INTRODUCTION
Taxes are complicated. The U.S. federal tax code contains over three million words – about 6,000 pages. A casual browsing of the tax code’s table of contents offers a glimpse into the vast complexity of federal taxation.
Annual changes to the tax code imply that taxes will continue to become more complex even as politicians tout tax simplification. Taxes levied by other jurisdictions, such as states and cities, add further complexity to taxation in the U.S. Americans spend billions of hours each year working on their taxes, not to mention the costs of accountants and tax preparers.
Fortunately, one needn’t comprehend the imposing complexity of the tax code to understand the crucial role of taxes in American society. Tax policy has important economic consequences, both for the national economy and for particular groups within the economy. Tax policies are often designed with the intention of stimulating economic growth – although economists differ drastically about which policies are most effective at fostering growth. Taxes can create incentives promoting desirable behavior and disincentives for unwanted behavior. Taxation provides a means to redistribute economic resources towards those with low incomes or special needs. Taxes provide the revenue needed for critical public services such as social security, health care, national defense, and education.
Taxation is as much of a political issue as an economic issue. Political leaders have used tax policy to promote their agendas by initiating various tax reforms: decreasing (or increasing) tax rates, changing the definition of taxable income, creating new taxes on specific products, etc. Of course, no one particularly wants to pay taxes. Specific groups, such as small-business owners, farmers, or retired individuals, exert significant political effort to reduce their share of the tax burden. The voluminous tax code is packed with rules that benefit a certain group of taxpayers while inevitably shifting more of the burden to others. Tax policy clearly reflects the expression of power in the U.S. – those without power or favor are left paying more in taxes while others reap the benefits of lower taxes because of their political influence. Tax policy has clearly been used to promote political, as well as economic, agendas.
This work is intended to provide a basic understanding of the economic, political, and social context of the entire U.S. tax system. When most people think about taxes, they tend to think only of the federal income tax. However, looking solely at the federal income tax would miss several important issues. Also, the federal income tax is one of the most progressive taxes in the U.S. system. When all taxes are considered, the U.S. tax system is much less progressive. Surprisingly, many taxes in the U.S. are actually regressive – hitting low-income households at a disproportionately high rate. First, some basic terms will be defined and discussed, including tax progressivity and the differences between several types of taxes. Second, a brief overview of tax history in the United States will be presented. Third, data on tax trends will be used to illustrate the changing nature of taxation with a focus on the overall progressivity of the entire tax system.
1 A BRIEF HISTORY OF TAXATION IN THE U.S.
Before the Federal Income Tax
The tax mechanisms used during first 150 years or so of U.S. tax history bears little resemblance to the current system of taxation. First, the U.S. Constitution restricted “direct” taxation by the federal government – meaning taxes directly on individuals. Instead, the federal government relied on indirect taxes including taxes on imports (tariffs) and excise taxes. Tariffs were the major source of U.S. government receipts from the beginning of the nation up to the early 1900’s. For example, in 1800 custom duties comprised about 84% of government receipts [13].
Internal federal revenue collections (which exclude tariffs on imports) as recently as the early 20th century were primarily derived from excise taxes on alcohol. In 1900 over 60% of internal revenue collections came from alcohol excise taxes with another 20% from tobacco excise taxes.
Another important difference is the scale of government taxation and expenditures relative to the entire economy. Government spending is currently a major portion of the total U.S. economy – in 2010 government expenditures and investment at all levels comprised about 20% of total economic output. In the late 1800s government expenditures were responsible for only about 2% of national output (earlier data on national output are not available). The role of government has become more prominent as a result of expansion of military activity and an increase in the provision of public services. Consequently an overall trend of increasing taxation is evident, although we’ll see that this trend has recently stabilized or reversed.
The Constitutional framers were wary of a government’s power to tax. Taxation of the American Colonies by a distant and corrupt England was a driving force behind the American Revolution. Consequently, they believed in decentralized taxation and delegated most public revenue collection to localities, which relied primarily on property taxes. During peacetime the federal government was able to meet its expenses through relatively modest excise taxes and tariffs. During times of war, such as the War of 1812, federal taxes were temporarily raised to finance the war or pay down the ensuing debts. Once the financial crisis passed, taxes were reduced in response to public opposition to high tax rates.
Like previous wars, the Civil War initiated an increase in both excise tax and tariff rates. Government revenue collections increased by a factor of seven between 1863 and 1866. Perhaps the most significant tax policy enacted during the Civil War was the institution of the first national income tax. Concerns about the legality of the tax, considering the Constitution’s prohibition of direct taxation, were muted during the national emergency. The income tax rates were low by modern standards – a maximum rate of 10% along with generous exemptions meant that only about 10% of households were subject to any income tax. Still, the income tax generated over 20% of federal revenues in 1865. After the war, few politicians favored the continuation of the income tax, and in 1872 it was allowed to expire.
