The W2s are in the mail and tax providers’ commercials on TV. Yes, it’s tax season and time for a reminder about what and why taxes are. Here’s a brief excerpt from Taxes in America: What Everyone Needs to Know by Leonard E. Burman and Joel Slemrod.
Most people know what the individual income tax is. It’s the tax that has made April 15 as iconic as the Super Bowl, without the parties or the popcorn. It’s probably the most salient tax for most people, even though these days most people owe more in payroll taxes than income taxes. The federal payroll tax is earmarked to fund Social Security retirement, survivors, and disability insurance and Medicare. Sometimes it’s called the FICA tax after the legislation that enacted it (the Federal Insurance Contributions Act). For self-employed people, it’s called the SECA tax (the Self-Employment Contributions Act). We have no idea why there are two names for basically the same tax, but it’s a fun fact that will impress your friends at cocktail parties.
What is the personal income tax?
Pretty simple: It’s a tax on individual income collected by the federal government and most states.
The federal tax is progressive, which means the tax rate rises with income. Defining income, however, is not as straightforward as you might think. The standard economist’s definition of income is the sum of what you spend and what you save. Spending is pretty straightforward.
But measuring saving is a little more complicated. It includes what we put in the bank, mutual funds, retirement accounts, and other kinds of investments. But increases in wealth that we don’t spend also add to savings (and hence to income). In many cases this unfamiliar definition lines up with the more familiar meaning—what you are paid if you are employed plus what you make from owning a business and from investments—but, in some cases that we’ll expand on later, it differs in important ways.
The income tax is much more than a tax on income. While some deductions account for the cost of earning income—for example, you can deduct the cost of uniforms that you have to wear to work—many deductions, exemptions, and tax credits are intended to provide subsidies of some sort or another. They often have little to do with the measurement of income.
The income tax is the most common point of contact between people and the government. The filing deadline of April 15 is as well-known a date as April Fools’ Day, and not many events bring on more stress than a tax audit. It’s really no surprise that, according to public opinion polls, the Internal Revenue Service (IRS) ranks near the bottom of American government institutions in popularity, while the Social Security Administration (SSA) tops the list: for most
Americans the IRS cashes your checks, while the SSA sends checks out. This image persists even though in recent years the IRS has dispersed hundreds of millions of payments related to, for example, the Earned Income Tax Credit and stimulus programs. Not only that, but the process of calculating what is owed is for many a complex, time-consuming, intrusive, expensive, and ultimately mysterious process, where the right answer is elusive. As the noted humorist Will Rogers said decades ago, “The income tax has made more liars out of the American people than golf has. Even when you make a tax form out on the level, you don’t know when it’s through if you are a crook or a martyr.” Many taxpayers suspect that they are suckers—when others find loopholes to escape their tax liability, they’re left holding the bag.
What is a tax?
A tax is a compulsory transfer of resources from the private sector to government that generally does not entitle the taxed person or entity to a quid pro quo in return (that’s why it has to be compulsory). Tax liability—what is owed to the government—may be triggered by a wide variety of things, such as receiving income, purchasing certain goods or services, or owning property.
Taxes can impose a substantial cost on people over and above the purchasing power they redirect to public purposes because they can blunt the incentives to work, save, and invest and can also attract resources into tax-favored but socially wasteful activities such as tax-sheltered orange orchards or construction of “see-through” office buildings (which could be profitable in the early 1980s because of tax benefits despite a dearth of tenants).
Tax policy affects the rewards or costs of nearly everything you can think of. It increases the price of cigarettes and alcohol, lowers the cost of giving to charity, reduces the reward to working, increases the cost of owning property or transferring wealth to your children, lowers the cost of homeownership, and subsidizes research and development. For this reason, tax policy is really about everything, or at least everything with an economic or financial angle.
Can taxes be discussed without getting into government spending?
The appropriate level of taxes should reflect a comparison of the benefits of what government spending provides—be it national security, social insurance, fire departments, or national parks—with the cost of taxes. When comparing the benefits to the costs, we need to bear in mind that the cost of taxes should also incorporate the disincentives and misallocations that taxes inevitably cause. For this reason a bridge that costs $500 million to build should promise benefits quite a bit higher than that.
Many Americans care little about the abstract question of whether overall taxes are too high, too low, or just about right. They care much more about their taxes, and their own tax liability. That’s a whole different matter, because whether my tax burden is $25,000 a year or $50,000 a year has absolutely no effect on the strength of our national defense, the viability of the Medicare system, or whether the local park system is well manicured. At the macro level, determining the right allocation of tax burdens depends on resolving what is fair—always a contentious issue—and how alternative tax systems that assign tax burdens differently affect economic growth.
Leonard E. Burman and Joel Slemrod are the author of Taxes in America: What Everyone Needs to Know. Leonard E. Burman is Daniel Patrick Moynihan Professor of Public Affairs at Maxwell School of Syracuse University. Joel Slemrod is Professor of Economics in the Department of Economics and the Paul W. McCracken Collegiate Professor of Business Economics and Public Policy in the Stephen M. Ross School of Business, at the University of Michigan.
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With the ongoing negotiations around the fiscal cliff — what taxes can we raise? what can we cut instead? — we’ve pulled a brief excerpt from Taxes in America: What Everyone Needs to Know by Leonard E. Burman and Joel Slemrod. When heated debates over taxation roil Congress and the nation, a better understanding of our tax system is of vital importance.
