I. GeneralEarl R. Rolph
II. Personal Income TaxesJoseph A. Pechman
III. Corporation Income TaxesArnold C. Harberger
IV. Property TaxesDick Netzer
V. Sales and Excise TaxesJohn F. Due
VI. Death and Gift TaxesCarl S. Shoup
Taxation is a general concept for devices used by governments to extract money or other valuable things from people and organizations by the use of law. A tax formula contains at least three elements: the definition of the base, the rate structure, and the identification of the legal taxpayer. The base multiplied by the appropriate rate gives a product, called the tax liability, which is the legal obligation that the taxpayer must meet at specified dates. A tax is identified by the characteristics of its base, such as income in the case of an income tax, the quantity of distilled spirits sold in the case of a liquor tax, and so on. The rate structure may be simple, consisting of one rate applying to the base, such as a specified number of cents per gallon for a tax on gasoline, or complex, for example, varying rates depending upon the size of the base for a tax on personal income.
Taxes may be assessed in money or in kind. The government of Communist China imposes taxes on peasants assessed in units of grain produced, and it requires payment in grain itself. In the American Confederacy, because of the deterioration of the Confederate money during the latter phases of the American Civil War, some taxes were assessed and collected in terms of commodities. In American frontier settlements of the eighteenth and early nineteenth centuries, the local governments formed by the people in the region commonly imposed taxes by requesting that each adult male work a given number of days constructing community facilities such as roads and schools. The modern-day counterpart of this practice is conscription of men for service in the armed forces, although conscription is not generally considered as a tax. The dominant practice, however, in the contemporary world is the assessment of taxes in money and the settlement of the tax liability by the payment of money.
Taxation presupposes private ownership of wealth. If a government owned all wealth in a society, including the wealth embodied in people, it would obtain all income, and there would be nothing to tax. No government has gone to such extremes in concentrating the wealth of a society in its own hands. Even in highly socialized societies, such as the Soviet Union, people are permitted, subject to restrictions, to own themselves, household goods, savings accounts, and money. Taxation therefore becomes feasible. Nevertheless, the more wealth a government itself owns, the less is taxation necessary, because revenue from the management of assets is a substitute for tax receipts. National governments, with the exception of some of the highly socialized countries, typically find themselves on the other side of the ledger, having on balance negative net worths apart from their taxing power. Some local governments in western Europe and the United States have substantial revenues from government-owned facilities such as electric power plants, municipal water facilities, and transport systems. The profits from the management of these facilities are occasionally sufficient to permit a government to dispense with taxation altogether.
Taxes are to be distinguished from prices imposed by a government for goods and services that it provides. A price is a money payment made as a condition of obtaining goods or services. It serves as a rationing device provided that the price is positive and provided that the amount of the goods or services the buyer receives in return depends upon the price. If a government supplies water and charges according to the amount of water taken by the buyer, the device is a price and not a tax. Borderline cases arise in two types of circumstances: (1) when a charge is made as a condition of an all-or-none choice, such as a fee for a license for an automobile as a condition of operating the vehicle on any public highway; or (2) when a government imposes a requirement that the citizen use a service and then charges for the service taken, such as a requirement for a passport for foreign travel accompanied by a charge for the passport. In situations in which the element of government compulsion enters significantly, it is customary as well as reasonable to treat the charge as a tax rather than as a price.
Classification of taxes . Taxes may be classified in various ways. Since a tax is a formula of three ingredients—a base, a rate structure, and identification of the legal taxpayer—a common characteristic of any of these three elements may be employed for grouping. Thus taxes may be classified as personal or business. In such a classification, a tax on beer is a business tax because business organizations are in fact the legal taxpayers. More commonly, taxes are grouped on the basis of similarities of the tax base; for example, commodity taxes refer to all taxes in which the production or sale of commodities becomes the occasion for a government levy. Even though personal income taxes vary widely in their characteristics among countries, the presumed common element of the tax base—personal income—is used for grouping purposes.
