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Taxation is the principal means by which governments get the resources to pay for activities such as armed forces, a court system, a health care program, and programs aimed at transferring resources to the destitute or the elderly. Taxation is not, however, the only means by which a government gains control of resources; for example, many countries draft people into the military. Among developed countries, taxation accounts for between 25 and 50 percent of national income. Taxation in developing countries generally raises substantially less than this, primarily due to the difficulty the tax authorities encounter in collecting taxes. Although tax receipts in many countries fall well short of covering current expenditures, the resulting deficits do not imply that the expenditures are costless; payment is simply delayed, and future generations bear the costs of the expenditure.
Taxation is as old as government itself. Indeed, the first known written records, made by the Sumerians about 5,000 years ago, are apparently tax records. Before money was widely used, taxes were paid in kind with grain, cattle, labor, and other valuable objects. Compulsory labor is the earliest form of taxation for which records exist; indeed, in the ancient Egyptian language the word labor was a synonym for taxes.
In Europe before the seventeenth century, most taxes were levied directly on people, depending on their status in society or on the land they owned. About that time, new taxes arose that were associated with the rising tax bases related to commerce, transactions, and urban markets. Some advocated such taxes as a way of introducing equality in taxation, because the privileged classes had managed to obtain virtual immunity from the existing status-based tax system.
Beginning in the nineteenth century, the growing scale and cost of war greatly expanded the revenue needs of many Western countries, and the tax systems expanded to keep up with these needs. The modern income tax began in Great Britain around 1800 to help pay for wars with France. Financing wars was then the major expense of government—from the twelfth to the nineteenth century, between 75 and 90 percent of the English government’s expenditure went to financing wars. The income tax was also a response to a concern that a tax system that relied on land as a tax base was failing to reach the growing commercial wealth and income that arose during the Industrial Revolution.
Resistance to taxes was a theme of the American Revolutionary War (1775-1783). In keeping with that spirit, taxes in the United States were relatively low until the twentieth century and are still among the lowest of all developed countries. In 1900 U.S. federal taxes amounted to just 3.1 percent of gross domestic product (GDP), while state and local taxes comprised another 4 to 5 percent. The U.S. income tax was introduced in 1913, after the passage of the Sixteenth Amendment to the Constitution, which set aside the constitutional provision that all direct taxes must be levied across states in proportion to their population.
The role of the U.S. federal government expanded greatly during the first half of the twentieth century, and by 1943 federal taxes increased to 19.7 percent of GDP. World War II (1939-1945) was clearly the critical juncture, although the New Deal years of the 1930s were also important. Many programs, particularly Social Security, were introduced during the 1930s and would require much higher taxes in later years. By 2003 federal tax receipts (including social insurance payroll taxes) amounted to 17 percent of GDP, with state and local taxes adding another 8.8 percent. The total share had been roughly constant since the 1970s, but since 2001 federal taxes as a share of GDP have fallen notably due to a series of tax cuts enacted during the George W. Bush administration.
In modern tax systems, a wide range of activities and circumstances can trigger tax liability—the purchase of a good from a retailer triggers a sales tax, the payment of wages for a business to a worker triggers an income tax, or the passing of wealth from one generation to the next triggers estate and inheritance taxes. Although there are a large variety of taxes, certain kinds predominate. Among developed countries, which raise on average about 37 percent of GDP in taxes, slightly more than one-third of tax revenue comes from income taxes; slightly less than one-third comes from various taxes on consumption, including value-added taxes remitted by all businesses; and about one quarter comes from social insurance taxes. The United States stands out among developed nations for its relatively low taxes and for making much less use of consumption taxes. The United States is also the only member country of the Organisation for Economic Cooperation and Development, a group of thirty developed countries, without a value-added tax.
On average, poorer developing countries collect taxes that amount to a substantially lower percentage of their national income. Of the tax revenue they do collect, a smaller share comes from income taxes and a larger share from both consumption taxes and, especially, taxes on international trade. The reliance of developing countries on trade taxes reflects the relative ease with which goods can be observed and valued as they cross international borders, which is important in countries where administrative resources are scarce. It also reflects the use of import taxes as a deliberate economic strategy to promote domestic industrial development, as well as the prevalence of easily taxed exports of primary products such as oil, food, and industrial crops. This lower reliance on income taxes is largely due to the difficulty of collecting income taxes in countries with large informal sectors; unlike developed countries, only a small proportion of the workforce is employed by well-established, financially sophisticated companies whose existence facilitates collection of taxes on the income of both businesses and employees.
