Taxation

Taxation, system of raising money to finance government. All governments require payments of money—taxes—from people. Governments use tax revenues to pay soldiers and police, to build dams and roads, to operate schools and hospitals, to provide food to the poor and medical care to the elderly, and for hundreds of other purposes. Without taxes to fund its activities, government could not exist.

Throughout history, people have debated the amount and kinds of taxes that a government should impose, as well as how it should distribute the burden of those taxes across society. Unpopular taxes have caused public protests, riots, and even revolutions. In political campaigns, candidates’ views on taxation may partly determine their popularity with voters.

Taxation is the most important source of revenues for modern governments, typically accounting for 90 percent or more of their income. The remainder of government revenue comes from borrowing and from charging fees for services. Countries differ considerably in the amount of taxes they collect. In the United States, about 30 percent of the gross domestic product (GDP), a measure of economic output, went for tax payments in 2000. The 30 percent figure is relatively low from a historical standpoint. As a result of a new round of tax cuts in 2003, the tax percentage share of GDP was expected to be lower than at any time since 1959 when many major government programs, such as Medicare and Medicaid, did not exist. In Canada about 35 percent of the country’s gross domestic product goes for taxes. In France the figure is 45 percent, and in Sweden it is 51 percent.

In addition to using taxation to raise money, governments may raise or lower taxes to achieve social and economic objectives, or to achieve political popularity with certain groups. Taxation can redistribute a society’s wealth by imposing a heavier tax burden on one group in order to fund services for another. Also, some economists consider taxation an important tool for maintaining the stability of a country’s economy.

II

TYPES OF TAXES

Governments impose many types of taxes. In most developed countries, individuals pay income taxes when they earn money, consumption taxes when they spend it, property taxes when they own a home or land, and in some cases estate taxes when they die. In the United States, federal, state, and local governments all collect taxes.

Taxes on people’s incomes play critical roles in the revenue systems of all developed countries. In the United States, personal income taxation is the single largest source of revenue for the federal government. In 2002 it accounted for about 48.8 percent of all federal revenues. Payroll taxes, which are used to finance social insurance programs such as Social Security and Medicare, account for 36.4 percent of federal revenues. The United States also taxes the incomes of corporations. In 2002 corporate income taxation accounted for 10.4 percent of federal revenues.

State and local governments depend on sales taxes and property taxes as their main sources of funding. Most U.S. states also tax the incomes of individuals and corporations, although less heavily than the federal government. All Canadian provinces collect income taxes from individuals and corporations.

A

Individual Income Tax

An individual income tax, also called a personal income tax, is a tax on a person’s income. Income includes wages, salaries, and other earnings from one’s occupation; interest earned by savings accounts and certain types of bonds; rents (earnings from rented properties); royalties earned on sales of patented or copyrighted items, such as inventions and books; and dividends from stock. Income also includes capital gains, which are profits from the sale of stock, real estate, or other investments whose value has increased over time.

The national governments of the United States, Canada, and many other countries require citizens to file an individual income tax return each year. Each taxpayer must compute his or her tax liability—the amount of money he or she owes the government. This computation involves four major steps. (1) The taxpayer computes adjusted gross income—one’s income from all taxable sources minus certain expenses incurred in earning that income. (2) The taxpayer converts adjusted gross income to taxable income—the amount of income subject to tax—by subtracting various amounts called exemptions and deductions. Some deductions exist to enhance the fairness of the tax system. For example, the U.S. government permits a deduction for extraordinarily high medical expenses. Other deductions are allowed to encourage certain kinds of behavior. For example, some governments permit deductions of charitable contributions as an incentive for individuals to give money to worthy causes. (3) The taxpayer calculates the amount of tax due by consulting a tax table, which shows the exact amount of tax due for most levels of taxable income. People with very high incomes consult a rate schedule, a list of tax rates for different ranges of taxable income, to compute the amount of tax due. (4) The taxpayer subtracts taxes paid during the year and any allowable tax credits to arrive at final tax liability.

After computing the amount of tax due, the taxpayer must send this information to the government and enclose the amount due. In 2001 the average taxpayer in the United States paid about 15 percent of his or her income in income taxes. Many taxpayers, rather than owing money, receive a refund from the government after filing a tax return, typically because they had too much tax withheld from their wages and salaries during the year. Low-income workers in the United States may also receive a refund because of the earned income tax credit, a federal government subsidy for the working poor.

Income taxation enjoys widespread support because income is considered a good indicator of an individual’s ability to pay. However, income taxes are hard to administer because measuring income is often difficult. For example, some people receive part of their income “in-kind”—in the form of goods and services rather than in cash. Farmers provide field hands with food, and corporations may give employees access to company cars and free parking spaces. If governments tax cash income but not in-kind compensation, then people can avoid taxation by taking a higher proportion of their income as in-kind compensation.

The Internal Revenue Service (IRS), an agency of the Department of the Treasury, administers the federal income tax in the United States. Canada Customs and Revenue Agency, which operates under the Minister of National Revenue, administers the tax in Canada.