Perhaps the single most widely used distinction is between what is called “direct” taxation and what is called “indirect.” This is a classification based on certain presumed effects of various taxes. A direct tax in this usage refers to one in which the legal taxpayer cannot shift any of the tax liability to other people, such as customers or suppliers. A clear illustration of a direct tax is a lump-sum charge levied on a person—sometimes called a head tax or poll tax. Income, death, net worth, expenditure, and sometimes property taxes are commonly classified as direct. Indirect taxes refer to those that are thought to be shifted from the legal taxpayer to others. Commonly, taxes on sales of commodities, import duties, and license fees are grouped together as indirect.
By postulating common effects of various taxes, the direct-indirect classification becomes subject to two serious defects. The effects of a particular tax device are not intuitively apparent; their discovery entails careful scientific investigation. It is thus awkward to employ a classification that begs these questions in advance. There is the further difficulty that the shifting of a tax by the legal taxpayer to others may occur in various degrees from 0 to 100 per cent. If a particular tax is proved to be shifted to others by the amount of 25 per cent, for example, the direct-indirect classification becomes irrelevant. One should have to say that the tax is 75 per cent direct and 25 per cent indirect. The difficulty arises because an all-or-none test is used when the relevant distinction is one of degree. For these and other reasons, the direct-indirect classification, although widely used in reporting revenue data, is usually avoided in scientific investigations.
Among other possible dichotomous classifications, taxes may be divided into those described as systematic means-test devices and those without this characteristic. Personal income, expenditure, and net worth are examples of means-test taxes: taxes whose base is systematically related to some relevant index of the taxpayer’s economic position. Personal income, the money gain a person experiences over a period, may be, and commonly is, looked on as a measure of his economic position. An expenditure tax treats the amount spent for personal living expenses or consumption as the index of relative economic status. Likewise, net worth, the value of assets possessed minus debts owed to others, may be used as such a measure. When the purposes of taxation include large yields and systematic redistribution of economic power, some form of means-test taxation must be employed. Although other taxes can also provide large yields, they are likely to be erratic in their effects on income distribution.
Functions of taxation . Any tax that has a yield extracts money from people or organizations and provides money for a government. As a result of a tax formula, taxpayers find themselves with less money to spend; governments, on the other hand, find themselves with more money. This transfer of money from people to government gives rise to two functions of taxation: a reduction in the spending potential of the private sector and an increase in the spending potential of the public sector.
Revenue. The negative function of reducing the spending potential of people often may be viewed as an unfortunate by-product of taxation. Few city officials, for example, would applaud the fact that as a result of the imposition of local taxes, the local citizenry has less money to spend. For local government units, it is the financial needs of the government that justify taxation. Until recent decades, this view was assumed correct for all levels of government; taxation was believed to arise solely out of the financial needs of governments rather than from a public objective of reducing citizens’ spending power.
A sovereign government with an advanced type of financial system controls the money system and, as one feature of this control, can if it wishes provide itself with unlimited quantities of money at negligible cost. This power arises from the use of national monies in the form of bank deposits and currency as opposed to commodities, such as gold and silver, whose quantity cannot be increased by government decree. A national government need no longer levy taxes in order to finance itself.
The discovery of the power of governments to free themselves from internal financial constraints has a long and complicated history. By the time of the Napoleonic Wars, the British government had discovered the convenience of having the Bank of England provide it with funds. In America, the colonies experimented rather freely with the money-issuing power; Massachusetts has the distinction of being the first government in the world to issue paper money. Yet the necessary institutions for the exercise of this power did not exist in the United States at the time of the War of 1812, and the federal government for the first and only time in its history found itself literally bankrupt. World War i was the first occasion when the power to finance government by creating money was freely used by all major belligerents. This financial power was clearly recognized by governments during World War n and was used on a vast scale. In the contemporary world, the possibility of national governments having insufficient money to finance their internal expenditures is no longer a real one. Thus, the amount of revenue to be raised by taxation depends on policy objectives rather than on government financial necessity.
Even though sovereign governments have freed themselves from financial constraints, the revenue function of taxation has not disappeared; this function becomes that of regulating private expenditures so as to stabilize employment and the price level. During periods of insufficient private expenditures, for example during recessions, a national government may allow its revenues to fall automatically and, in addition, may take steps to reduce effective rates of tax in order to increase private expenditures. Similarly, during periods of excessive expenditures, tax rates may be increased as a depressant measure. Even as late as the 1930s, few governments possessed leaders who understood the policy choices available; through fear and desperation they took steps to increase tax rates when effective recovery called for tax reduction. Thanks to the spread of economic intelligence, such serious errors in financial policy are unlikely to be duplicated should a serious world depression ever again develop.