2 THE STRUCTURE OF TAXATION IN THE UNITED STATES
The overall system of taxation in the United States is progressive. By a progressive tax system, we mean that the percentage of income an individual (or household) pays in taxes tends to increase with increasing income. Not only do those with higher incomes pay more in total taxes, they pay a higher rate of taxes. This is the essence of a progressive tax system. For example, a person making $100,000 in a year might pay 25% of their income in taxes ($25,000 in taxes), while someone with an income of $30,000 might only pay a 10% tax rate ($3,000 in taxes).
A progressive tax embodies the concept that those with high incomes should pay more of their income in taxes because of their greater ability to pay without critical sacrifices. By paying a tax, any household must forego an equivalent amount of spending on goods, services, or investments. For a high-income household, these foregone opportunities might include a second home, an expensive vehicle, or a purchase of corporate stock. A low-income household, by comparison, might have to forego basic medical care, post-secondary education, or vehicle safety repairs. As income increases, the opportunity costs of paying taxes tend to be associated more with luxuries rather than basic necessities. The ability-to-pay principle recognizes that a flat (or regressive) tax rate would impose a larger burden, in terms of foregone necessities, on low-income households as compared to high-income households.
A progressive tax system is also a mechanism to addresses economic inequalities in a society. To evaluate a tax system’s impact on inequality, one must consider both the distribution of taxes paid and the distribution of the benefits derived from tax revenue.
There is also an economic argument for a progressive tax system – it may yield a given level of public revenue with the least economic impact. To see why, consider how households with different levels of income would respond to a $100 tax cut. A lowincome household would tend to quickly spend the entire amount on needed goods and services – injecting $100 of increased demand into the economy. By comparison, a highincome household might only spend a fraction on goods and services, choosing to save or invest a portion of the money. The money that a high-income household saves or invests does not add to the overall level of effective demand in an economy. In economic terms, we say that the marginal propensity to consume tends to decrease as income increases. So, by collecting proportionally more taxes from high-income households the system tend to maintain a higher level of effective demand and more economic activity.
3 TYPES OF TAXES IN THE U.S.
Federal Income Taxes
The federal income tax is the most visible, complicated, and debated tax in the U.S. The federal income tax was established with the ratification of the 16th Amendment to the U.S. Constitution in 1913. It is levied on wages and salaries as well as income from many other sources including interest, dividends, capital gains, self-employment income, alimony, and prizes. To understand the basic workings of federal income taxes, it is needed to comprehend only two major issues. First, all income is not taxable – there are important differences between “total income,” “adjusted gross income,” and “taxable income.” Second, you it is important to know the distinction between a person’s “effective tax rate” and “marginal tax rate.”
Total income is simply the sum of income an individual or couple receives from all sources. For most people, the largest portion of total income comes from wages or salaries. Many people also receive investment income from the three standard sources: interest, capital gains, and dividends. Self-employment income is also included in total income, along with other types of income such as alimony, farm income, and gambling winnings.
The amount of federal taxes a person owes is not calculated based on total income. Instead, once total income is calculated, tax filers are allowed to subtract some expenses as non-taxable. To obtain adjusted gross income (AGI), certain out-of-pocket expenses made by a tax filer are subtracted from total income. These expenses include individual retirement account contributions, allowable moving expenses, student loan interest, tuition, and a few other expenses. AGI is important because much of the tax data presented by the IRS are sorted by AGI.
Social Insurance Taxes
Taxes for federal social insurance programs, including Social Security, Medicaid, and Medicare, are taxed separately from income. Social insurance taxes are levied on salaries and wages, as well as income from self-employment. For those employed by others, these taxes are generally deducted directly from their paycheck. These deductions commonly appear as “FICA” taxes – a reference to the Federal Insurance Contributions Act. Self-employed individuals must pay their social insurance taxes when they file their federal income tax returns. Social insurance taxes are actually two separate taxes. The first is a tax of 12.4% of wages, which is primarily used to fund Social Security. Half of this tax is deducted from an employee’s paycheck while the employer is responsible for matching this contribution. The other is a tax of 2.9% for the Medicare program. Again, the employee and employer each pay half. Thus, social insurance taxes normally amount to a 7.65% deduction from an employee’s wage (6.2% + 1.45%). Self-employed individuals are responsible for paying the entire share, 15.3%, themselves.
4 THE DISTRIBUTION OF TAXES IN THE UNITED STATES
Tax Incidence Analysis
There are basically two ways to analyze how the tax burden is distributed. The easiest way is to measure the taxes directly paid by entities, such as households or businesses, classified according to criteria such as household income, business profit levels, etc. These data can be obtained directly from aggregate tax return data published by the IRS and from reports from other government agencies. This approach considers only who actually pays the tax to the government. Thus, it would allocate corporate taxes to corporations, excise taxes to manufacturers, sales taxes to consumers, etc.
