# Taxation in the United States

 Topics:

## 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. Entire sections of the tax code apply specifically to such topics as the taxation of vaccines, shipowners' mutual protection and indemnity associations, specially sweetened natural wines, and life insurance companies. 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 layers of complexity. 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. Taxation is an important, but commonly neglected, topic for students of economics, political science, and other social sciences. 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 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. Broad attempts to reform the tax system have produced dramatic and sudden shifts in tax policy, generally motivated by political factors rather than sound economic theory. For example, the top marginal federal tax bracket on individual income in the U.S. dropped precipitously from 70% to 28% during the 1980s. Tax policy has clearly been used to promote political, as well as economic, agendas.

## The Structure of Taxation in the United States

### Tax Progressivity

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. 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 tax system may also be regressive or proportional. A regressive tax system is one where the proportion of income paid in taxes tends to decrease as one’s income increases. A proportional tax system simply means that everyone pays the same tax rate regardless of income. A given tax system may display elements of more than one approach. Consider a hypothetical tax system where one pays a proportional, or flat, rate on income below a certain dollar amount and then progressively increasing rates above that dollar amount. Also, within an overall tax system, some particular taxes might be progressive while other taxes are regressive. We’ll see later on that this is the case in the United States.

### Reasons for Progressive Taxation

The overall tax system of the United States, and in most other countries, is progressive for a number of reasons. 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 way to address economic inequalities in a society. A high degree of inequality can be lessened by taxing high-income households at a relatively higher rate than low-income households. But we also need to consider who receives the benefits derived from tax revenues to fully evaluate a tax system’s impact on inequality. If the benefits of programs funded by taxation primarily accrue to low-income households while high-income households pay the majority of taxes, then the tax system effectively operates as a transfer mechanism. Increasing the progressivity of the tax system or altering the distribution of benefits allows redistribution of economic resources. We’ll mainly focus on tax payments in this article but you should also be aware that the benefits of public expenditures are not evenly distributed throughout society.

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 low-income 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 high-income 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 level of demand for goods and services 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 we tend to maintain a higher level of effective demand and more economic activity.

Of course, one can posit that a tax system can become too progressive. Extremely high tax rates at high-income levels might create a significant disincentive that reduces the productive capacity of society. Very high taxes might limit the risks taken by entrepreneurs, stifling innovations and technological advances. The desire to “soak the rich” through an extremely progressive tax system might be viewed as unfair, and not just by the rich. In fact, this was a concern of the Constitutional framers – that in a democratic system, the majority could impose unduly burdensome taxes on the wealthy minority. We’ll see that their concerns have proved groundless. Many critics of the current tax system point to the contrary position – that a powerful minority have used their might to shift the tax burden away from themselves onto an immobilized and misinformed majority.

Even if one could devise a tax system that is economically optimal (i.e., producing the highest overall level of economic growth), the topic of taxation encompasses ideals about equity and fairness. A society may be willing to sacrifice some degree of economic growth in exchange for a more equitable distribution of economic resources. This is not to say that economic growth must always be sacrificed with redistribution. In fact, analysis of the U.S. historical data finds that high levels of economic growth tend to be associated with periods of relatively equitable distribution of economic resources.

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. A final section will consider taxes that are generally not used in the U.S. but are important in other nations.

### 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, you need to comprehend only two major issues. First, all income is not taxable – there are important differences among “total income,” “adjusted gross income,” and “taxable income.” Second, you need 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 receive investment income from 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 estate and gift taxes are the most progressive element of federal taxation, paid exclusively by those with considerable assets. The majority of estate taxes are paid by a very small number of wealthy taxpayers. In 2000 over half of estate taxes were collected from estates worth more than $5 million, about 0.15% of all estates. ### State and Local Taxes Like the federal government, state governments also rely on tax revenues to fund public expenditures and transfer programs. Like the federal government, state governments rely on several different tax mechanisms including income taxes, excise taxes, and [[corporate tax]es. Thus, much of the above discussion applies to the tax structures in place in most states. However, there are some important differences that deserve mention. Table 1. 1999 U.S. Tax Receipts, by Source Source Amount (Millions$)
Percent of
All Taxes
Federal Taxes
Income Taxes 879,500 34.5%
Social Insurance Taxes 611,800 24.0%
Corporate Taxes 184,700 7.2%
Excise Taxes 70,400 2.8%
Estate Taxes 22,900 0.9%
Total, Federal Taxes 1,769,300 69.4%
State Taxes
Sales Taxes 200,600 7.9%
Property Taxes 240,100 9.4%
Income Taxes 189,300 7.4%
Corporate Taxes 33,900 1.3%
Excise and Other Taxes 114,500 4.5%
Total, State Taxes 778,400 30.6%
Total, All Taxes 2,547,700 100.0%
Source: U.S. Census Bureau (2002), except for federal
estate tax data from Johnson and Mikow (2002).

First, nearly all states (45 as of 2003) have instituted some type of general sales tax. State sales tax rates range from 2.9% (Colorado) to 7.25% (California). A few states reduce the tax rate on certain goods considered to be necessities, such as food and prescription drugs. For example, the general sales tax in Illinois is 6.25% but food and drug sales are taxed at only 1%. Other states with sales taxes exempt some necessities from taxation entirely. In most states, localities can charge a separate sales tax. While local sales taxes are generally lower than state sales taxes, there are exceptions. In New York the state sales tax is 4% but local sales taxes are often higher than 4%. Unlike income taxes, sales taxes tend to be regressive. The reason is that low-income households tend to spend a larger share of their income on taxable items than high-income households. Consider gasoline – which tends to be a declining share of total expenditures as income rises. An increase in gas taxes impacts low-income households more than high-income households. Some states, such as Idaho and Kansas, offer low-income households a tax credit on their state income taxes to compensate for their regressive state sales taxes.

Forty-one states levy an income tax. Most of these states have several progressive tax brackets (up to 10 rates) similar to the federal income tax. However, state income taxes tend to be much less progressive than the federal income tax. Six states have only one income tax rate, meaning that their income tax approaches a flat tax. Several more states have what is effectively a single tax rate because the top rate applies at a very low income. For example, Maryland’s top rate of 4.75% kicks in at only \$3,000 of income.

Another important distinction between the federal system of taxation and the taxes levied at state and local levels is use of property taxes. In fact, property taxes tend to be the largest revenue source for state and local governments. The primary property tax levied in the U.S. is a tax on real estate, including land, private residences, and commercial properties. Generally, the tax is an annual assessment calculated as a proportion of the value of the property, although the formulas used by localities differ significantly. Property taxes are commonly collected at a local level, but a share of property taxes is allocated for state purposes. Property taxes tend to be regressive, although less regressive than excise and sales taxes. The reason is that high-income households tend to have a lower proportion of their assets subjected to property taxes. While renters do not directly pay property taxes, most economists conclude that the costs of property taxes are largely passed on to renters in the form of higher rents.

### Composition of Tax Collections in the U.S.

Table 1 presents government tax receipts, by tax source, for 1999 (the most recent year for which complete data were available). The table shows that federal taxes dominate the nation’s tax system with nearly 70% of all receipts. The largest federal tax is the income tax, followed closely by social insurance taxes. State and local tax systems are primarily dependent on sales, income, and property taxation. The data in Table 1 cover the major taxes utilized in the United States.