Resource reallocation. In addition to the revenue function of taxation, taxes may alter the product-mix generated within the private sector. In Great Britain, for example, such commodities as automobiles, household appliances, liquor, and tobacco are made more expensive by taxation, whereas such items as milk, vegetables, meat, cider, and household help are made less expensive, in part through subsidies, or negative taxes. As a consequence, the British people use rather more of the latter group of commodities and rather less of the former. The tax-induced change in the product-mix comes about through the effects of taxes on prices and quantities produced. British manufacturers of electric dishwashers, for example, being confronted by a heavy tax on these goods, charge higher prices for them, and so the number these companies can profitably sell is curtailed. The labor and capital services not used to produce dishwashers as a result of the curtailed output of them are devoted instead to the production of other commodities that are lightly taxed or not taxed at all. These other commodities are therefore made more abundant and sell for lower prices. From the point of view of buyers, this alteration of the product-mix benefits those who happen to like the lightly taxed commodities and injures those who prefer the heavily taxed goods. Whether the entire consuming public as a whole can be said to be better off or worse off as a result of the alteration of the product-mix depends on whether an optimum is defined in terms of consumer preferences as expressed in the market or as expressed through political processes. [See Consumer Sovereignty.]
Almost all actual tax devices commonly used by governments display some features that may alter the pattern of productive activities in the society. Personal income taxes as found in the Western world define the tax base incompletely, leaving some gains subject to little or no tax. In the administration of net worth taxes in the Scandinavian countries, agricultural land in comparison with other types of assets is appraised lightly for tax purposes. Value-added taxes, as employed in the state of Michigan and in France, completely omit important types of value-adding activities from the tax base. In all such cases, the tax system encourages some activities over others. Although complete neutrality of a tax system can never be achieved in fact, actual tax systems become more neutral as their coverage of economic activities becomes more general.
As tax systems have developed, they have tended to favor activities of a nonmarket character, such as leisure, production of goods for personal use instead of for sale, and “do-it-yourself” projects in general. Governments have difficulty in catching such gainful activities in their tax net and, with occasional exceptions, do not attempt to do so. Consequently, and for political reasons also, tax policies in advanced countries generally favor agricultural over industrial activities.
Income redistribution. A further main function of taxation is the redistribution of economic power as measured by income or wealth. With respect to money income, a tax system is distributionally neutral if it reduces each person’s income in the same proportion. Taxation may be systematically progressive in the sense of taking an increasing proportion of income increases. Technically, a tax system is defined as progressive if the marginal rate of tax with respect to income exceeds the average rate of tax, provided marginal rates do not exceed 100 per cent. Regressive tax structures refer to the opposite case. In this context, “proportional,” “progressive,” and “regressive” describe the effect of the entire tax system on the distribution of income.
Accompanying the development of democratic political institutions in the Western world, various ethical ideas arose concerning the appropriate criteria for evaluating taxes. The dominant ethical idea that emerged is the “ability-to-pay” doctrine. This rather vague expression is intended to provide a justification for tax systems that are systematically progressive as opposed to those that are proportional, regressive, or merely erratic. Income is usually taken as the appropriate measure of personal ability-to-pay, although net worth and expenditure have also been advocated as appropriate measures. The concept of ability-to-pay implies both equal treatment of people with equal ability, however measured, and a progressive rate structure. The ability-to-pay doctrine has strong affinities to egalitarian social philosophy; both support measures designed to reduce inequalities of wealth and income.
Strict adherence to the test of ability-to-pay, when income is used as the measure of ability, would call for a monolithic tax structure restricted to personal income taxation. Logically, the idea implies systematic negative taxation as well. If a person with a modest income pays zero tax, a person with an even smaller income should pay less than zero tax—that is, receive a subsidy—to achieve appropriate differences in the treatment of people with different tax-paying abilities.