B

Corporate Income Tax

All corporations in the United States and Canada must pay tax on their net income (profits) to the federal government and also to most state or provincial governments. U.S. corporate tax rates generally increase with income. For example, in 2001 corporations with profits of up to $50,000 paid 15 percent in taxes, whereas corporations with profits greater than about $18.3 million were taxed at a flat rate of 35 percent. In Canada the basic rate for corporations was 28 percent in 2000.

The corporate income tax is one of the most controversial types of taxes. Although the law treats corporations as if they have an independent ability to pay a tax, many economists note that only real people—such as the shareholders who own corporations—can bear a tax burden. In addition, the corporate income tax leads to double taxation of corporate income. Income is taxed once when it is earned by the corporation, and a second time when it is paid out to shareholders in the form of dividends. Thus, corporate income faces a higher tax burden than income earned by individuals or by other types of businesses. Tax legislation passed in 2003 in the United States attempted to address this issue by lowering the tax rate on dividends.

Some economists have proposed abolishing the corporate income tax and instead taxing the owners of corporations (shareholders) through the personal income tax. Other students of the tax system see the corporate income tax as the price corporations pay in return for special privileges from society. The most important of these privileges is limited liability for shareholders. This means that creditors cannot claim the personal assets of shareholders, because the liability of shareholders for the corporation’s debts is limited to the amount they have invested in the corporation.

C

Payroll Tax

Whereas an income tax is levied on all sources of income, a payroll tax applies only to wages and salaries. Employers automatically withhold payroll taxes from employees’ wages and forward them to the government. Payroll taxes are the main sources of funding for various social insurance programs, such as those that provide benefits to the poor, elderly, unemployed, and disabled. In 2002 payroll taxes accounted for about 36.4 percent of all federal tax revenues in the United States; in Canada, the figure was 21 percent. For most people, payroll taxes are the second-largest tax they must pay each year, after individual income taxes.

The U.S. federal government levies the Social Security and Medicare payroll taxes at a flat rate. In 2003 the rate was 7.65 percent for employees and 15.3 percent for the self-employed. Of the 7.65 percent, 6.2 percent goes for Social Security and 1.45 percent for Medicare. The rate is based on annual gross income up to a certain limit. The limit was $87,000 in 2003. The limit rises each year at the same rate as the growth in average wages. The government imposes no payroll tax on earnings above the limit. Employers pay half the tax and employees pay the other half. The Medicare payroll tax is 2.9 percent of all earnings, with no cap. Again, employers and employees split the cost of the tax. Self-employed individuals must pay the entire payroll tax.

Although the legislators who set up payroll taxes intended to divide the tax burden equally between employers and employees, this may not occur in practice. Some economists believe that the tax causes employers to offer lower pretax wages to employees than they would otherwise, in effect shifting the tax burden entirely to employees.

D

Consumption Taxes

A consumption tax is a tax levied on sales of goods or services. The most important kinds of consumption taxes are general sales taxes, excise taxes, value-added taxes, and tariffs.

In the United States, consumption taxes account for only 3.3 percent of all federal tax revenues. This is considerably lower than in most other countries. In Canada, the figure is 24 percent. General sales taxes and excise taxes are the largest sources of revenue for state and local governments in the United States, accounting for about 36 percent of their total tax revenues.

D1

General Sales Taxes

A general sales tax imposes the same tax rate on a wide variety of goods and, in some cases, services. In the United States, most states and many local governments have a general sales tax. The country has no national general sales tax. State sales taxes range from 3 to 7 percent, and local sales taxes range from a fraction of 1 percent to 7 percent. In Canada, all provinces except Alberta impose a general sales tax on goods. In some provinces, the provincial sales tax and the federal goods and services tax (GST) are combined into a single tax known as the harmonized sales tax (HST). Local governments in Canada do not have the authority to impose general sales taxes.

Although sellers are legally responsible for paying sales taxes, and sellers collect sales taxes from consumers, the burden of any given sales tax is often divided between sellers and consumers (for more information, see the Effects of Taxes section of this article). Most states exempt certain necessities from sales tax, such as basic groceries and prescription drugs. Both individuals and businesses pay sales tax. See Sales Tax.

D2

Excise Taxes

Federal, state, and local governments levy excise taxes, which are sales taxes on specific goods or services. Excise taxes are also called selective sales taxes. Goods subject to excise taxes in the United States and Canada include tobacco products, alcoholic beverages, gasoline, and some luxury items. Excise taxes are applied either on a per unit basis, such as per package of cigarettes or per liter or gallon of gasoline, or as a fixed percentage of the sales price.

Governments sometimes levy excise taxes to pay for specific projects. For example, voters in a city might approve a tax on hotel rooms to help pay for a new convention center. Some national governments impose an excise tax on airline tickets to help pay for airport improvements or airline security. Revenues from gasoline taxes typically pay for highway construction and improvements. Excise taxes designed to limit consumption of a commodity, such as taxes on cigarettes and alcoholic beverages, are commonly known as “sin taxes.”

Another type of excise tax is the license tax. Most states require people to buy licenses to engage in certain activities, such as hunting and fishing, operating a motor vehicle, owning a business, and selling alcoholic beverages. See Excise Tax.

