Taxes are compulsory payments to a government based on financial criteria that indicate capacity to pay. Tax payments
differ from prices because they lack any connection to a specific purchase of a governmental good or service. Taxpayers
do not contribute on the basis of their sense of civic pride or
duty. Congress establishes tax statutes and administrative
regulations through a political process. Some taxes may have
quasi-market effects, especially those designed so that the
heaviest users of a governmental good or service pay the majority of its cost.
The three primary measures of the taxpayer’s capacity to
bear a tax burden include income, purchases or sales, and
property ownership or wealth. The U.S. government relies on
corporate and individual income taxes, and the Social Security tax, levied on payrolls, has become an additional incometype tax. The federal government levies neither a general sales
tax nor a property tax; however, it does collect selective excise
taxes on some items and customs duties on imported products. Taxes on the purchase or sale of goods and services remain the largest source of state revenues. All states have either
a sales or gross receipts tax, and almost all have a general sales
tax as well. A great majority of states also levy individual income taxes and/or corporate income taxes. Fewer than half
levy a general property tax. Although property taxes constitute the majority of local tax revenues, localities also levy general sales taxes, selective excise taxes, individual income taxes,
and corporate income taxes. State laws authorize municipalities to establish local tax rates.
Some taxes discourage an undesirable individual or business activity, but a tax levied for revenue proves adequate if it
can generate sufficient revenues at socially acceptable rates. A
zero percent tax would raise no revenue. A 100 percent tax
also would raise no revenue because no one would engage in
an activity that delivered all of the proceeds to government.
Thus, taxing agencies utilize a rate-to-revenue curve to determine or estimate any tax. Depending on the rate-to-revenue
curve, either a tax increase or a tax reduction could generate
greater or lesser revenues.
Tax adequacy has both long-term and short-term aspects.
A tax with cyclical aspects will collect adequate revenues during short-term economic fluctuations. Property taxes have
cyclical stability, whereas general sales taxes and corporate income taxes are less stable. Although a tax system must deliver
adequate revenues during cyclical economic downturns in
order to finance public assistance expenditures, it must also
increase revenues as an economy expands in order to meet
the growing demands for government services.
In The Wealth of Nations, Adam Smith proposed four
principles of taxation (italics added):
I. The subjects of every state ought to contribute
toward the support of the government, as nearly as
possible, in proportion to their respective abilities;
that is, in proportion to the revenue which they
respectively enjoy under the protection of the state.
II. The tax which each individual is bound to pay ought
to be certain and not arbitrary. The time of payment,
the manner of payment, the quantity to be paid,
ought all to be clear and plain to the contributor,
and to every other person.
III. Every tax ought to be levied at a time or in the
manner, in which it is most likely to be convenient
for the contributor to pay it.
IV. Every tax ought to be so contrived as both to take
out and to keep out of the pockets of the people as
little as possible, over and above what it brings into
the public treasury of the state.
Smith believed that tax laws should be adopted in an open
legislative process and based on objective and explicit criteria
that are understandable and fair to all taxpayers.
Economists George Break and Joseph Pechman declared
that taxation was wealth redistribution accomplished without disrupting other economic activities. In addition to
transferring purchasing power from the private sector to the
public sector, taxes redistribute purchasing power within the
private sector.
Since a tax system creates winners and losers, tax policy
must determine who will bear the tax burden. Officials can
levy taxes according to the benefit the taxpayer receives or
according to the taxpayer’s ability to pay. A benefit-received
system operates as a quasi-market, with individuals paying for
government services that they want and use. However, two
problems exist with a benefit-received system. First, many
government agencies provide services (such as social assistance) even though the recipients cannot purchase them. Second, many government services, including the safety provided
by police patrols, benefit all residents although only some of
the residents pay for them. Some benefit-based selective excise
taxes, such as those levied on motor fuels or automobile tires,
remain closely linked to the use of a governmental good or
service, such as a highway. Many Americans accept use taxes if
the tax burden remains consistent with the taxpayer’s usage—
that is, they will not use public services if the low taxes create
wasteful oversupplies, and they will not utilize a public service
if the tax rate exceeds the value of the service in their minds.
However, since some consumers cannot pay the tax and since
some services benefit those who do not share the cost, the
adoption of the ability-to-pay principle remains necessary.