In the development of actual tax systems, only modest success can be claimed for reducing the incomes of the very wealthy by tax measures— even in countries such as the United States, Great Britain, and Australia, all of which use progressive income taxation and have been governed over appreciable periods of time by groups unsympathetic to economic plutocracy. There is little evidence to suggest that in these countries taxes have substantially reduced the wealth of the very wealthy, despite the apparent high rates of tax on large incomes and large estates.
By far the most important government measures used to reduce income inequality have been government welfare programs. Various social services, such as medical care, education, and income maintenance in the form of social security programs, have mitigated the economic hardship of low-income groups in Western countries. These programs directly raise the money incomes of the unemployed, the aged, and the incapacitated; they also potentially raise the consumption of all qualifying groups by providing some services free or at nominal cost. In some Western countries, the programs have virtually eliminated grinding poverty; they have not achieved this goal in the United States.
Shifting and incidence . A tax is said to be shifted if the legal taxpayer can by some means force others to contribute extra amounts of money to him because of the presence of the tax. Shifting is therefore achieved in degrees ranging from zero, that is, no shifting, to 100 per cent, or complete shifting. To the extent a tax is shifted from the legal taxpayer, such as the proprietor of a retail establishment in the case of a retail sales tax, other people are thereby selected to contribute to the government. Actually, full explanations of tax shifting require the determination of the true amount each person must pay to governments, including the amounts shifted to him, so that at least in principle the investigator can state precisely the amount of money a person or family contributes to government per unit of time. Nothing approaching this precision has yet been achieved in any country. It is a safe generalization that the typical citizen goes through life never knowing, even within wide limits, how much in tax he is actually paying.
The concept of tax incidence, sometimes called tax burden, is closely related to that of tax shifting. If, of the taxes imposed by a government, none are shifted at all, the incidence of a tax is said to fall on those who are the legal taxpayers—those persons who would be sued by the government for failure to pay the amounts specified by the tax formula used. In this event, the incidence of the tax holds few mysteries. The concept does involve difficult issues, however, if a tax is shifted in whole or in part. The concept of tax incidence is concerned with the identification of the persons who “finally” or “ultimately” pay the tax liabilities as opposed to those who, although legally required to pay money to the government, are acting wholly or partly as intermediaries in the tax-collection process. Thus, legislators in voting taxes on such items as liquor or cigarettes do not ordinarily assume that the vendors of these commodities are “really” paying the tax because legislators ordinarily operate on the theory that vendors can pass along the tax to buyers. Granted the validity of the theory, the incidence of the tax falls on these buyers.
Theories of tax shifting and incidence exist in great variety. Insofar as a consensus can be found, it is that means-test taxes (for example, income taxes) either are not shifted at all or are shifted only to a trivial extent and that commodity taxes, including import and export duties, are largely shifted from the legal taxpayers to others. The incidence of the general property tax imposed by local governments in the United States, company (corporation) profits taxes, taxes on the transfer of physical and financial assets, and of many minor levies is analyzed in many different ways; no definite consensus can be found among experts on the subject.
Differences in analysis of various tax devices reflect differences both in the general theoretical framework deemed appropriate to explain economic events and in the precise manner in which the investigator views the device being studied.
Tax theory has developed mainly as a by-product of classical and neoclassical economic theory, as exemplified by the works of such thinkers as Adam Smith, John Stuart Mill, W. Stanley Jevons, and Alfred Marshall. Continental general equilibrium approaches, mainly through their influence on such American thinkers as Irving Fisher, have, after a considerable time lag, become important in the explanation of the effects of various taxes. The Keynesian system of thought has a large and devoted contemporary following; it is widely used to explain the effects of entire fiscal systems. More recent theoretical work has been dominated by model building, often of a highly esoteric kind, constructed with such highly simplifying assumptions that government only rarely gets into the picture at all . Given the variety of approaches to the explanation of economic events, a generally endorsed approach to the explanation of how taxes are shifted and in what amounts cannot be expected.