D3

Value-Added Tax

In Canada and Europe the favored form of consumption taxation is a value-added tax (VAT). In this system, the seller pays the government a percentage of the value added to goods or services at each stage of production. The value added at each stage of production is the difference between the seller’s costs for materials and the selling price. In essence, a VAT is just a general sales tax that is collected at multiple stages.

In the production of apple pies, for example, the farmer grows apples and sells them to a baker, who turns them into a pie. The baker sells the pie to a restaurant owner, who sells it to a consumer. At each stage, the producer adds value to the commodity by processing it with capital (machines) and labor. The farmer, the baker, and the restaurant owner each charge their customer a VAT. However, they can each claim a credit to recover the tax they paid on purchases related to their commercial activities. See Value-Added Tax.

Canada’s VAT, adopted in 1991, is known as the goods and services tax (GST). In 2003 the GST was 7 percent on most goods and services in Canada. The government exempts certain goods and services from the tax, including most food, most medical and dental services, child-care services, and previously owned residential housing.

D4

Tariffs

Tariffs, also called duties or customs duties, are taxes levied on imported or exported goods. Import duties are considered consumption taxes because they are levied on goods to be consumed. Import duties also protect domestic industries from foreign competition by making imported goods more expensive than their domestic counterparts. In the United States, import duties were the largest source of federal revenues until the introduction of the income tax in 1913. Today they account for only a small portion of federal revenues.

For general information on tariffs, see Tariff. For a history of tariffs in the United States, see Tariffs, United States.

E

Property Taxes

In principle, a property tax is a tax on an individual’s wealth—the value of all of the person’s assets, both financial (such as stocks and bonds) and real (such as houses, cars, and artwork). In practice, property taxes are usually more limited. In the United States, state and local governments generally levy property taxes on buildings—such as homes, office buildings, and factories—and on land. There is no federal property tax. In 2000 property taxes accounted for 2.0 percent of state tax revenues and 72 percent of local tax revenues. The Canadian constitution allows the federal government to levy property taxes. However, currently only local and provincial governments collect property taxes. The property tax is by far the largest source of revenue for local governments.

The property tax is often unpopular with homeowners. One reason is that, because homes are not sold very often, governments must levy the tax on the estimated value of the dwelling. Some citizens believe that the government overvalues their homes, leading to unfairly high property tax burdens.

F

Estate, Inheritance, and Gift Taxes

When a person dies, the property that he or she leaves for others may be subject to tax. An estate tax is a tax on the deceased person’s estate, which includes everything the person owned at the time of death—money, real estate, stock, bonds, proceeds from insurance policies, and material possessions. Most governments levy estate taxes before the deceased person’s property passes to heirs, although many governments do not impose an estate tax on property inherited by a spouse. An inheritance tax also taxes the value of the deceased person’s estate, but after the estate passes to heirs. The inheritors pay the tax. Estate and inheritance taxes are sometimes collectively called death taxes. A gift tax is a tax on the transfer of property between living people.

In the United States, the federal government imposes gift and estate taxes, and some states impose inheritance or estate taxes. However, they are usually minor sources of revenue because the taxes apply only to very large estates and gifts. Property transferred to a deceased person’s spouse is not taxed. Under the Economic Growth and Tax Relief Reconciliation Act of 2001, estate taxes were to be gradually lowered and then phased out altogether in 2010. Under the new law, the exemption for estate taxes was to rise from $1 million in 2002 to $3.5 million in 2009. However, the new law itself was due to be repealed on the eve of 2011, reverting to the legislation that existed prior to the passage of the act unless Congress agreed to extend it. These so-called “sunset” provisions are often enacted as a result of legislative compromises. Opponents of the provision agree to support a tax bill only if the provision is due to expire. Proponents of the provision agree to the compromise because they anticipate that the provision will prove popular and will be extended.

In 2002 less than 2 percent of the people who died in the United States had estates that were subject to the estate tax. In 2002 federal gift-tax law allowed each individual to give any other person up to $11,000 per year tax-free. The Tax Relief Reconciliation Act amended other provisions of the gift tax as well. In Canada, there are currently no death taxes, although both the federal and provincial governments levied estate taxes in the past.

Estate and gift taxes are controversial. Proponents argue that they are useful tools for distributing wealth more equally in society and preventing the rise of powerful oligarchies. Opponents argue that it is a person’s right to pass on property to his or her heirs, and the government has no right to interfere. If an individual has paid tax on his or her income while in the process of accumulating wealth, critics ask, why should it be taxed again when the wealth is transferred? Others argue that estate and gift taxes discourage individuals from working and saving to accumulate wealth to leave to their children. On the other hand, the presence of an estate tax might encourage people to accumulate greater wealth in order to reach a given after-tax goal. See Estate Tax. See also Gift Tax.

G

Other Taxes

A poll tax, also called a lump-sum tax or head tax, collects the same amount of money from each individual regardless of income or circumstances. Poll taxes are not widely used because their burden falls hardest on the poor. When the British government implemented a system of local poll taxes in 1990, citizens considered the tax so unfair that they held demonstrations—some violent—around the country. The extreme unpopularity of the tax contributed to the downfall of Prime Minister Margaret Thatcher. Her successor, John Major, repealed the tax in 1991. In the United States, the 24th Amendment, ratified in 1964, prohibited the payment of poll taxes as a requirement for voting in federal elections. Until that time, a number of Southern states had used poll taxes to deny poor blacks the right to vote. See Poll Tax.

