Taxes play an essential 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 economic and social policy tools, reflecting their philosophies. Issues involving taxes often affect large segments of the population. As a result, they can cause controversy.
As one of the major fiscal policy levers, the tax system plays a critical role when swift policy action is essential, such as during the economic recession of 2020. The tax system offers the fastest way to reach the majority of Americans directly. Policymakers use it to distribute stimulus payments or other forms of urgent assistance quickly.
Americans pay a variety of taxes on 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 revenue systems vary widely, both compared with the federal system and with each other. State and local governments tend to rely heavily on retail sales taxes and property taxes for funding rather than on income taxes.
The tax systems at all levels of government are closely intertwined. First, states receive a considerable portion of their revenue from 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 federal tax forms is used as the starting point on some state tax forms.
One common concept used in describing tax systems is their 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 why the overall public finance system is progressive. The public finance system includes taxes and spending by all levels of government.
By comparison, the overall state and local tax structure is regressive due to the heavy use of sales, excise, and property taxes. In addition, the taxation of income in many states also is regressive.
This chapter outlines key components of taxation, including tax reform, various revenue sources, tax expenditures, and tax administration.