Real income approach. The question of just what the investigator is attempting to explain in connection with taxation is also approached in different ways. A major disputed issue is the alternative, implicitly or explicitly presupposed, to the tax under investigation. Some students define the problem as the effects of the tax together with some government expenditure assumed to be financed by that tax. Accordingly, the problem of explaining a personal income tax is looked upon as including the effects of certain or all of some government expenditures. This approach is adopted more or less automatically by those who view economics as fundamentally a “real” system, meaning a system in which money is assumed to be absent or in which money is viewed as a purely passive device to effect exchanges, having no distorting effect on price relations among goods and services. In this approach, a tax is viewed as levied in goods and services that the government either uses directly in its affairs or trades with private individuals to obtain the goods and services used in its expenditure programs. Explanation consists of showing how the combination of income taxation and the assumed expenditures changes relative prices, quantities produced, and the amount of leisure taken. The incidence of the tax-expenditure combination is believed to be established by showing what groups experience a decline in real income.
This approach has little appeal to most students of public finance because of its remoteness from reality. (It remains, however, the dominant approach to the analysis of the incidence of import duties in pure international trade theory.) It has the further defect, apart from its restrictive assumptions, of identifying particular taxes with particular government programs, when in fact neither a government nor an individual can generally determine which expenditure is financed from a particular tax or income source. Logically, the approach is inherently incapable of isolating the effects of a tax as such, because a tax apart from expenditures is undefined. Since, in fact, government programs can take on any of a great variety of forms, including negative taxes (subsidies), the approach in principle can only give answers for each of an indefinitely large number of possible combinations.
Money income approach. A relatively recent approach, what may be called the “income theory” of tax incidence, views the basic problem of tax analysis to be the determination of the portion of each person’s income diverted to the government by a tax. This approach finds that any tax that provides a government with revenue must simultaneously make the after-tax money income of some people who work or own property smaller by the amount of the revenue. The investigator, accordingly, attempts to identify, for each tax device, those persons whose after-tax incomes are curtailed. In this approach, government expenditure for goods, services, or assets enters as a factor determining demands for current output and as analytically distinct from revenues.
This approach to taxation can be explained by illustration. A tax on cigarettes, for example, is commonly believed to be paid by cigarette smokers. According to the income theory, such a tax reduces the money incomes of certain groups. People, as buyers of services and goods, including cigarettes, are prepared to spend some dollar amount per period. The demand schedule for cigarettes being highly inelastic, a change in price results in little change in the quantity purchased—the tax raises the price of cigarettes by almost the full amount of the tax per unit, and the dollar amount spent on cigarettes increases. Given constraints on total private expenditures, the amount spent on other commodities diminishes. If these “other commodities” consist of all commodities other than cigarettes, all industries find the demands for their products lowered and all will earn lower incomes. If these “other commodities” consist of a narrow class of commodities, such as food, the industries, including agriculture, producing these goods experience reduced prices and reduced income. To only a small extent, because of the low price elasticity of the demand for cigarettes, do tobacco companies and tobacco growers also experience lower profits and wages. The product-mix changes only slightly in this case. If a tax is placed on cornflakes, the pattern of results would be somewhat different. Cornflakes, being one of a great variety of breakfast foods, has a highly elastic demand. The tax would increase the price of cornflakes, greatly reduce the amount bought, and drive resources out of cornflake production. In this case, the companies and workers in the taxed industry would experience lower incomes.
There is no shifting of a general tax on income or net worth; taxpayers experience a lowering of their after-tax income and no incentive is created to reduce further other factor incomes. Commodity taxes, import duties, retail sales taxes, and expenditure taxes are shifted more or less, depending upon the setting where they are used. Property taxes of the American type, where the tax base is mainly the assessed value of real estate, business equipment, and inventories, present complications because of the great diversity in effective rates within and among local jurisdictions and because of the benefit element of local expenditures to owners of taxed property. Property taxes can be shown to reduce property income in general and to be progressive with respect to total income.
The income theory of tax incidence applies in a symmetrical manner to negative taxes, such as subsidies to the production of some food products in Great Britain and to income-maintenance social security programs. The incidence of negative taxes refers to the identification of the ultimate recipient and the amount he receives. As is the case with ordinary taxes, the problem is to identify the private counterpart of the government’s financial transactions.
