Learning Objectives

Learning Objectives

By the end of this section, you will be able to do the following:
  • Differentiate between a regressive tax, a proportional tax, and a progressive tax
  • Identify the major sources of revenue for the U.S. federal budget

There are two main categories of taxes: those collected by the federal government and those collected by state and local governments. What percentage is collected and what that revenue is used for vary greatly. The following sections will briefly explain the taxation system in the United States.

Federal Taxes

Federal Taxes

Just as many Americans erroneously think that federal spending has grown considerably, many also believe that taxes have increased substantially. The top line of Figure 16.5 shows total federal taxes as a share of GDP since 1960. Although the line rises and falls, it typically remains within the range of 17 percent to 20 percent of GDP, except for 2009, when taxes fell substantially below this level, due to the Great Recession.

The graph shows five lines that represent federal taxes (as a percentage of GDP). Total federal tax receipts was around 17% in 1960 and dropped to around 17.5% in 2014. Individual income taxes were consistently between 7% and 10%, but rose to 8% in 2014. Payroll taxes rose from under 5% in 1960 to around 6% in the 1980s. It has remained virtually consistent since then. Corporate income taxes has always remained below 5%. Excise taxes were highest in 1960 at around 2%; in 2009, it was less than 1%.
Figure 16.5 Federal Taxes, 1960–2014 Federal tax revenues have been about 17–20 percent of GDP during most periods in recent decades. The primary sources of federal taxes are individual income taxes and the payroll taxes that finance Social Security and Medicare. Corporate income taxes and social insurance taxes provide smaller shares of revenue. (Executive Office of the President Council of Economic Advisors, 2015)

Figure 16.5 also shows the patterns of taxation for the main categories of taxes levied by the federal government: individual income taxes, corporate income taxes, and social insurance and retirement receipts. When most people think of taxes levied by the federal government, the first tax that comes to mind is the individual income tax that is due every year on April 15 or the first business day after. The personal income tax is the largest single source of federal government revenue, but it still represents less than half of all federal tax revenue.

The second largest source of federal revenue is the payroll tax, which is captured in social insurance and retirement receipts and provides funds for Social Security and Medicare. Payroll taxes have increased steadily over time. Together, the personal income tax and the payroll tax accounted for about 80 percent of federal tax revenues in 2014. Although personal income tax revenues account for more total revenue than the payroll tax, nearly three-quarters of households pay more in payroll taxes than in income taxes.

The income tax is a progressive tax, which means that the tax rate increases as a household’s income increases. Taxes also vary with marital status, family size, and other factors. The marginal tax rates, which is the tax that must be paid on all yearly income, for a single taxpayer range from 10 percent to 35 percent, depending on income, as the following Clear It Up feature explains.

Clear It Up

How does the marginal rate work?

Suppose that a single taxpayer’s income is $35,000 per year. Also suppose that income from $0 to $9,075 is taxed at 10 percent, income from $9,075 to $36,900 is taxed at 15 percent, and, finally, income from $36,900 and beyond is taxed at 25 percent. Since this person earns $35,000, their marginal tax rate is 15 percent.

The key fact here is that the federal income tax is designed so that tax rates increase as income increases, up to a certain level. The payroll taxes that support Social Security and Medicare are designed in a different way. First, the payroll taxes for Social Security are imposed at a rate of 12.4 percent up to a certain wage limit, set at $118,500 in 2015. Medicare, on the other hand, pays for elderly healthcare and is fixed at 2.9 percent, with no upper ceiling.

In both cases, the employer and the employee split the payroll taxes. An employee only sees 6.2 percent deducted from his paycheck for Social Security and 1.45 percent from Medicare. However, as economists are quick to point out, the employer’s half of the taxes are probably passed along to the employees in the form of lower wages, so in reality, the worker pays all of the payroll taxes.

The Medicare payroll tax is also called a proportional tax, that is, a flat percentage of all wages earned. The Social Security payroll tax is proportional up to the wage limit, but above that level, it becomes a regressive tax, meaning that people with higher incomes pay a smaller share of their income in tax.

The third-largest source of federal tax revenue, as shown in Figure 16.5, is the corporate income tax. The common name for corporate income is profits. Over time, corporate income tax receipts have declined as a share of GDP, from about 4 percent in the 1960s to an average of 1 percent to 2 percent of GDP in the first decade of the 2000s.

The federal government has a few other, smaller sources of revenue. It imposes an excise tax—that is, a tax on a particular good, often imposed because it is bad for people’s health or for the environment—on gasoline, tobacco, and alcohol. As a share of GDP, the amount collected by these taxes has stayed nearly constant over time, from about 2 percent of GDP in the 1960s to roughly 3 percent by 2014, according to the nonpartisan Congressional Budget Office (CBO). The government also imposes an estate and gift tax on people who pass large amounts of assets to the next generation—either after death or during life in the form of gifts. These estate and gift taxes collected about 0.2 percent of GDP in the first decade of the 2000s. By a quirk of legislation, the estate and gift tax was repealed in 2010, but reinstated in 2011. Other federal taxes, which are also relatively small in magnitude, include tariffs collected on imported goods and charges for inspections of goods entering the country.

State and Local Taxes

State and Local Taxes

At the state and local levels, taxes have been rising as a share of GDP over the last few decades to match the gradual rise in spending, as Figure 16.6 illustrates. The main revenue sources for state and local governments are sales taxes, property taxes, and revenue passed along from the federal government, but many state and local governments also levy personal and corporate income taxes, as well as impose a wide variety of fees and charges. The specific sources of tax revenue vary widely across state and local governments. Some states rely more on property taxes, some on sales taxes, some on income taxes, and some more on revenue from the federal government.

The graph shows that total state and local revenue (as a percentage of GDP) was less than 8% in 1960. It has decreased a bit since 2013.
Figure 16.6 State and Local Tax Revenue as a Share of GDP, 1960–2014 State and local tax revenues have increased to match the rise in state and local spending. (Executive Office of the President Council of Economic Advisors, 2015)