A pollution tax is a tax levied on a company that produces air, water, or soil pollution over a certain level established by the government. The tax provides an incentive for companies to pollute less and thus reduce damage to the environment. The United States, France, Germany, and The Netherlands all levy taxes on some types of pollution. However, these taxes account for just a tiny amount of total tax revenue. In Canada, some provincial governments levy pollution taxes.

III

HOW GOVERNMENT SPENDS TAXES

Governments spend the revenues raised by taxation on an enormous variety of items, from atomic weapons to drug-abuse treatment programs. The annual budget published by the U.S. government requires more than 1,000 pages to list and describe all of the various programs it pays for.

Federal government spending comprises several major categories. One of the largest government expenditures is national defense. The most important nonmilitary program is Social Security, whose main function is to provide income to individuals during their retirement years. Another major program for the benefit of the elderly is Medicare, a health insurance program. Social welfare programs—which include unemployment insurance and payments of cash and food to the poor—also account for a large slice of the federal budget (see Welfare).

When the government borrows money from the public, it must pay interest like any other borrower. One popular way the federal government borrows money is by selling U.S. treasury bonds. By purchasing the bonds, individuals lend money to the government. At the end of a bond’s term, the government returns the investment plus interest.

State and local governments spend the largest share of their tax revenues on public school systems. Other important expenditures include welfare programs, police and fire protection, maintenance of roads and highways, and public hospitals.

IV

PRINCIPLES OF TAXATION

Seventeenth-century French statesman Jean-Baptiste Colbert declared, “The art of taxation is the art of plucking the goose so as to get the largest possible amount of feathers with the least possible squealing.” Today’s economists have rather different ideas of what constitutes a good tax system. Most believe that a tax system should follow two main principles: fairness and efficiency. Scottish economist Adam Smith laid out these principles in his landmark treatise The Wealth of Nations (1776). See the Sidebar “From The Wealth of Nations.”

A

Fairness

Economists consider two principles of fairness to determine whether the burden of a tax is distributed fairly: the ability-to-pay principle and the benefits principle.

A1

Ability-to-Pay Principle

The ability-to-pay principle holds that people’s taxes should be based upon their ability to pay, usually as measured by income or wealth. One implication of this principle is horizontal equity, which states that people in equal positions should pay the same amount of tax. If two people both have incomes of $50,000, then horizontal equity requires that they pay the same amount of tax. Suppose, however, that two individuals both have incomes of $50,000, but one has a lot of medical bills and the other is healthy. Are they in equal positions? If not, then perhaps the tax burden of the person with medical bills should be reduced. But by how much? And how does a person document to tax authorities that he or she is truly paying medical costs, and not just pretending in order to lower the tax bill? This example illustrates a fundamental dilemma in tax design: Fairness is often the enemy of simplicity.

A second requirement of the ability-to-pay principle is vertical equity, the idea that a tax system should distribute the burden fairly across people with different abilities to pay. This idea implies that a person with higher income should pay more in taxes than one with less income. But how much more? Should families with different incomes be taxed at the same rate or at different rates? Taxes may be proportional, progressive, or regressive. A proportional tax takes the same percentage of income from all people. A progressive tax takes a higher percentage of income as income rises—rich people not only pay a larger amount of money than poor people, but a larger fraction of their incomes. A regressive tax takes a smaller percentage of income as income rises—poor people pay a larger fraction of their incomes in taxes than rich people.

Which is fairest—a proportional, progressive, or regressive system? There is no scientific way to resolve this question. The answer depends on ethical and philosophical judgments, such as whether a society has the right to take income from one group of people and give it to another. A progressive, proportional, or even slightly regressive system all can achieve vertical equity’s requirement that a richer person should pay more in taxes than a poorer person. Most industrialized nations have progressive income tax systems, which impose a heavier tax burden as one’s income increases. In the United States, the individual income tax system divides taxable income into different tax brackets—ranges of income with different tax rates.

Some economists consider sales taxes regressive because individuals with higher incomes spend a smaller proportion of their incomes on sales taxes than those with lower incomes. A poor person and a rich person who spend the same amount on groceries each year will pay the same amount in sales taxes, even though the rich person earns more money. However, rich people consume more than poor people, and studies of people’s spending patterns reveal that, over the course of a lifetime, the rich person will pay roughly the same proportion of his or her income in sales taxes as the poor person.

A2

Benefits Principle

The benefits principle of taxation states that only the beneficiaries of a particular government program should have to pay for it. The benefits principle regards public services as similar to private goods and regards taxes as the price people must pay for these services. The practical application of the benefits principle is extremely limited, because most government services are consumed by the community as a whole. For example, one cannot estimate the benefit received by a particular individual for general public services such as national defense and local police protection.

One can make a case that, for some taxes, there is a relationship between taxes paid and benefits received. Gasoline taxes, for example, are used to finance highway construction. But even here, the link between taxes and benefits is weak. Some drivers have more fuel-efficient cars than others. They may use the roads as much as other drivers, but buy less gasoline and thus pay less tax. Merchants who operate stores along the sides of highways benefit from the presence of the roads, but the benefit has nothing to do with the merchants’ gasoline consumption. Despite its intuitive appeal, the benefits principle is not important in practice, and it plays little role in the design of tax systems.