The income theory of tax shifting, as the name implies, treats government income as arising at the expense of private income. Tax revenues are treated as a form of transfer income—as are interest paid to owners of debt instruments, dividends paid by corporations, and pensions and social security payments made by governments.
Role of determinant price systems. In order to arrive at definitive conclusions, all theories ’of tax shifting need a pricing system that is determinant as opposed to one that is capricious or random. If prices of commodities depend on what executives of corporations eat for breakfast, the incidence of corporation income taxes or commodity taxes cannot be definitively ascertained. Actual price systems in Western countries exhibit capricious elements arising from market power, illustrated by the pricing of some varieties of labor services, government price regulation based on concepts of fair return and historical costs, and many others. Systematic tax theory, like the economic theory of which it is a part, assumes the orderly features of price systems and fails to the extent that the actual world lacks these characteristics. Economists differ widely in their outlook on the degree of orderliness exhibited in contemporary societies; some find that the economic world neatly illustrates the properties of a perfectly competitive pricing system, and, at the opposite pole, others find no system to explain and as a consequence deprecate economic theory.
Taxation and fiscal policy . The main financial weapons of a national government are its expenditures on goods and services, transfers (including negative taxes), taxation, public debt management, and monetary policy. Some or all of these may be manipulated to alter the level of total expenditures by all groups in the economy and at the same time may be used to alter the pattern of these expenditures.
The deliberate manipulation of taxes for the purpose of achieving full employment is subject to both political and economic constraints. The reduction of effective rates of tax, for example, may be irreversible because of political objections to tax rate increases. In addition, taxes have other functions besides revenue, such as resource reallo-cation and income redistribution, and these functions may be partly defeated by changing the tax structure for purposes of influencing private expenditures. These considerations do not imply that the manipulating of effective rates of tax poses insurmountable difficulties; only that the difficulties must be recognized and, if possible, weighed when making a final decision.
Taxes are interdependent among themselves and also interdependent with other fiscal weapons. A reduction in taxes on company profits leads to increased revenue from a personal income tax because some portion of the increase in after-tax profits will appear as an increase in dividends. Different taxes compete for the income of owners of resources; an increase in the effective rates of one tax reduces the yield of others. In selecting taxes to manipulate in influencing private expenditures, these repercussions on other tax yields must be taken into account if the desired total change in revenues is to be achieved.
Taxes are also interdependent with other fiscal devices. In Western countries, and many others as well, national monetary systems are banking systems characterized by bank creation and destruction of money, fractional reserve requirements, and central bank determination of changes in bank reserves. Treasuries must conduct their finances within this institutional framework. Effective fiscal policy presupposes cooperative central bank policies; otherwise, fiscal measures designed to stimulate the economy may be offset by monetary measures. A main problem in financial administration remains that of effective coordination of fiscal and monetary policies. They are so closely interdependent that some students prefer to speak of national financial policies rather than of two sets of policies, fiscal and monetary.
The use of taxation as a weapon to influence private expenditures becomes feasible to the extent a treasury is free from financial constraints, and freedom from constraint implies access to an unlimited amount of money. Central banks are the institutions that have the power to create money in any amount. If, then, a government decides, for example, to reduce effective rates of tax as a stimulating measure during a depression, its treasury will initially find itself depleting its cash position or, in the case of European national treasuries, will be increasingly in debt to the central bank. If the treasury department sells public debt or if the central bank does so instead, the cash released to taxpayers is reabsorbed by net sales of public debt. Depending on the circumstances, these combined actions may be perfectly offsetting, or they may on balance be stimulating or depressing with respect to private expenditures on goods and services. If a stimulating combination of measures is to be assured for a given amount of tax reduction, the maximum is achieved if no debt is sold to the public at all. In this event, with a fractional reserve system of banking, bank reserves increase at the rate of the tax cut. Such increases in bank reserves, given the practice of relatively low fractional reserve requirements or customs, would lead to a potential increase in the amount of money so exceedingly large for even modest tax reductions that central bankers would almost certainly feel obliged to offset them in part. Perhaps a more relevant definition of zero offset is a central bank response to a tax-rate change that permits the quantity of demand deposits plus currency in the hands of the public to change by the change in the yield of the tax systems. In actual practice, however, it would be rare to observe such a result. Normally, central banks and treasuries, when tax cuts are made, use debt operations to offset a sizable fraction of the tax change. For this and other reasons, faith in the efficacy of tax changes to influence the economy must be tempered; one must examine what response, in terms of changes in the size of the outstanding debt, may be expected.
