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Chapter 1: The Government Raises Money: Introduction to Some Basic Concepts of Taxes and Taxing Income
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Chapter 1: The Government Raises Money: Introduction to Some Basic Concepts of Taxes and Taxing IncomeI. Introduction to Some Basic ConceptsThe word is out: the United States Government needs money in order to operate. The vast majority of us do want the government to operate and to continue to provide benefits to us. There are many ways in which the Government may endeavor to raise money, only one of which is to tax its own citizens on their income. A few examples follow: Tariffs: The Government might impose tariffs (i.e., taxes) on imports or exports. In order to sell their wares in the United States, foreign merchants at one time had to pay very high tariffs. Tariffs would of course protect domestic producers of the same wares who did not have to pay such tariffs. However, this hardly helps domestic consumers of products subject to a tariff because they must either pay an artificially inflated price for an import or a higher price for a (lower-quality?) domestic product. Export duties could also have a pernicious effect. They encourage domestic producers to endeavor to sell their goods at home, rather than in foreign markets where they might have made more profits. Export tariffs also discourage imports of perhaps more efficiently produced (and therefore more inexpensive) foreign imports. And notice: the use of tariffs as a means of raising revenue creates a cost that mostly the buyers and sellers of those products alone pay. The burden of paying for Government is not spread very evenly if tariffs are the means of raising revenue to support the Government. Nevertheless, tariffs were one very important source of revenue for our country in its early days. This is not nearly so true any longer. Government Monopoly: The Government might choose to enter a business and perhaps make competition in that business unlawful. Lotteries were illegal in most places until some wag discovered that the state could make a lot of money by engaging in the business of running lotteries and giving itself a monopoly over the business. Nowadays, most states have lotteries that they run with no competition other than what they are willing to tolerate, e.g., low-stakes bingo games that charities operate. One argument favoring this means of financing government is that there is no compulsion to buy lottery tickets, i.e., willing buyers contribute to the Government coffers. States may also become quite adept at making customers feel good about buying lottery tickets because the state is able to do so much good with the money it raises. Again, the burden of paying for what lottery proceeds purchase falls only on the consumers of lottery tickets. Many non-purchasers derive benefits from lottery proceeds at the expense of those willing to give up some of their wealth in the forlorn hope of hitting it big. Also, governments may engage in businesses other than lotteries. For example, many states own the liquor stores that operate within its borders. Governments may charge for services that they provide with a view to making profits that are spent in pursuit of other government objectives. There is always the risk that the Government might not be very good at running a particular business. Government-operated airlines are notorious money-losers. And again, why should consumers of certain products or services be saddled with the burden of paying for a government that (should) benefit(s) all of us? Taxing Citizens: Instead of trying to raise money from those willing to give it to the Government, Government may tax its citizens or residents – and perhaps try to tax non-citizens or non-residents. This raises the question of what it is government should tax – or more formally, what should be the “tax base.” There are various possibilities. The Head Tax: A head tax is a tax imposed on everyone who is subject to it, e.g., every citizen or resident, every voter. The tax is equal in amount for all who must pay it. A head tax has the advantage that it is only avoidable at a cost unacceptable to most (but not all) of us: leave the country, renounce one’s U.S. citizenship, surrender the right to vote. Its relative inescapability assures that all who derive some benefit from the existence of a government bear its cost burden. A head tax of course has many drawbacks. Obviously, its burden falls unequally on those subject to it. Some persons might hardly notice a head tax of $1000 per year while others might find it to be a nearly insurmountable hardship. Surely we as a society have a better sense of fairness than that. With one notable exception, we hear very little of involuntary head taxes in the United States. The notable exception was the poll tax whereby some southern states in the post-Civil War era imposed a uniform tax, payment of which was necessary in order to vote. The very purpose of imposing such a tax was to discourage recently emancipated and almost uniformly poor Black persons from asserting their constitutional right to vote. The unfairness of the relative tax burdens associated with this cost of voting led to adoption of the 24th Amendment to the Constitution, which made poll taxes unconstitutional. Consumption Taxes: As the name implies, consumption taxes tax consumption. There are different variants of consumption taxes. Three important consumption taxes are the sales tax, the excise tax, and the value added tax (VAT). Sales Tax: A sales tax is a tax on sales and are usually a flat percentage of the amount of the purchase. Sellers usually collect sales taxes at the point of sale from the ultimate consumer. Many states and localities rely on a sales tax for a substantial portion of their revenue needs. Sales taxes are relatively easy to collect. By their very nature, sales taxes are not collected on amounts that citizens or residents save. Hence, their effect is more burdensome to those persons who must spend more (even all) of their income to purchase items subject to a sales tax. While such taxes are nominally an equal percentage of all purchases, their effect is regressive (infra) for those who accumulate no wealth and who spend all of their income on items subject to them. The Ramsey Principle: Taxes on items for which demand is inelastic raise the most revenue for the state. See F.P. Ramsey, A Contribution to the Theory of Taxation, 37 Econ. J. 47 (1927). For our purposes, “inelastic demand” means that the quantity that buyers buy does not change (much) as prices increase or decrease. A life-saving