Economics - Taxation: A Few Important Issues

It has often been said that there are only two certainties in life - taxes and death. Here we will restrict ourselves to the first of these issues - to taxation - and to start off the discussion you should try to identify all the taxes you have paid in the past year. If you have bought gas for your car, alcohol, or cigarettes then you have paid excise taxes to the federal and state governments. If you have gone to the Mall and bought some CDs for your collection, then you have paid a sales tax to the state. Those of you who own a car may also have paid a property tax on the car to your city or town, while anyone owning a house has paid a property tax to the local government.

Given the amount people pay in taxes and the importance of taxes to the economy, and the fact you are already paying your share of taxes, we will look at taxes in more detail. More specifically, we are going to look at three issues: what should we tax, how should we tax it, and what does the future look like.

It should be clear from the above example that the government has found many things to tax, but this should come as no surprise. Those of you who have worked and taken home a paycheck know there is a large difference between what you earn and what you actually take home in your paycheck. The difference is the taxes you pay - Federal Withholding Tax which is your federal income tax, F.I.C.A. which is your social security contribution, and your state income tax if your state has one.

But what should the government be taxing. In the US the primary source of revenues has changed substantially over time. In the earliest days of the nation the primary source of government income was the tax on international trade - tariffs. By the 1930s it was excise taxes that were the primary source of tax income for the federal government and today it is the income tax, with the withholding tax (F.I.C.A.) coming in a close second. At the present time there is considerable debate over the future structure of taxes, so let's try to sort out the alternatives and the rationale for them. When we talk about the federal government there are three prime candidates for the tax base, all of which are related to one's ability to pay - income, consumption, and wealth. We can see the relationship between the two three concepts with the simple equation:

Individuals' income is either spent or saved - you either buy a sandwich or a bike, or you put you money into a bank account or a mutual fund. In the first of these you are using the income for consumption today, while in the latter you are saving it for future consumption. The distinction can be blurred in cases such as a home where the value of the home could appreciate and you could sell it for more than it is worth. We can introduce wealth into the equation by noting that Wealth can be defined as:

If you acknowledge that savings is simply the addition to net worth, then you have the equation:

So what does the government tax since they are all related. One argument raised by those in favor of a consumption tax is consumption spending most closely approximates the standard of living and those who benefit more from the system should pay more. There is also the issue of double taxation if one chooses to tax income. Assume you earn $50,000 after taxes and must pay a tax of 10 percent on any income. You decide to use $40,000 for spending and $10,000 for saving that you invest at a rate of 5%. The problem is your interest earned is also income and the $500 you will earn in interest for the first year will be taxed so you will receive only $400. Given the lowered value of your savings you would be more inclined to spend now to avoid the double taxation. A final argument for the consumption tax is easier to collect once the flow of resources across national borders becomes quite extensive. This is one of the reasons why the consumption tax, called a VAT tax (value added tax) is a favorite source of revenue in Europe where mobility of resources and goods is so high.

Income is a second candidate. The rationale is income is the best measure of the potential standard of living. If you earn more you could buy more and therefore you could benefit more from the system, and therefore you should be taxed based on this figure.

The final candidate is wealth. The rationale is a person with wealth of $1 million is in a better position to pay taxes than a person with wealth of $1 thousand.

What you prefer to tax depends upon the criteria that you set, which is the subject of the next section.

A closely related issue to what we tax is, how we tax it. A government, at least one whose power is not based on fear, will need to raise revenues through taxes widely perceived as fair. Unfortunately, we know from our experience "fair" is a relative concept - we will never get everyone to agree with what is fair. This certainly is true when it comes to taxes, although you will find nearly everyone pushing a particular tax plan will emphasize the plan's fairness. In this section we will discuss two concepts of fairness, but first we will discuss the issue of efficiency - the extent to which the taxes distort individual decisions. The general perception is that taxes should distort individual's decisions as little as possible. On these grounds you would favor a lump-sum tax of $100 per person over a 10% tax rate on earnings. The reason is that in the case of the income tax you would tend to discourage people from working since it would taxing away some of their earnings gained from working. For those who did not work, the tax would not effect their financial position so we would say that the tax favored nonworking to working and this would alter behavior. On the other hand, a $100 per person tax would affect everyone equally so there would be no incentive to alter the work-no work decision.