B

Efficiency

In addition to being fair, a good tax system should be efficient, wasting as little money and resources as possible. Three measures of efficiency are administration costs, compliance costs, and excess burden.

B1

Administration Costs

Running a tax collection authority costs money. The government must hire tax collectors to gather revenue, data entry clerks to process tax returns, auditors to inspect questionable returns, lawyers to handle disputes, and accountants to track the flow of money. No tax system is perfectly efficient, but government should strive to minimize the costs of administration.

B2

Compliance Costs

Complying with the system—paying taxes—costs taxpayers money above and beyond the actual tax bill. These costs include the money that people spend on accountants, tax lawyers, and tax preparers, as well as the value of taxpayers’ time spent filling out tax returns and keeping records.

B3

Excess Burden

A third measure of a tax system’s efficiency takes into account the fact that when the government levies a tax on a good, it distorts consumer behavior—people buy less of the taxed good and more of other goods. Instead of choosing what goods to buy solely on the basis of their intrinsic merits, consumers are influenced by taxes. This tax-induced change in behavior is called an excess burden. The larger the excess burden of a tax, the worse it is for efficiency.

Taxes on labor can also lead to excess burdens. When the government taxes people’s labor (through an income tax), people may decide to change the number of hours that they work. The tax distorts their choice between working and leisure.

Not every tax generates an excess burden. Consider a lump-sum tax—a fixed amount of money that all taxpayers must pay regardless of their circumstances. If the government levies a tax of $1,000 on each citizen, regardless of what he or she buys or earns, the only way to avoid paying the tax is to leave the country or die. Citizens cannot avoid the tax by changing their behavior. Because it does not distort behavior, a lump-sum tax has no excess burden—it is perfectly efficient. However, most people would perceive such a tax as extremely unfair because it disregards individual circumstances such as a person’s ability to pay. Thus, the principles of fairness and efficiency conflict: fairness comes at the cost of efficiency. Each society must find the best tradeoff between fairness and efficiency, given the ethical beliefs of its citizens.

V

EFFECTS OF TAXES

Economists have devoted considerable effort to studying the effects of taxes. In particular, they study how taxes affect people’s behavior, including their choices in working, saving, and investing.

To understand the effect of any tax, one must first determine who bears the burden of the tax. This is not always an easy task. Suppose that the price of a chocolate doughnut is $1.00. The government then imposes on sellers a tax of 10 cents per doughnut. A few weeks after its imposition, the tax causes the price to increase to $1.10. The doughnut seller clearly receives the same amount per doughnut as he or she did before the tax—the tax has not made the seller worse off. Consumers pay the entire tax in the form of higher prices. On the other hand, suppose that after the tax the price increases to $1.04. In this case, the seller keeps only 94 cents per doughnut, and is worse off by 6 cents per doughnut. Consumers are also worse off, however, because they have to pay 4 cents more per doughnut. In this case, retailers and consumers share the burden of the tax.

The way a tax affects people is called the tax incidence. The statutory incidence of a tax refers to the individuals or groups who must legally pay the tax. The statutory incidence reveals essentially nothing about a tax’s real burden, because as previously illustrated, prices may change in response to a tax. In contrast, the economic incidence of a tax refers to its actual effects on people’s incomes. The economic incidence of a tax depends on how buyers and sellers of the commodity react when the tax is imposed. The more sensitive consumers are to changes in price, the easier it is for them to turn to other products when the price goes up, in which case producers bear more of the tax burden. On the other hand, if consumers purchase the same amount regardless of price, they bear the whole burden.

A

Labor Supply

An economy's labor supply is the number of hours that people work. Taxes can affect the labor supply by influencing people's decisions about whether to work and how much to work. Suppose that an individual earns $10 per hour, and the government imposes a 40 percent tax on earnings. Then after tax, the individual receives only $6 per hour ($10 minus $4 in taxes). The impact of such a tax is hard to predict. On one hand, the tax lowers the cost to the individual of not working. For each hour of leisure, the individual gives up only $6 instead of $10. In effect, leisure has become cheaper, so the individual tends to consume more of it—that is, to work less. On the other hand, with a lower wage, the individual must work more hours to maintain the standard of living he or she had before the tax. Thus, the tax simultaneously leads to two effects that work in opposite directions.

However, empirical work—analysis based on observation of real-world data—has suggested two important general tendencies. First, for most men, the effect of taxes on hours of work is relatively small. Second, the work-related decisions of married women are quite sensitive to changes in taxes. Research suggests that a tax increase that lowered their wages by 10 percent would lower the number of hours that married women work by about 5 percent.

