Taxes play an important role in the functioning of modern society. Their primary goal is to fund government operations, but their role goes well beyond that. Policymakers use taxes as effective tools of economic and social policy. Taxes also frequently reflect the underlying philosophies of policymakers. For this reason issues involving taxes often affect large segments of the population and frequently cause controversy.
Key Concepts in Taxation
Economists believe that taxes have both positive and negative intrinsic features. The policymakers’ task is therefore to raise sufficient revenue while maximizing the former and minimizing the latter. The result of most tax-policy deliberations is a balance among several competing priorities.
As a revenue-raising tool, taxes must bring in enough to pay for government functions. This requirement does not have to be met every year, because governments at all levels typically have the ability to borrow money on the capital markets. Nevertheless, as a practical matter, the level of government debt has to be sustainable in the eyes of lenders. This imperative limits governments’ ability to borrow. Governments therefore face the issue of raising revenue in a way that minimizes the cost to the society. The cost of taxes to the society comes as direct monetary cost (i.e., taxes that are being paid to the treasury) and as a social cost from dead weight loss (i.e., the reduction in economic activity and distortion of prices that can occur as a result). For example, a tax on goods may reduce sales. As a result of taxation, some transactions that would have taken place in the absence of the tax, and thus would have generated profits and improved quality of life, never occur. Similarly, price distortions lead to overusing scarce resources, reducing national income, and restricting economic growth.
Economists believe taxes should be neutral, meaning that they do not distort people’s economic choices. In reality, no tax is completely neutral, but some taxes are better than others. In addition, taxes may be neutral in one respect, but not another. Excise taxes, for example, may not be neutral across different types of goods but may be neutral with respect to consumption today versus consumption tomorrow. Income taxes, on the other hand, may be neutral across different goods, but not with respect to consumption today versus consumption tomorrow. Though it is impossible to eliminate these distortions, understanding and balancing them remains an important goal.
To understand how taxes affect different taxpayers, economists analyze tax burden, which indicates who has to reduce consumption as a result of a tax. For example, even though corporations pay taxes, they do not bear any economic burden because they do not consume. Rather, the burden of corporate taxes is borne by people (e.g., shareholders through lower profits, employees through lower wages, customers through higher prices, suppliers through lower input prices). Typically and with rare exceptions the burden is split among all these groups. Unfortunately, it is often difficult to verify the precise share of the tax burden borne by different groups of taxpayers, and in many cases different assumptions shape the views about favorability of tax policies.
Minimizing the negative impact of taxes requires, in part, that the burdens they create are spread across as many taxpayers and forms of income as possible. Such a broad base allows tax rates to be as low as possible. The alternative policy of raising the same amount of revenue through a tax imposed at a high rate from a narrow tax base typically would cause larger distortions and dead weight losses.
Economy theory suggests that, in terms of their macroeconomic effects on the business cycle, taxes are automatic stabilizers, since by their mere presence they help mitigate natural fluctuations in the growth rate of the economy. People pay less in taxes during economic downturns and pay more in taxes during periods of high economic growth. Policymakers can take steps to enhance the stabilizing aspect of taxes. For example, states may set money aside during a boom year to be used later during a recession. In recent years stimulative fiscal policy tools were used very extensively at the federal level to respond to the “Great Recession.”
Taxes have another important function: mitigating income inequality, which some believe can damage a democratic society, undermining its economic foundation and ultimately leading to its demise.
Nevertheless, reflecting the important goal of reducing income inequality, the overall US tax system is progressive, (i.e., people with higher incomes pay a greater share of their income in taxes than do lower-income people). While crafting a progressive tax system is a commonly accepted undertaking, there is vast disagreement over how progressive the system should be. Consequently the degree of progressivity has changed over time. Moreover the lack of a universally accepted measure of progressivity and the difficulty in comparing the progressive nature of different tax structures often complicate these debates.
Modern Structure of Taxes in the US
Federal taxes—the federal government collected $3.3 trillion dollars in revenue in fiscal year (FY) 2016. This represents 17.8 percent of the nation’s gross domestic product, above the long-term average of 17.4 percent and the highest share since 2001.
Federal revenues come from three major sources: individual income taxes, social insurance taxes, and corporate income taxes, with the first two accounting for about 81 percent of total revenue in FY2016. Other sources include excise, estate, and gift taxes; customs duties; and other receipts.
The federal tax system has evolved over the years, relying on these major components in differing amounts. For example, before the 1940s the individual income tax affected only a very small number of wealthy individuals. It became a mass tax during the Second World War, but even then its structure and parameters were different from today. Our current income tax regime stems largely from tax reform legislation enacted in 1986, though many changes have occurred, particularly since 2001.
Social insurance taxes have also evolved, with major changes taking place in 1982. Those made the general structure of social insurance taxes more stable, but revisions have continued in this area as well.
Every major income source has a different pattern as far as its tax burden distribution is concerned. The individual and corporate income taxes are generally more progressive than the social insurance taxes.
The federal tax and fiscal systems are closely intertwined with the fiscal systems of the states and localities through a variety of channels. States receive a considerable portion of their revenue from federal transfers. The federal government subsidizes states indirectly through tax provisions benefitting states. In addition, many state and local tax systems are tied to the federal one.
State and local taxes—state and local governments collected $1.5 trillion in taxes in 2013, representing 69 percent of their general revenue.
State and local taxes vary widely by jurisdiction, but certain features are common to most. Individual income tax, sales tax, and property tax accounted for about 89 percent of tax revenue. The largest of them—the sales tax, levied in 45 states and the District of Columbia—accounted for 24 percent of the general revenue from states’ own sources. Next was the property tax, amounting to about 22 percent of own general revenue. The individual income tax, present in some form in 43 states, yielded 16 percent of own general revenue. State fiscal experts advocate a balance among these sources to avoid the severe revenue fluctuations of business cycles and to limit competition between neighboring states with disparate tax rates.
Overall the state and local tax structure is much less progressive than the federal one. Income taxes are generally the most progressive of state taxes. Sales and excise taxes, however, are usually regressive. Property taxes are also regressive and burdensome for older people because property values and therefore taxes tend to increase over time while the income of older taxpayers tends to decline or remain the same.
Besides taxes, state and local governments receive considerable revenue from other sources, such as federal transfers or user fees. Federal support contributed 22 percent of total state and local general revenue. Historically user fees were a small revenue source, but they have been growing fast in recent years. Compared with the federal government, states have a set of unique challenges and limitations as far as tax policies are concerned. For example, most states have some balanced budget requirement, which, while not preventing borrowing, does shape state tax policy. States are under continuous competitive pressure from one another and must keep their tax policies attractive enough to lure new businesses and residents. (For more, see this chapter’s section Income Taxes—State Income Taxes.)