drug might be such an item. Unfortunately, the things for which demand is inelastic are often things that poorer people must buy. Strict adherence to the Ramsey principle would create an excessive burden for those least well-off. Moreover, the burdens of such taxes would not fall evenly across those who benefit from them. In states that have sales taxes applicable to all purchases, every citizen or resident who buys anything pays some sales tax. In this sense, citizen/beneficiaries may more equitably share the burden of paying for state or local government than is the case of the financing schemes already noted.1 The recent financial crisis has made clear that a state’s revenues are vulnerable to economic downturns during which citizens or residents must reduce their purchases. Such downturns are the very occasions when states need more funds to finance services for which their citizens stand in greater need. Sales taxes are particularly attractive to states that perceive an ability to pass them on to non-citizens or non-residents. There is nothing quite so politically attractive as making someone who cannot vote in state elections fill the state’s coffers. Tourist-destination states that persons from out-of-state visit find sales taxes attractive Excise Taxes: An excise tax is a sales tax that applies only to certain classes of goods, e.g., luxury items. Excise taxes on luxury items may be politically popular, but those excise taxes do not raise much revenue because they are avoidable. The demand for luxury items is usually highly elastic (see text box, The Ramsey Principle). Excise taxes on high-demand (arguably) non-necessities, e.g., cellular telephones, raise much more revenue. Tourist-destination states find excise taxes on services that out-of-state visitors are more likely to purchase than residents to be attractive, e.g., renting cars, staying in hotels, visiting tourist sites. Some states impose excise taxes on “sin” purchases, e.g., cigarettes, alcohol. The public health costs associated with activities such as smoking or drinking may be high, so states tax heavily the purchases of products that cause it to have to provide such services. Arguably, such taxes may discourage persons from making the purchase in the first place. Value Added Tax: This tax is imposed upon every sale, not only the sale to the ultimate consumer, i.e., it is imposed at every stage of production of a product. One who pays a VAT to a seller and who later collects a VAT from a purchaser is entitled to a refund of the tax that he/she/it paid. Thus, the tax base is only a purchase’s actual additions to the value of a product. Since the final consumer does not resell the product, he/she/it pays the final tax bill. Many European countries favor a VAT, often in combination with an income tax. A Progressive Consumption Tax: As we shall see infra from our discussion of the Schanz-Haig-Simons concept of income, it is quite possible to collect a tax only on consumption once per year upon filing a tax return. We could simply use the information that we already collect or can easily begin collecting. We now know what an employee-taxpayer’s total wages are; every taxpayer who works for an employer receives a W-2 wage statement. If a taxpayer saves a portion of his/her earnings, the saving or investment institution could report resulting increases to a taxpayer’s total savings or investment. Similarly, such institutions could report the total amount of a taxpayer’s withdrawals from savings or investments. A taxpayer’s total consumption for the year would be his/her/its income minus increases to savings or investment plus withdrawals from savings or investment. Importantly, the tax on such consumption could be made progressive, i.e., the rate of tax increases as the amount of a taxpayer’s consumption increases (infra). Wealth Taxes: We could tax wealth. There are at least two common forms of wealth taxes: estate taxes and property taxes. The estate tax is imposed on the estates of decedents and the amount of the tax depends on the size of the estate. Property taxes are imposed on taxpayers because they own property. Municipalities often rely on property taxes to raise the revenues they need. Notice that in the case of property taxes, the taxing authority can tax the same “wealth” again and again, e.g., every year. This is quite unlike an income tax, infra. The burden of wealth taxes falls upon those who hold wealth in the form subject to tax. Both persons subject to the tax and those not subject to the wealth tax may reap its benefits. Wage Taxes: We could tax wages by a flat percentage irrespective of how much those wages are. This is sometimes called a “payroll” tax. Some states rely on a payroll tax. It is cheaper to administer than an income tax because there are few deductions or exclusions from the tax base – at least there are few that are not also deducted or excluded from the tax base of the income tax. Social security taxes and Medicare taxes are wage taxes. The tax base of the Social Security tax (6.2%2 on both employer and employee) is limited to an indexed amount, about the first $100,000 of wage income. The ceiling on the tax base of the Social Security tax of course creates a regressive effect (infra), i.e., those with incomes higher than the ceiling pay an effective rate that is lower than the effective rate that those whose income is below the ceiling must pay. The tax base of the Medicare tax (1.45% on both employer and employee) is not subject to a limit. These programs mainly benefit senior citizens – and both are funded by a flat tax on wages of those currently working. The flat tax on all wages of low- to middle-income persons (combined 7.65% plus a like amount paid by employers) assures that many workers pay more in these flat taxes than they do in progressive income taxes. This point makes the burden of paying federal taxes of whatever type much less progressive than the brackets established by § 1 of the Internal Revenue Code imply.3 Income Tax: And of course we could tax income. We recognize that this is what the United States does. In the pages ahead, we describe just what we mean by “income,” i.e., the tax base. It might not be what you expect. We also describe the adjustments (i.e., reductions that are called “deductions”) we make to the tax base and the reasons for these adjustments. An income tax is difficult to avoid: a citizen or resident must have no income in order not to be subject to an income tax.4 Thus the burden of income taxes should be spread more evenly over those who derive benefits from government activities. 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