The Tax System of the United States
p align="left">As a percent of state and local government spending, federal aid peaked in the late 1980s at about 24 percent of state and local government expenditures and has since declined to about 17 percent. Although they have been declining slowly in importance, intergovernmental revenues are still large and can have significant effects on government finance. Although each individual intergovernmental transfer program will have its own motivation, there are three basic reasons why intergovernmental transfer programs might be established: (1) higher-level governments provide money to encourage certain types of programs by lower-level governments; (2) taxation for lower-level governments can be shifted to higher-level governments, where taxes are harder to avoid; and (3) programs are established for equity reasons, to give poorer states or localities parity with richer states or localities in funding government programs. [2, p.158]
But state governments rely mainly on sales and income taxes for their revenues, while local governments rely mainly on property taxes.
Now we shall tell about tax reforms. Tax laws are continually being modified at all levels of government. Indeed, most changes in tax law tend to be small changes that directly affect only a few taxpayers, and with good reason. Changes in any laws tend to be initiated as a result of a demand for the change, and special interests will consistently demand changes that will benefit them, while the general public will remain on the sidelines of most policy debates. Thus, the tax laws change as one small provision after another is added to the tax code as a result of requests from special interests.
Although each change by itself may have a plausible rationale, changes in the tax code tend to be in the form of loopholes that allow some taxpayers to reduce their tax payments. This was the general idea that drove the federal income tax reform in 1996. The tax code had so many loopholes in it that much income was escaping taxation, making everyone's tax rates higher. If all the loopholes and special interest benefits could be done away with, everyone could have lower tax rates but the tax system could still raise the same amount of revenue.
Thus, the idea of that tax reform was to broaden the tax base by closing loopholes and making more income subject to taxation and lowering rates to raise the same amount of revenue. That effort at reform was mostly successful for two reasons. It considered the tax system as a whole rather than piecemeal, and the reform proposals were revenue neutral, which meant that they all proposed a more efficient tax structure that would raise the same amount of revenue. [1, p.356]
When tax reform takes place by examining one small tax issue after another, special interests can have undue influence over the reform process, and the resulting reform will tend to favor special interests rather than the general public interest. Small changes to the tax code will not affect most people very much one way or the other, so it will not pay them to get involved in the debate, whereas special interests can benefit substantially from small changes in the tax code. Thus, when the tax code is changed a little at a time, special interests will tend to benefit, and the tax code will become increasingly complex as loopholes are added to the tax system one at a time.
This problem of an overly complex tax code ridden with loopholes may be overcome by proposing a complete overhaul of the tax system that does away with all the loopholes in exchange for lower tax rates for everyone. Everyone tends to lose some special interest benefits with such a reform, but, overall, the more efficient tax code with lower rates can more than make up for the loss of these special interest benefits. Thus, a comprehensive tax reform has the potential to be a Pareto superior move, and all citizens can agree to give up their loopholes in exchange for a more efficient tax system that improves the welfare of all. This was the philosophy underlying federal tax reform in 1996.
Since the 1996 tax reform, changes in the tax code have been small ones, and this type of change is likely to benefit special interests rather than further the general public interest. Cynics might even suggest that by 1996, Congress had created just about all the special interest loopholes that it could fit into the tax code and that to create any more would have required taking away someone else's. Therefore, Congress moved to eliminate as many of the special interest provisions as it could so that it could start giving them out again, one at a time, in exchange for renewed political support from the favored special interests. An optimist can hope that once a better tax system has been enacted, Congress and the general public will resist tampering and might even improve upon it.
For special interests in the private sector, the tax code provides a method by which they might be able to produce benefits for themselves. For governments, the tax system is a method of raising revenues. With the federal government running a substantial deficit and states and localities also finding themselves strapped for revenues, many people see tax reform as an opportunity to generate more revenues for cash-strapped governments. This view is not universal, however, and others think that governments spend too much and that taxes should be cut. Inevitably, when tax matters enter the political debate, there will be tension between those who think the government needs to increase taxes and those who think taxes need to be cut.
Both groups should agree that however much revenue the government raises, it should do so as efficiently as possible. Thus, there is a possibility to get agreement among all parties to create a more efficient tax structure if they can lay aside differences regarding whether the government should increase or decrease its revenues.
Agreeing to adhere to the principle of revenue neutrality when changing the tax structure partitions the policy debate so that issues regarding how much revenue the government should raise can be considered separately from efficiency and equity issues. On one side of the partition, legislators can debate how to create a fair and efficient tax structure, leaving the amount of revenues unchanged, and, on the other side of the partition, they can debate whether tax rates should be raised or lowered to collect the right amount of revenue.
So, the federal government relies on income and payroll taxes for the vast majority of its revenues. Social insurance payroll taxes, which consist mostly of Social Security and Medicare taxes, make up the second-largest category. When Social Security taxes were relatively low, the regressive nature of the tax might not have been much of an issue, but with rising Social Security tax rates and uncertain future benefits, the issue is worth considering.
One of the major sources of revenues for lower-level governments is intergovernmental revenue. Revenues collected by the federal government are distributed through grants to state and local governments, and state governments also provide financial assistance to local governments.
But tax laws are continually being modified at all levels of government. Although each change by itself may have a plausible rationale, changes in the tax code tend to be in the form of loopholes that allow some taxpayers to reduce their tax payments. Thus, the idea of tax reform was to broaden the tax base by closing loopholes and making more income subject to taxation and lowering rates to raise the same amount of revenue.
Chapter 3
The Progressivity of the Tax System. Political Influences on the Tax System
One of the important issues in the analysis of individual taxes in the previous chapters was the progressivity of taxes. The progressivity of individual taxes is of minor importance, however, when compared with the progressivity of the tax system as a whole. For example, taxes on cigarettes are widely viewed as regressive taxes because lower-income people spend a larger percentage of their incomes on tobacco than do higher-income people. In general, regressive taxes are viewed as inequitable, yet there is minimal resistance to increases in this regressive tax because it is a sumptuary tax on a product that is increasingly viewed as harmful to consume. There is not necessarily an inconsistency in calling for an increase in a regressive tax and favoring a proportional or progressive tax system if that one tax is a small part of the total system. Thus, the progressivity of the tax system as a whole is more important than the progressivity of any particular tax. [2, p.165]
Analyzing the entire tax system is not an easy task, for several reasons. If one simply examines the amount of taxes paid in one year when compared with people's incomes for that year, the degree of regressivity of the tax system is sure to be overstated. Many people at the low and high ends of the income distribution in a particular year are there because of temporary circumstances. People who are temporarily unemployed, or college students who expect to have higher-paying jobs in a few years, will have relatively high consumption and taxes when compared with their incomes, and, at the other end of the income distribution, some people have annual income may be especially high incomes in a year because they have realized capital gains, such as might occur if one sold a business or even a house that one has owned a long time. Thus, it may be more reasonable to look at the progressivity of the tax system compared with lifetime income rather than with income in a particular year.