There are two key aspects to all taxes: Who bears the burden, and what is the effect on the economy? Ascertaining who bears the tax burden is not simply a matter of keeping track of who writes the checks to the government. For example, in the United States most of the income tax liability of employees is remitted by employers in the form of withholding, although it is widely believed that it is the employee, not the employer, who bears the burden through lower take-home pay. The filing of an employee’s tax return reconciles his or her actual tax liability to what has already been remitted, on the worker’s behalf, by the employer.
Taxes can also impose burdens by changing the prices of what people buy, as occurs with cigarette taxes. Taxes can even have an impact on individuals buying untaxed goods. For example, a tax on butter may cause some consumers to switch to margarine, driving up the price of margarine and shifting some of the tax to people who prefer margarine for health reasons.
Some types of taxes, such as the corporation income tax, are legally owed by a business entity, but the tax burden will be shared among the company’s shareholders, workers, and customers to the extent that the company is able to “pass on” the tax burden by, for example, paying lower or charging higher prices for their products. Assessing the burden of the corporation income tax is one of the most controversial questions in the study of taxation, made more difficult by the advent of multinational corporations that have operations, customers, and shareholders in many countries.
The question of who should bear the burden of taxes is separate from who does bear the burden. It is a perennially contentious issue for which there is no right or wrong answer. One aspect is how the burden should be shared across income classes, an issue often referred to as tax pro-gressivity. Intuitively appealing but vague principles—for example, taxes should match the benefits one receives from government activities, or taxes should equalize sacrifice—do not offer much practical guidance, and modern economics has for the most part given up on refining such principles to instead focus on the consequences of different levels of progressivity. Moreover, it is not clear why, in assessing the distributional consequences of government, it makes sense to focus on tax progressivity rather than the progressivity of what the government provides its citizens and how it assesses taxes to pay for those programs.
Aside from progressivity, tax systems should avoid arbitrary distinctions in tax burden based on people’s tastes or characteristics, whether intended or capricious. In the past, such arbitrary taxes have been imposed on minorities; examples include the poll tax collected from Jewish communities in the Holy Roman Empire and the poll tax levied on non-Muslims in the eighth-century Abbasid caliphate of Persia. Modern tax systems often make tax-burden distinctions among families of the same income level, based, for example, on such factors as family size, charitable inclinations, or tastes for cigarettes.
The second question to ask about any tax system is what costs it imposes. The first and most obvious cost is that every dollar of taxes remitted to the government leaves one less dollar for taxpayers to spend on goods and services. For this reason, a responsible government will only raise taxes to provide programs whose value exceeds the private consumption that is given up.
But there are costs over and above the money taxed away. For one thing, collecting taxes requires a substantial bureaucracy. The Internal Revenue Service (IRS) budget is over $10 billion per year, although that amounts to only about 0.5 percent of the revenue it collects. Dwarfing that are the costs borne directly by the taxpayers—called compliance costs—which include the value of their time spent on tax matters and money spent on tax software and professional tax preparers and planners. This cost has been estimated to exceed $100 billion a year for the U.S. income tax system, ten times the administrative cost for all taxes combined and about 10 percent of revenues collected.
Administration of a legitimate, nonarbitrary tax system is facilitated when there are observable, measurable things that can serve as tax bases. For example, it is notoriously difficult to enforce taxes on food products grown and consumed by farmers and on the income of self-employed individuals. Most modern tax systems rely on businesses that withhold taxes on employees’ earnings and provide information reports to the tax authority that can be matched with employees’ tax returns. Withholding and information reports are supplemented by random audits, with penalties for noncompliance. In many countries, the employee-withholding system is exact and final so that no tax return need be filed by most employees; the British pay-as-you-earn system is an example.