Taxes have always been an incendiary topic in the United States. A tax revolt launched the nation and the modern day Tea Party invokes the mantle of the early revolutionaries to support their call for low taxes and limited government.
And yet, despite the passion and the fury, most Americans are remarkably clueless about how our tax system works. Surveys indicate that they have no idea about how they are taxed, much less about the overall contours of federal and state tax systems. For instance, in a recent poll a majority of Americans either think that Social Security tax and Medicare tax are part of the federal income tax system or don’t know whether it is or not, and more than six out of ten think that low-income or middle-income people pay the highest percentage of their income in federal taxes. Neither is correct.
Thus, there is a desperate need for a clear, concise explanation of how our tax system works, how it affects people and businesses, and how it might be made better.
Should tax reform and deficit reduction be separated?
One critical point in the current debate about tax reform is whether it should be revenue-neutral. Some argue that it should be so as to follow the successful blueprint laid out in 1986. Also, many advocates of revenue-neutrality object to tax increases on principle. But some counter that our long-run budget problems are so severe that more revenues will be needed and potentially tying tax reform to lessening future debt burdens could be an effective strategy.
We side with those who think more revenue will be needed and that tax reform should be part of a revenue-raising, deficit-reducing plan. The two go together in that raising revenue is less damaging if done with a more efficient tax system. As discussed below, the Bowles-Simpson deficit reduction plan and the proposal by the Bipartisan Policy Center’s Debt Reduction Task Force both followed this approach. They would eliminate many tax expenditures to finance income tax rate cuts, as in 1986, but reserve some of the revenue gains for deficit reduction. The BPC plan cut fewer tax expenditures, but would introduce a new VAT to augment federal revenues.
Are there some sensible tax reform ideas?
Sure. President George W. Bush put together a blue ribbon panel to propose fundamental tax reform, and they came up with two alternative packages that would have each been simpler and more efficient than the existing tax code. One option would have radically simplified the tax code by eliminating many tax expenditures and converting many of the remaining tax deductions to flat credits. One insight of the Bush tax reform panel was that while tax experts view the standard deduction as a simplification—because people who do not itemize don’t need to keep records on charitable contributions, mortgage payments, taxes, and so on—most real people think it’s unfair that high income people can deduct those items while lower income people can’t. The proposal would have dispensed with itemization.
The “simplified income tax” under the Bush panel’s scheme would have reduced the number of tax brackets and cut top rates, eliminated the individual and corporate alternative minimum tax, consolidated savings and education tax breaks to reduce “choice complexity” and confusion, simplified the Earned Income and Child Tax Credits, simplified taxation of Social Security benefits, and simplified business accounting. The alternative “growth and investment” tax plan would have lowered the taxation of capital income compared with current law—somewhat similar to Scandinavian dual income tax systems.
The Bipartisan Policy Center Debt Reduction Task Force contained a tax reform plan aimed at simplifying the tax code enough so that half of households would no longer have to file income taxes. That plan would create a new value-added tax and use the revenue to cut top individual and corporate income tax rates to 27 percent.
President Obama empaneled another commission, commonly called the Bowles-Simpson Commission (after its two heads) with the mandate to reform the tax code and reduce the deficit. (The Bush panel had been instructed to produce a revenue-neutral plan.) The commission failed to achieve the super-majority required to force legislative consideration, but a majority supported the chairmen’s blueprint. Bowles-Simpson would have eliminated even more tax expenditures than the BPC Task Force, allowing substantial tax rate cuts without the need for a new VAT or other revenue source.
Senators Ron Wyden (D-OR) and Dan Coats (R-IN) produced a more incremental tax reform plan, designed to be revenue-neutral and preserve the most popular tax breaks. It would eliminate the AMT and cut the corporate tax rate to 24 percent while capping individual income tax rates at 35 percent. The cost of these provisions would be offset by closing or scaling back various tax expenditures. The proposal would raise tax rates on high income taxpayers’ long-term capital gains and dividends from 15 to 22.75 percent. It would revise the formula the federal government uses to adjust tax parameters for inflation, generally cutting the revenue cost of annual inflation adjustments. The plan would also reduce businesses’ interest deductions. It would consolidate and simplify individual tax breaks for saving and education. The most radical process change is that the plan would require the IRS to prepare pre-filled tax returns for lower-income filers.
Columbia law professor Michael Graetz has an even more sweeping proposal.6 He proposes to raise the income tax exemption level so high that 100 million households would no longer owe income tax. To make up the lost revenue a new 10 to 15 percent VAT would be enacted. Only families with incomes above $100,000 would have to file an income tax return. The plan would also substantially simplify the income tax for those few who continued to file, but the main simplification would be to take most households off the income tax rolls entirely. (However, households would still have to supply information to claim new refundable tax credits aimed at offsetting the regressivity of the VAT.)
Leonard E. Burman and Joel Slemrod are the author of Taxes in America: What Everyone Needs to Know. Leonard E. Burman is Daniel Patrick Moynihan Professor of Public Affairs at Maxwell School of Syracuse University. Joel Slemrod is Professor of Economics in the Department of Economics and the Paul W. McCracken Collegiate Professor of Business Economics and Public Policy in the Stephen M. Ross School of Business, at the University of Michigan.
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Image credit: Macro shot of the seal of the United States on the US one dollar bill. Photo by briancweed, iStockphoto.
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