The ability-to-pay approach requires the development of
sliding-scale fees and a determination of the distribution of
the tax bill among taxpayers. Horizontal equity considers
equal treatment of taxpayers who have equal capacities to pay
taxes. Vertical equity concerns the proper relationship between the relative tax burdens paid by individuals and different capacities to pay taxes. A tax structure becomes regressive
if tax rates are lower in high-ability groups than in low-ability
groups. It is proportional if tax rates remain equal for all
groups. Progressive tax rates charge higher rates for highability (higher-income) groups than for low-ability (lowerincome) groups. Thus, a proportional rate does not alter a
population’s income distribution, a regressive rate transfers
wealth to higher-ability individuals, and a progressive rate
transfers wealth to lower-ability individuals. Increasing collection rates can decrease equity because taxing payrolls remains convenient, but higher-income individuals have more
interest, dividend, rental, and capital gain incomes, which are
difficult to locate and tax.
Accounting records disclose who makes tax payments, but
the distribution may not accurately show the final impact of
the tax burden. Both businesses and individuals make tax
payments, and those bearing the initial tax impact may shift
a portion of the tax burden by changing prices or by altering
purchasing behavior. A tax paid by a business may lower the
owners’ profits, the management’s salaries, the suppliers’
prices, or the employees’ salaries or benefits. Or it may raise
the prices that customers pay.
Business taxes include property taxes, income taxes, gross
receipts taxes, franchise taxes, licenses, severance taxes, document and stock transfer taxes, and miscellaneous business
and occupation taxes. Taxes on individuals include property
taxes, income taxes, retail sales taxes, and selective excise
taxes. In all cases, the final and total responsibility for personal taxes belongs to an individual, owner, manager, employer, employee, or customer. State and local governments
favor taxes on business because the ultimate burden of such
taxes may fall on owners or customers who live outside the
state or municipality. However, an attempt to put the majority of a government’s tax burden on businesses could cause
the businesses to move to another jurisdiction. The area’s
economy would suffer, so state and local governments weigh
the impact that taxes have on economic development and job
creation. Officials often compare tax types and rates to those
of neighboring governments and offer tax concessions if
businesses will relocate into a given jurisdiction. Access to
raw materials or markets; the availability of skilled or unskilled labor; convenient air, ground, or water transportation;
and a variety of production costs may have an equal or
greater influence on business-location decisions, but elected
and appointed government officials eagerly offer tax incentives as part of an industrial development package. Tax considerations often may determine the choice of a final location, but they are unlikely to influence the choice of a general
area. If officials offer no tax incentives and a business locates
elsewhere, voter dissatisfaction might occur if the area’s economy declines. Consequently, officials often offer incentives
such as tax abatements, exemptions, or credits in exchange
for industrial location or job creation.
The tax burden includes both the tax bill and the cost of
calculating and paying the tax. A complicated tax system increases compliance costs, compliance problems, and governmental administrative duties and expenses. Changes in the
tax system increase the cost of compliance, and they prohibit
effective business and personal planning.
A broader-based tax, which places a tax on larger sums of
money, can raise greater amounts of revenue with a lower tax
rate, causing fewer economic dislocations. Higher tax rates
may induce individuals to choose to enjoy more leisure time
instead of working more hours, or the higher rate may cause
workers to work more hours to replace the income taken by
the taxes. High tax rates on specific types of business organizations, production techniques, and distribution or marketing systems may cause owners to quit an industry or change
their firm’s methods. Business owners or individuals may also
alter their after-tax rates of return by modifying their investment types or techniques and savings rates.
Income Taxes
Because of a U.S. Supreme Court ruling that declared the personal income tax unconstitutional, Congress in 1913 enacted
the Sixteenth Amendment, which sanctions an income tax.
During World War II, the levy became a mass tax at a rate that
applied to the majority of the population. The national government also uses payroll taxes to finance the social insurance
system, including Social Security and Medicare.
The federal government defines income as the money or
other gain received in a given period of time by an individual, corporation, or other economic entity for labor, goods,
or services or from property, natural resources, investments,
or operations. However, any government can establish its
own definition of income. In fact, the government defines
income and decides what sums are exempted, how the
amounts are manipulated, and by what rates the defined income is multiplied or divided. The basic tax calculation
equals the total income less adjustments, including deductions and exclusions, multiplied by a percentage rate ob-
tained from a tax schedule, less any tax credits. Partnerships
or proprietorships usually pay the same tax as the individual.