In spite of these measures, substantial tax evasion occurs. According to the IRS, about 16 percent of the federal taxes that should be paid are not. The noncompliance rate varies widely by the type of income; it is less than 2 percent for wages and salaries and as much as 50 percent for self-employment income, the stark difference reflecting the availability of withholding and information reports for the former but not the latter type of income.
Taxes impose another kind of cost on an economy because they alter the costs and rewards of various behaviors. For example, both income and consumption taxes reduce the incentive to work by reducing the consumption reward per hour of labor supplied to the market. Income taxes, but not consumption taxes, also reduce the reward and therefore the incentive of individuals to save and businesses to invest. These behavioral responses represent costs because they channel resources in socially unproductive directions. For example, from society’s point of view it is costly if income taxes dissuade someone from joining the labor force. Much economic analysis has tried to quantify these behavioral responses; the consensus view is that the overall labor supply response is not large and the saving response is not well understood, but certain other behaviors, such as the timing of capital assets sales to anticipated tax changes, are highly responsive to the tax system. The bigger the behavioral response, the higher the economic cost per dollar raised. Some have estimated that, all in all, the behavioral responses to the U.S. income tax system generate an extra forty cents of social cost for every additional tax dollar raised.
Tradeoffs
Tax policy is controversial because the objectives often conflict. Although the economic costs could arguably be reduced by making the tax burden less progressive (i.e., reducing how much the tax burden rises with income), many would find such a system to be an unfair shifting of the burden toward low-income people. Simplifying the tax system could save substantial administrative and compliance costs, but a simplified system might render the tax burden less finely tuned to individual circumstances. Many of the debates about tax policy involve such choices. For example, would lowering taxes on entrepreneurial income stimulate enough economic activity to offset the fact that (successful) entrepreneurs are often among society’s wealthiest citizens?
The twentieth-century expansion of the role of government, and the associated need for more tax revenues, seems to have peaked in the 1980s, and on average the worldwide ratio of tax collections to GDP has not changed much since that time. Looking ahead, as national economies become more interconnected, it may become more difficult to collect taxes without substantial crosscountry cooperation. Furthermore, governments may compete to attract businesses by offering lower taxes. Some view this development as a dangerous “race to the bottom” that will undermine the ability of governments to provide public goods and social insurance, while others applaud it as a way to discipline otherwise profligate governments in the same way that competition among companies promotes cost-minimizing business operations.
Especially in the last two decades, the U.S. income tax system has become much more than a way to raise revenue; it also delivers a wide range of social programs. Thus, it is misleading to associate government expenditure programs with what the government does and the tax system with how it pays for what it does because much of what government does is achieved via the tax system. For example, the U.S. income tax subsidizes charitable giving by making it deductible from taxable income. It also promotes homeownership through its favorable tax treatment, and it delivers the country’s biggest antipoverty program via the earned income tax credit. These programs add to the complexity of the tax system, and thus to its administrative and compliance costs, and the constituencies that benefit often oppose efforts to simplify the tax system that would eliminate these programs.
Bibliography:
- Auerbach, Alan J., and Kevin A. Hassett, eds. 2005. Toward Fundamental Tax Reform. Washington, DC: American Enterprise Institute Press.
- Brownlee, W. Elliot. 2004. Federal Taxation in America: A Short History. 2nd ed. Washington, DC: Woodrow Wilson Center; Cambridge, U.K., and New York: Cambridge University Press.
- Messere, Ken, Flip de Kam, and Christopher Heady. 2003. Tax Policy: Theory and Practice in OECD Countries. New York: Oxford University Press.
- President’s Advisory Panel on Federal Tax Reform. 2005. FinalReport. Simple, Fair, and Pro-growth: Proposals to Fix America’s Tax System. http://www.taxreformpanel.gov/final-report/.
- Rosen, Harvey. 2004. Public Finance. 7th ed. New York: McGraw-Hill. Slemrod, Joel, and Jon Bakija. 2004. Taxing Ourselves: A Citizen’s Guide to the Debate over Taxes. 3rd ed. Cambridge, MA: MIT Press.
- Webber, Carolyn, and Aaron B. Wildavsky. 1986. History of Taxation and Expenditure in the Western World. New York: Simon & Schuster.
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