B

Saving

Saving is the portion of income that is not spent. Might taxes levied on returns to saving (such as interest and dividends) influence the amount people save? When a tax is levied on interest or dividends, it reduces the reward for saving. For example, if an individual earns 10 percent interest on a savings account and faces a 20 percent income tax rate, then he or she makes only an 8 percent return—the other 2 percent goes to the government. This effect tends to reduce the amount of saving that an individual does. On the other hand, when interest is taxed, an individual must save more to achieve any particular savings goal. For example, if parents regularly save money to accumulate enough for their child’s college tuition payments, and taxes on interest increase, they must save more in order to reach their saving target. This effect tends to increase the amount of saving. Because the two effects work in opposite directions, in theory an increase in the tax on interest can increase or decrease saving. Economists have devoted a great deal of effort to studying people’s saving behavior. Although no firm consensus has emerged on the impact that changes in interest and dividend tax rates have on saving, a reasonable estimate is that such changes have a negligible effect.

C

Physical Investment

Physical investment refers to the purchase by businesses of manufactured aids to production. Physical investment includes such items as machines, factories, computers, trucks, and office furniture. The return on a physical investment is the amount by which the investment increases the business’s revenues. How do taxes affect physical investment? In effect, a tax on business income is a tax on the physical investment’s return—the tax reduces the firm’s income and thus the benefit from making the investment. Most economists believe that business taxes decrease the amount of physical investment by businesses.

Taxes also influence the types of physical investments that businesses make. This is because the government taxes returns on some types of investments at higher rates than others. These differences cause businesses to make investment decisions based on tax consequences, rather than whether they are sound from a business point of view. By distorting physical investment decisions, the tax system leads to an inefficient pattern of investment.

D

Tax Evasion and Avoidance

Tax evasion is failing to pay legally due taxes. One important way that high tax rates affect behavior is by increasing evasion. For example, people may fail to report income to the government, thus reducing their tax bill and the government’s tax revenue. Tax cheating is extremely difficult to measure. The Internal Revenue Service estimates that taxpayers voluntarily pay only about 80 percent of the taxes they legally owe. The greater an individual’s tax rate, the greater the incentive to defraud the government.

Tax avoidance occurs when people change their behavior to reduce the amount of taxes they legally owe. When individuals relocate their business to a state with lower taxes or take advantage of loopholes in tax laws, they are practicing tax avoidance. There is nothing illegal about tax avoidance.

VI

HISTORY OF TAXATION

For as long as governments have existed, they have had to come up with ways to finance their activities. Methods of public finance have changed enormously over time.

A

Ancient Times

In the ancient civilizations of Palestine, Egypt, Assyria, and Babylonia, individual property rights did not exist. The king was sole owner of everything in his domain, including the bodies of his subjects. Thus, instead of taxing individuals to support the government, the king could simply force them to work for him. Ancient kings earned income in the form of food from their lands and precious metals from their mines. If this income did not meet the king’s demands, he might lead his armies into neighboring countries to confiscate their property. The conquered peoples might also be required to make payment (known as tribute) to the conqueror in acknowledgment of their submission to his power. If kings were not very wealthy or not very good at stealing from other countries, they would resort to taxing their own people. In societies that operated without money, the ruler taxed farmers by requiring that they turn over some proportion of their crops to the state. Poll taxes were a major source of revenue in Egypt under the Ptolemaic dynasty (323 bc-30 bc).

The government of ancient Athens, Greece, relied on publicly owned silver mines, tribute from conquered countries, a few customs duties, and voluntary contributions from citizens for revenue. It levied poll taxes only on slaves and aliens (noncitizens) and made failure to pay a capital crime.

In the early years of the Roman republic all Roman citizens paid a poll tax. However, Roman military victories brought in so much foreign tribute that the government exempted citizens from this tax in the 2nd century bc, after the Punic Wars between Rome and Carthage. More than 100 years later, Emperor Augustus introduced land and inheritance taxes. Succeeding emperors raised rates and found an increasing number of things to tax, including wheat and salt.

B

Medieval Times

During the Middle Ages, from about the 5th century ad to the 15th century, taxation varied from region to region. Europeans were subject to many forms of taxation, including land taxes, poll taxes, inheritance taxes, tolls (payments for the use of bridges, roads, or seaports), and miscellaneous fees and fines. Many people paid taxes in the form of money or crops directly to the local lord whose land they farmed.

Under the system of feudalism that dominated in Western Europe beginning in about the 11th century, kings, nobles, and church rulers all collected taxes. Kings derived income from their lands, from import and export duties, and from the various feudal dues and services owed by their vassals. For the most part, church officials and nobles were granted exemption from royal taxes, so the burden of taxation fell heavily on the peasantry. When King John of England tried to increase his income by a series of heavy scutages (payments that knights made in lieu of military service), the feudal nobility refused to pay. In 1215 they forced the king to sign the Magna Carta, a document in which he agreed to collect scutage only with the “common consent” of his barons—thus limiting the king’s power to tax.

The Roman Catholic church was a major tax collector during the Middle Ages. One of the most important sources of church revenue was the tithe, a compulsory payment of one-tenth of a person’s harvest and livestock. The church also collected various fees, fines, and tolls, and required clergy members, such as bishops and archbishops, to make payments to the papacy in Rome.

An important development toward the end of the feudal period was the dramatic growth in the number and population of towns and cities. These urban centers collected revenues using taxes on property as well as sales taxes on certain items.

