that can be shared around your site (such as a press release, form or fact sheet)?
- Is there a business need to support local sites such as service centers or local events?
- Are there different states you need to set (such as left navigation / breadcrumbs) for site sections?
- Are there needs around providing default lists of content by taxonomy term or default RSS feeds by term?
Many contributed modules rely on Taxonomy-generating; for example, menus based on existing tags.