Governments can designate the income or payroll tax to be
levied on the employer, the employee, or a combination of
both, although the employers can place the final impact on
employees by adjusting salaries or benefits. Nevertheless, income remains an important measure of tax capacity, and
governments can adopt exemptions, deductions, or credits
to adjust the tax base in light of family size, physical or mental infirmities, or economic circumstances. The income tax’s
broad base allows for the collection of large revenues without making unacceptable impacts on the overall economy.
However, the adjustments complicate the income tax, making it expensive to administer, and most taxpayers have a difficult time understanding the complicated tax structure. Aspects of the tax system also discourage saving and
investment and specifically discourage investment in certain
sectors of the economy. Since the federal government taxes
corporate profits as well as investors’ dividends from profits,
the United States doubly taxes corporate profits paid out in
dividends.
Personal deductions, subtracted from total income, can
improve horizontal and vertical equity by adjusting the tax
base. Deductions for uncontrollable expenditures, such as
medical or property casualty losses; for meritorious expenditures, such as charitable or religious contributions; and for
expenditures necessary to generate income, such as travel expenses, union dues, or work uniforms, can lower the tax obligation. Tax credits are subtracted from a calculated tax liability. Credits can be refundable, meaning the taxpayer
receives a payment from the government, or they can be nonrefundable, meaning they can only be subtracted from a tax
liability. A credit can be given for an entire expenditure or for
some portion of it.
Congress taxes corporations as legal persons. A depreciation schedule uses a formula to allocate portions of the cost
of long-lived assets to particular years in order to create a deduction similar to the individual’s deductions for the cost of
earning income. Similarly, nations and states must calculate
the portion of a corporation’s income subject to the jurisdiction’s tax system.
Consumption Taxes
Taxes on wages, goods, and services operate as broad-based
taxes that raise large amounts of revenues with low tax rates.
Consumption taxes provide a way for governments to collect
revenues from persons with high taxpaying capacities but low
current incomes. States and localities collect a majority of
their revenues from general sales or selective excise taxes.
States cannot tax expenditures in interstate commerce, but
purchases may be taxed at the destination of the purchase
rather than at the location of the seller.
A general sales tax applies to all transactions, with possible
exceptions such as prescription medicines or food for athome consumption. An excise tax applies to specific transactions, such as purchases of tobacco, alcohol, or motor fuels.
Excise tax revenues, levied as unit taxes on each item purchased or ad valorem taxes as a percentage of the purchase
price, grow slowly because the unit taxes do not reflect increasing prices. The tax is collected from a purchaser or from
the manufacturer, who then raises the sale price to recapture
all or part of the tax levy. An excise tax can be adopted to discourage the use of a particular item, such as the sumptuary
taxes on tobacco and alcohol; it can be adopted as a quasiprice for a government service, as is the case with the benefitbased tax on motor fuels as a quasi-price of highways; or it
can be used as a method of taxing extraordinary taxpaying
capacity, as with hotel and motel lodging taxes. Excise taxes
can also be applied to business purchases—for example, the
regulatory and environmental taxes on chemicals that contribute to environmental pollution. With both sales taxes and
excise taxes, revenues can be collected for the general support
of the government, or they may be earmarked for a specific
government function.
Retail sales taxes are ad valorem taxes either on consumers’
purchases or on merchants’ gross receipts. Final determination of purchases and the associated payment of taxes falls
primarily on the purchaser. Business purchases of raw materials, components and materials, or equipment used in production are exempted because to tax those items would raise
finished goods’ prices and increase inflation. The taxation of
commercial purchases between businesses would also lead to
increased mergers of suppliers and manufacturers.
Purchases of services are often exempted from sales taxes,
often for purely historical reasons. In addition, business purchases of specific professional services are exempted because
taxing the purchases from professionals would encourage the
practice of moving the services into the organization rather
than making purchases from outside the organization. Commodity exemptions for purchases of consumer goods such as
prescription medicines, food for at-home consumption, and
sometimes clothes are politically popular because they make
up higher percentages of the purchases made by low-income
families and because these are necessary, not discretionary,
expenditures.
Property Taxes
Local governments rely heavily on the revenue derived from
property taxes. States developed taxes on goods and services
because during the Great Depression, property taxes, which
were the predominant revenue source at the time, could not
be collected. Subdivisions within states, such as counties and
special districts, are greatly dependent on property taxes for
their operating revenues.
