Chapter 3 Introduction

Taxes play an essential role in the functioning of modern society. Their primary goal is to fund government operations. But they do much more than that. As one of the major fiscal policy levers, the tax system plays a critical role when swift policy action is essential. The tax system often offers the most practical way to reach the majority of Americans directly. Policymakers use it to distribute stimulus payments or other forms of urgent assistance quickly.

Taxes also can cause controversy. They affect large segments of the population differently. Moreover, policymakers may use taxes to advance economic and social policy agendas that reflect their ideologies.

Americans pay a variety of taxes at the federal, state, and local levels. Federal revenues come from three primary sources: individual income taxes, social insurance taxes, and corporate income taxes. Other sources include excise taxes, estate taxes, and customs duties.

State and local governments tend to rely more heavily on retail sales and property taxes than income taxes. But the composition of revenue sources is unique in every state.

The tax systems at all levels of government are closely intertwined. First, states receive a considerable portion of their revenue from direct federal transfers. Second, the federal government subsidizes states indirectly through tax provisions benefiting states, such as exempting state and local bonds from federal taxation. In addition, many state and local tax systems are administratively tied to the federal system. For example, the income figure from the federal tax return is used as the starting point on many state income tax returns.

One of the key characteristics of a tax is its degree of progressivity. A tax is considered progressive if people with lower incomes pay a lower percentage of their income to cover that tax than those with higher incomes. A regressive tax is the opposite: People with lower incomes pay a higher percentage of their income for the tax than do those with higher incomes.

The federal income tax is the largest progressive revenue source in the U.S. It is one of the key reasons the overall federal tax system is progressive. By comparison, the overall state and local tax structure is regressive due to its heavy use of sales, excise, and property taxes. This is particularly true in states that do not have an income tax.

This chapter outlines key components of taxation, including tax reform, various revenue sources, tax expenditures, and tax administration.