Sometimes, however, taxes can be imposed for precisely that reason, so they will alter behavior. A good example would be the excise tax on cigarettes. The federal government has restricted cigarette advertisements and begun to advertise the risks of smoking in an effort to discourage smoking. In addition to the negative advertising, the government could also raise the price of cigarettes with an excise tax, which, if you believe in the downward sloping demand curve, should reduce smoking. This type of tax is likely to be supported if there is widespread acceptance of the government's goal. This explains why the US has been so unsuccessful at charging higher taxes on gasoline to bring the cost more in line with what Europeans pay for gas. Too many Americans drive and do not see the benefits of reduced driving to warrant the additional taxes that add to driving costs.

Fairness, meanwhile, requires that there should be a positive relationship between what a person pays in taxes and the benefits received from the government, what is sometimes referred to as the benefits principle. Two examples would be the gasoline tax and social security. The more you drive, the more you pay in gas excise taxes; and the more you contribute to social security, the more you receive in benefits. It is this sentiment that has been behind the move toward user fees for some government services such as national park entry fees. The problem is many goods and services provided by the government cannot be priced this way - the classic example being defense. Everyone benefits from defense, but everyone has an incentive to underpay their share for defense and the government has no way of ascertaining the magnitude of the benefit accruing to each individual, so it is "forced" to set tax collections independent of any benefit.

A second principle is the ability-to-pay principle. The concept is straightforward. Rather than setting taxes according to the benefits received, the government will set taxes according to an individual's financial position. Furthermore, it is generally accepted that for fairness, taxes should increase with the ability to pay. This is referred to as vertical equity. It is also accepted that individuals with similar ability-to-pay should pay similar amounts of taxes - what is referred to as horizontal equity.

Of course, it is the details that cause the problem. One of the problems is the movement from theory to practice can be quite difficult. For example, consider the concept of horizontal equity. When you read the income tax code you can see the difficulty of achieving horizontal equity. Should homeowners pay the same as those who do not have home mortgages? Should those who are married and have children pay the same as those who are single? Should those who have substantial business expenses pay the same as those who have limited expenses? You will never find agreement on these issues. A second problem, one we have already addressed, is how do we measure ability-to-pay? Once the ability-to-pay question has been resolved, there is the related issue of the proper link between taxes and ability-to-pay. While we may agree that there is a positive relationship between taxes paid and ability-to-pay, there are many possible positive relationships to choose from.

To understand the possibilities let's look at the table below where there are three candidates for the income tax. In each case the principle of fairness is preserved since there is a positive relationship between the taxes paid and the income earned.

Taxable Income	Income Tax #1	Tax rate #1	Income Tax #2	Tax rate #2	Income Tax #3	Tax rate #3
$30,000	$3,000	10%	$3,000	10%	$3,000	10%
$60,000	$6,000	10%	$4,800	8%	$7,200	12%
$100,000	$10,000	10%	$6,000	6%	$14,000	14%

We can also look at the relationships between the tax rate and the level of income, which is what we do in the diagram below. The tax rate could increase as income increases so that individuals with higher incomes are paying a higher share of their income in taxes. This would be called a progressive tax and is represented by the green line and green columns in the table. A second possibility would be a tax rate that remains the same for all income levels - what we would call a proportional tax. This is represented by the horizontal black line in the diagram and the black numbers in the table. The final possibility would be a regressive tax where the rate of taxation decreases as ability-to-pay increases.

What is the structure of the primary taxes in the US? An example of a progressive tax would be the federal income tax. If you look up on the IRS web page you will find the tax forms including the 1040 form and the tax tables that will allow you to calculate your federal income tax. To see the nature of the relationship between tax rates and ability-to-pay we can use the tables to determine what a single individual would pay in taxes with taxable income of $30,000, $60,000, and $100,000. The results appear in the table below. As you can see the tax rate increases as income increases, although the increase is far less than it was in the 1970s before the Reagan tax cuts.