C

16th Century to Modern Period

Over a period of time, feudalism faded and strong centralized states emerged in Europe. During the 16th and 17th centuries, these states relied heavily on revenues generated by the king’s own estates and by taxes on land. In England, the power of Parliament grew steadily because the kings and queens had to convene it frequently to obtain money. In 1689 the English Bill of Rights guaranteed that the king could not tax without Parliament’s consent.

By the 18th century, England started imposing various taxes on transactions. Taxes on imported goods (tariffs) assumed great importance, as did taxes on a wide variety of commodities, including sugar, meat, chocolate, alcohol, coffee, candles, and soap. As time passed, people became dissatisfied with this system of public finance for several reasons. First, although the English government levied some taxes on commodities consumed only by the rich—window glass, for example, which was a great luxury at the time—in general people perceived that the burden of taxes fell mostly on the poor. In addition, tax systems did not generate as much revenue as the governing classes wanted. Finally, economists and political leaders began realizing that by reducing trade, tariffs created economic losses for society.

In the late 19th and early 20th centuries, concerns about both fairness and the ability of tax systems to generate sufficient revenue led governments to enact income taxes. In 1799 Britain enacted the first national income tax, to finance the Napoleonic Wars. The government discontinued the tax when the war ended in 1815, but revived it in 1842. The first progressive income tax—which imposed a greater tax burden on people with higher incomes—was introduced in Prussia in 1853. Other countries introduced progressive income taxation in subsequent decades, including Britain in 1907, the United States in 1913, and France in 1917. Although income taxes generated little revenue at first, today they play a major role in all modern tax systems.

D

Taxation in the United States

D1

Early Colonies

During the 17th and early 18th centuries, local and provincial governments in the British colonies of North America levied taxes to finance schools, road building, military expenditures, law enforcement, and in some cases, churches. Cities and counties levied property taxes based on a person’s ownership of land and livestock and imposed poll taxes on adult men—who also paid the poll taxes of their slaves, servants, and hired workers. Some communities imposed an additional tax on doctors, lawyers, and other professionals and artisans whose special training gave them greater earning power. The colonies taxed imported goods from Europe and the West Indies (but not from Britain), and some colonies taxed certain exports, such as tobacco or furs. Many colonies collected excise taxes on liquor from tavern owners.

Taxation of the American colonies by Great Britain was one of the major causes of the American Revolution. Before the French and Indian War (1754-1763), Britain imposed few taxes on the colonies. The war left Britain deeply in debt, however, and the British Parliament insisted that the prosperous colonies help pay for the cost of protecting them. In 1764 Parliament passed the Sugar Act, which taxed non-British imports of sugar and molasses and, unlike the Molasses Act of 1733, was strictly enforced (see Sugar and Molasses Acts). A year later Parliament passed the Stamp Act, which required colonists to buy and place tax stamps on all legal documents, licenses, newspapers, pamphlets, and playing cards. Both taxes caused widespread resentment among the colonists. They believed that the British government had no right to tax the colonies without allowing them representation in Parliament—the principle of “no taxation without representation.” In response, colonists rioted and boycotted British goods, causing the British Parliament to repeal the Stamp Act in 1766.

In 1767 Parliament passed the Townshend Acts, which imposed duties on a variety of imports to the colonies. Colonists responded with violent protests—one riot led to the Boston Massacre—and by again boycotting British goods. In 1770 Britain repealed all but the tea duty, leaving it as a symbol of its right to tax the colonies. The Tea Act, passed by Parliament in 1773, lifted tea import duties in England but retained them in the colonies. The measure incensed American patriots and resulted in the Boston Tea Party, in which patriots dumped shiploads of British tea into Boston Harbor . War broke out between the colonies and Britain in 1775. See American Revolution.

D2

A New Nation

The Articles of Confederation, adopted in 1781 as the first constitution of the United States, denied the federal government the power of taxation. The federal government relied on donations from individual states for its revenues, but sometimes states refused to make payments to the federal government. The inability of Congress to tax rendered it largely ineffectual. For example, Congress was unable to meet patriot officers’ demands for back pay, and it could not pay interest on the war debt.

The federal government obtained the power to levy taxes with the ratification of the Constitution of the United States in 1789. The Revenue Act of 1791 established tariffs on select imported goods and imposed excise taxes on a variety of goods, including horse-drawn carriages, distilled liquor, snuff, and refined sugar. These taxes proved extremely unpopular. Discontent boiled over into the Whiskey Rebellion of 1794, in which farmers protested a tax on whiskey of 30 cents per gallon. The government repealed most of these sales taxes in 1801 but temporarily reinstated them to finance the War of 1812. During the Civil War (1861-1865) the Union government financed itself through an elaborate system of excise taxes, including taxes on alcohol, tobacco, manufactured goods, legal documents, and bowling alleys. Until the beginning of the 20th century, various excise taxes, along with tariffs, were the largest sources of revenue for the federal government.

D3

Introduction of Income Taxes

The federal government first imposed an individual income tax in 1862 as an emergency means of financing the Civil War. It also established the Bureau of Internal Revenue, predecessor of the Internal Revenue Service. Tax rates were 3 percent on income from $600 to $10,000 and 5 percent on income above $10,000. Later in the war the maximum rate increased to 10 percent of income. In 1872 the government eliminated the tax because the extraordinary revenue needs of the war no longer existed.