Property taxes are not wealth taxes because some items of
personal property are exempted. In addition, the tax on a
home is based on the gross value, which is not adjusted for
any mortgage liability. Some properties are taxed twice,
which occurs, for example, when a corporation’s assets are
taxed and then an owner’s corporate stock, representing a
share of the assets, is taxed.
Taxed property can be either real property, including real
estate and improvements on the land, or personal property,
including machinery, automobiles, jewelry, and stocks and
bonds. Some jurisdictions tax personal property more heavily than real property. Many others exempt personal property
from the tax assessment. Even more jurisdictions tax businesses’ property at higher rates than individuals’ property. Intangible property, such as stocks and bonds, may be exempted from property taxation, or it may be taxed at a
different rate than tangible property, such as machinery or
automobiles.
Property tax rates are often determined as part of the jurisdiction’s annual budget process, with the rate set at the
level necessary to create adequate revenues to finance governmental activities, including debt service. Property taxes on
real estate are based on assessments in order to determine the
tax base. One standard of assessment, market value, is the
cash price that the real property would bring in a competitive
and open market, but the value is hypothetical because most
property is not for sale in such a market. Sales of comparable
properties can be used to estimate a property’s value. Some
jurisdictions assess value on a cost-summation approach,
with each building characteristic having a predetermined
dollar value and with the sum adjusted for the property’s age
and depreciation. Many jurisdictions assess the property base
on its current usage, and they often have different tax rates for
different property uses, including lower rates for agricultural
land. Although most states have some system of periodic reassessment, others revalue real estate only when it is sold,
leading to very different tax levies on adjoining and otherwise
identical properties that have been sold in different years.
Real property can be assessed yearly; every piece of property
can be assessed in the same year on a periodic schedule; or
the jurisdiction can divide the property into groups, with the
groups being assessed in a rotation. In all cases, new construction would be immediately assessed.
Property tax relief is offered in the form of reductions in
the tax base, preferential rates, or tax credits. A homestead exemption reduces the tax base for an owner who lives on a
property. Veterans and the elderly often receive tax exemptions. The exemptions are popular, but other property owners’ taxes are increased to create adequate tax revenues. Businesses and industries often receive tax rebates or exemptions
for industrial development or job creation. Churches, charities, and other governments do not pay property taxes. Many
jurisdictions have adopted circuit-breaker systems to refund
property taxes if they become an excessive part of lowincome individuals’ expenditures. Some jurisdictions defer
property taxes on real estate owned by the elderly but calculate the growing liability and recoup the sum from the person’s estate. Many jurisdictions tax agricultural property at a
lower rate than residential or industrial property, but when
the real estate is converted to another use, the deferred taxes
from a specific number of years are collected.
Property can be assessed at its calculated value or at some
percentage of the calculated value. If the property were assessed at its calculated value, a tax rate would be established.
If the property were assessed at a fraction of its calculated
value, possibly half of the market value, the tax rate would be
adjusted, possibly to twice the existing rate. Fractional adjustment can lead to taxpayer confusion when a taxpayer believes
that the low assessment means that a tax bill is being similarly
reduced. Because property taxes require assessment, confusing fractional assessment can produce differing assessments
in different areas of the same jurisdiction, either by accident
or by favoritism.
Property owners receive a statement each year detailing
the amount of property taxes that they pay to each jurisdiction in which they live, including the city, the county, the
school districts, and all of the special districts. Similarly, taxpayers each year calculate their income tax payments and
submit tax returns detailing all of their tax liabilities. Although sales taxes once were deductible from the federal income tax, there is no reason today for taxpayers to total the
consumption taxes that they pay. Property taxes and income
taxes generate significant taxpayer dissatisfaction, but consumption taxes receive comparatively little attention.
Among the industrialized nations, the United States is a
low-tax country, with total taxes being approximately 30 percent of the gross domestic product (GDP). The average in industrialized nations is approximately 40 percent of the GDP.
—Theo Edwin Maloy
References
Mikesell, John. Fiscal Administration: Analysis and
Applications for the Public Sector. 5th ed. Fort Worth, TX:
Harcourt, Brace, 1999.
O’Brien, D. P., ed. The History of Taxation. Brookfield, VT:
Pickering and Chatto, 1999.
Ratner, Sidney. A Political and Social History of Federal
Taxation, 1789–1913. New York: W. W. Norton, 1942.