Taxable Income	Income Tax Liability	Tax rate
$30,000	$5,112	17%
$60,000	$13,498	22%
$100,000	$25,855	26%

Three examples of regressive taxes would be property taxes, the consumption (sales) tax and the payroll tax, although on the surface they all sound like proportional taxes. A sales tax, such as you have in RI, taxes all sales at a rate of 7 percent, while the payroll tax rate is approximately 13 percent of income. The apparent discrepancy with the sales tax can be traced to the fact that consumption spending rises slower than income - that as income grows individuals begin to save and saving's share of income rises with income. In the example below, consumption (sales) falls from 95 percent of a $30,000 income too 80 percent of a $100,000 income. Given a sales tax that is proportional to consumption (7%), the effective income tax rate falls from 6.6 percent of a $30,000 income to 5.6 percent for a $100,000 income. To avoid the regressive nature of consumption taxes, some governments exempt spending on necessities such as food and clothing which represent a larger share of spending for low income individuals. A property tax would also be regressive since housing expenses represent a larger share of income for those at the bottom end of the income distribution and therefore the tax would represent a higher proportion of their income.

Income	Consumption Rate	Consumption (Sales)	Sales Tax	Tax / Sales Rate	Tax / Income Rate	Payroll Tax	Payroll Tax Rate
$30,000	95%	$28,500	$1,995	7%	6.6%	$4,590	15.3%
$60,000	90%	$54,000	$3,780	7%	6.3%	$9,180	15.3%
$100,000	80%	$80,000	$5,600	7%	5.6%	$10,465	10.5%

The regressive nature of the payroll tax can be traced to the fact that the tax is paid only on the first $68,400 of income with all income above that level tax free. A payroll tax is proportional through the maximum rate and then the effective tax rate declines. For an individual with an income of $200,000, the payroll tax is $10,465 which is a rate of 5.2 percent.

An example of a proportional tax would be a true flat tax where everyone would pay a certain share of their income in taxes. This sounds very much like what Steve Forbes, a Republican candidate for president in 1996 and 2000, was pushing but is not. The reason it is not a true proportional tax is not all income is taxed and the income that escapes taxation is not equally distributed across the income spectrum.

One thing is for certain, it will be different than today. As mentioned earlier, the means by which the federal government has raised its funds as well as the level of those funds has varied substantially over time and there is no reason to expect the changes to stop now. Where taxes go will reflect in part the prevailing ideology, and in part technology. At the turn of the twentieth century you find there is pressure to move from an income tax to a consumption tax because this would encourage savings, a long-held conservative position, and because it will be easier to collect in a more mobile world. There also seems to be pressure to move taxation from the federal to the state and local levels, a process known as devolution. This is a move pushed by the conservatives who believe the role of the federal government has extended too far beyond its original function - the maintenance of secure borders - and that its powers should be turned back. This is the move toward block grants where federal monies are given to state and local areas that can use the monies as they want to, not as the federal government specifies. You will also see a move toward taxing less heavily the most mobile factors. This can be seen in the move to reduce the capital gains taxes. Since capital is very mobile, investors can move their money anywhere, then it will be difficult for a particular government to raise its tax on capital above other rates. You can see examples of this on a regular basis in the US where companies are given tax breaks to locate their factories in a specific state. Two of the most notable and largest were the deals cut by South Carolina and Alabama to attract the Mercedes and BMW plants. You can also see it in the move to lower the rate on high income individuals in Rhode Island in 1999. The rationale is that these people can live anywhere, and if Rhode Island is to be able to retain these people then it will need to offer competitive tax rates.

The challenge facing government will be to solve the apparent dilemma - a faster pace of technological change and global restructuring that creates a large pool of displaced workers needing government protection at the same time the ability of the governments to raise money is being reduced.

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