The second approach, called tax incidence analysis, is more complex yet more meaningful. While taxes are paid by various entities other than individuals, such as corporations, partnerships, and public service organizations, the burden of all taxes ultimately fall on people. The final incidence of taxation is contingent upon how a specific tax translates into changes in prices and changes in economic behavior among consumers and businesses: “Tax incidence is the study of who bears the economic burden of a tax. More generally, it is the positive analysis of the impact of taxes on the distribution of welfare within a society. It begins with the very basic insight that the person who has the legal obligation to make a tax payment may not be the person whose welfare is reduced by the existence of the tax. The statutory incidence of a tax refers to the distribution of those legal tax payments – based on the statutory obligation to remit taxes to the government. ... Economic incidence differs from statutory incidence because of changes in behavior and consequent changes in equilibrium prices. Consumers buy less of a taxed product, so firms produce less and buy fewer inputs – which changes the net price or return to each input. Thus the job of the incidence analyst is to determine how those other prices change, and how those price changes affect different groups of individuals” [6].
Tax incidence analysis has produced a number of generally accepted conclusions regarding the burden of different tax mechanisms. Remember, for example, that the payroll tax on paper is split equally between employer and employee: “So, who really pays the payroll tax? Is the payroll tax reflected in reduced profits for the employer or in reduced wages for the worker? ... there is generally universal agreement that the real burden of the tax falls almost entirely on the worker. Basically, an employer will only hire a worker if the cost to the employer of hiring that worker is no more than the value that worker can add. So, a worker is paid roughly what he or she adds to the value of production, minus the payroll tax; in effect, the whole tax is deducted from wages. ... to repeat, this is not a controversial view; it is the view of the vast majority of analysts...” [4, p. 43]
CONCLUSION
The taxation history underwent many changes, from early 1900’s to modern taxation system. The development of the U.S. taxes firstly relied on the indirect taxes including taxes on imports (tariffs) and excise taxes. During times of war federal taxes were temporarily raised to finance the war or pay down the ensuing debts. Once the financial crisis passed, taxes were reduced in response to public opposition to high tax rates. The tax was not envisioned as a means to generate significant additional public revenue but as a vehicle of social justice. The final stage of the brief history is the Bush tax cut passed in 2001. The major provisions of this act include lowering individual income tax rates across-the-board, scheduling repeal of the estate tax in 2010, and increasing the amount employees can contribute under various programs for retirement purposes. The modern taxation system is characterized mostly by various tax credits.
As federal revenues grew during the 20th century, the composition of taxation has changed considerably. At the beginning of the century federal taxation was dominated by excise taxes. Except for a revival of excise taxes during the Depression Era, their importance has generally diminished over time. Corporate taxes became the most significant source of federal revenues for the period 1918-1932. After a period of higher corporate taxes during World War II, corporate taxes have generally diminished in significance relative to other forms of federal taxation. Personal income taxes became the largest source of federal revenues in 1944 and have remained so. Since World War II, income taxes have consistently supplied between 40-50% of federal revenues. Since about 1950, social insurance taxes have increased their share of federal revenues from about 10% up to nearly 40%. In fact, social insurance taxes may soon exceed personal income taxes as the largest source of federal revenues.
Thus, the structure of the taxation system has the features of progressivity, but also it can be regressive or proportional. We now turn to differentiating between the different types of taxes levied in the U.S. We’ll first discuss several forms of federal taxation, roughly in order of the revenue they generate, and then consider taxation at the state and local levels.
There are different types of taxes in the U.S. taxation system. Obviously some of them are progressive and some are regressive. The taxes that feature progressiveness are the federal income tax- one of the most progressive taxes, corporate tax rates, the estate and gift taxes. On the other hand there are types of regressive taxes in the taxation system, such as federal excise taxes, sales taxes and property taxes. Property taxes tend to be less regressive then excise and sales taxes. Based on the previous analyses the most progressive element of federal taxation are the estate and gift taxes.
GLOSSARY
1. above
2. accelerate
3. accept
4. accountant
5. additional
6. adjust
7. affect
8. agenda
9. alimony
10. allocation
11. allow
12. amendment
13. amount
14. annual
15. assessment
16. asset
17. attribute
18. available
19. behavior
20. beneficiary
21. benefit
22. bias
23. bill
24. billion
25. boost
26. born
27. broad
28. browsing
29. budget
30. burden
1. выше
2. ускорять
3. принимать
4. бухгалтер
6. настраивать
7. влиять
8. повестка дня
9. алименты
10. распределение
11. позволять
12. поправка
13. сумма
14. ежегодный
15. оценка
16. актив
17. атрибут
18. доступный
19. поведение
20. бенефициар
21. преимущество
22. предвзятость
23. законопроект
24. миллиард
25. подталкивать
26. рождаться
27. широкий
28. просмотр
29. бюджет
30. бремя
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