As the 19th century came to a close, sentiment in favor of income taxation grew. Just as in other countries, the public believed that sales taxes and tariffs permitted wealthy people to avoid their fair share of the burden of financing government. Congress passed a progressive income tax in 1894, but the Supreme Court declared it unconstitutional a year later. The Court ruled that the Constitution required taxes on people to be collected in proportion to a state’s population, and that income taxes violated this requirement. In 1909 the government imposed a tax on the income of corporations for the first time. At the same time, proponents of an individual income tax pressed for a constitutional amendment. The 16th Amendment, ratified in 1913, authorized individual income taxation. It gave Congress the power “to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

In late 1913 Congress enacted a tax on annual income over $3,000, with marginal (bracket) rates ranging from 1 to 7 percent. At the time, few people earned more than $3,000 per year, so less than 1 percent of the population even filed tax returns. The costs of World War I (1914-1918) led Congress to raise income taxes and make more people eligible to pay them. In 1935 the government imposed a tax on payrolls to finance the Social Security system. In 1943 it began mandatory withholding of individual income taxes from payrolls, which dramatically increased the ease of administering the income tax. By 1945 marginal rates ranged from 23 percent to 94 percent. The maximum marginal tax rate dropped to 70 percent in 1965.

In the 1980s President Ronald Reagan made tax reform a centerpiece of his presidency. He embraced a policy of supply-side economics, which predicted that lower taxes would stimulate work effort and saving. The Economic Recovery and Tax Act of 1981 reduced business taxes and lowered the maximum marginal tax rate to 50 percent. The landmark Tax Reform Act of 1986 further lowered this rate to 28 percent. It also ended deductions for interest paid on consumer loans and student debt, raised the capital gains tax rate to that of ordinary income, and eliminated some special provisions and loopholes in tax laws.

In 1990 President George H. W. Bush and Congress agreed to raise taxes to trim the budget deficit, which had grown substantially in the 1980s. Their tax bill raised the highest marginal tax rate to 31 percent. President Bill Clinton's deficit-reduction bill, passed by Congress in 1993, sharply increased corporation taxes, increased tax credits for the poor, and raised taxes on upper-income individuals. The maximum marginal tax rate on individual income increased to 39.6 percent. In the 1990s Congress also restored preferential tax rates for income from capital gains.

President George W. Bush, like Reagan, also made tax cuts the centerpiece of his administration. Bush’s Economic Growth and Tax Relief Reconciliation Act of 2001 gradually lowered tax brackets, with the top tax bracket dropping to 35 percent by 2006. The law also gradually increased exemptions for the estate tax and eliminated the estate tax entirely in 2010. A second round of tax cuts in 2003 immediately lowered the top tax bracket to 35 percent, reduced the tax on capital gains for most investors from 20 percent to 15 percent, lowered the tax on dividends from a maximum rate of 38.6 percent to 15 percent, and increased the child tax credit for families in certain income brackets.

The 2003 tax cuts were particularly controversial and narrowly passed Congress. Critics, mostly Democrats, charged that the cuts would worsen the nation’s budget deficit, making it more likely that popular social programs such as Social Security and Medicare would have to be curtailed in the future. Some critics even charged that this was the intent of the tax cuts. The tax cuts were also criticized for favoring the wealthy and shifting the tax burden to middle-class taxpayers, creating a more regressive tax system in the United States. Some wealthy Americans, such as investor Warren Buffett, opposed the reduction of the tax on dividends and the elimination of the estate tax because they gave disproportionate tax benefits to the rich. The Bush administration, however, argued that the cuts were necessary to stimulate the economy and create jobs. As with previous tax legislation, sunset provisions were incorporated into the new tax law. The new tax rates on dividends and capital gains were scheduled to expire in 2004.

E

Taxation in Canada

The first known taxes in Canada were export taxes on furs imposed by the French regime in 1650. The French government soon replaced these with tariffs on imported goods. Tariffs continued to be of major importance during the period of British rule, which began in 1763. The British North America Act of 1867 stated that the provinces could levy income taxes, but could no longer levy tariffs. However, the levying of income taxes on individuals and businesses did not become widespread in the provinces until the end of the 19th century.

In 1917 the federal government, which had relied primarily on excise taxes, created both a personal income tax and a corporate income tax, both of which had previously been levied only by provinces. The federal government introduced a general sales tax in 1920. All the provinces created gasoline taxes in the 1920s and collected taxes on alcohol sales. During World War II the provinces suspended their income taxes.

After World War II, the federal government took over the income tax from the provinces, paying them a fee for this right. In 1962 the provinces regained the right to levy income taxes. All provinces soon imposed individual income taxes. (Except in the province of Québec, provincial income taxes are collected by the federal government and then given over to provincial governments.) Also, from 1973 to 1990, all provinces adopted some form of corporate income tax.

In 1991 the federal government introduced a goods and services tax (GST). This broad-based tax applies to most goods and services, although certain commodities, such as basic groceries and medical supplies, are exempt from the tax. In 2000 Canada adopted one of the largest tax cuts in its history. It was designed to reduce personal taxes an average of 15 percent over a five-year period.