World tax structures . In advanced countries, tax revenues range from a high of about 35 per cent of the gross national product in West Germany to a low of about 21 per cent in Japan; the United States government (federal, state, and local) takes an amount equal to about 25 per cent of the gross national product. Such comparisons may, however, be misleading. In advanced European countries, provision for retirement income is usually made through government programs, whereas in the United States various private pension plans supplement in substantial amounts the federal social security programs. Were retirement deductions from the remuneration of employees counted as taxes, the United States would rank closer to such high-tax countries as West Germany, Sweden, and France in effective tax rates.
International comparisons also neglect negative taxes such as family allowances, subsidies, and social security transfers, creating an impression of heavier taxation of the average household than would data showing both the amount taken in tax and the amounts received in the form of government transfers. Net tax data have unfortunately not been systematically compiled for purposes of international comparisons.
The structure of tax systems reflects the political and social characteristics of national groups. France, a country of high taxation, relies heavily on value-added taxation, whereas the United Kingdom, also a high-tax country, relies heavily on income taxes. The. United States, being a federal political system with long traditions of local financing of local functions, employs many taxes that can be administered at the state and local levels, resulting in a highly complex combination of taxes, such as federal, state, and even local income taxes, state and local retail sales taxes, and the continuation of the important, though generally criticized, local property tax. A centralized system of taxation as found in France would be alien to the mores of Americans. Tax systems, to be workable, must be in keeping with popular feelings and beliefs. This consideration explains why politicians may succeed when tax experts, especially foreign experts, fail in attempts to redesign a country’s tax system.
Of the developing nations, apart from some oil-rich countries, few are in a position to impose taxation at the effective rates found in advanced European and English-speaking countries. Mass poverty, weak public administration, and the concentration of political power in the hands of wealthy groups rule out heavy taxation. Tax systems in these countries ordinarily consist of import duties and, in a few, export duties, transaction and commodity taxes, low-rate income taxes, land taxes, and some form of death tax, usually of the inheritance type. India uses systematic income taxation, although less than 10 per cent of the population is subject to it. As these poor countries develop, their tax systems may be expected to develop as well, and in the direction of higher effective rates of tax.
The outlook generally is for continued high-level taxation where already found and increasingly high effective rates of tax elsewhere, with the possible exception of the communist countries. From a long-run point of view, revenue requirements of government are closely geared to government expenditure and transfer programs. The goods and services that governments provide are looked upon as superior to alternative private commodities, with the consequence that, even apart from military programs, government expenditures exhibit a long-run tendency to rise relative to national income. This tendency is not inevitable and may be reversed. Yet continued urbanization alone, with all that this development implies for government action, may be sufficient to assure relatively expanding government programs. In addition, the welfare state has already demonstrated its political popularity in the Western world, and, despite the lamentations of political conservatives and some economic liberals, government activities appear destined to grow both absolutely and relatively. If so, high taxation can also be expected to be an enduring characteristic of advanced societies.
Earl R. Rolph
[See also Public Expenditures
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Vickrey, William S. 1947 Agenda for Progressive Taxation. New York: Ronald Press.
The personal income tax is widely regarded as the fairest method of taxation yet devised. It is the major element of progression in modern tax systems and permits differentiation of tax burdens on the basis of family responsibilities and other personal circumstances of taxpayers. The yield of the tax expands or contracts more rapidly than personal income, thus imparting built-in flexibility to government revenue systems. The income tax is less burdensome on consumption and more burdensome on personal saving than an equal-yield expenditure tax, but the difference in aggregate terms is probably small for taxes of broad coverage. The effect of the income tax on work and investment incentives is unclear. Although personal income taxation has a long history, some of its major features still present numerous unsettled problems.
The first general personal income tax was introduced in 1799 in Great Britain, where it has been in effect continuously since 1842. Despite this early example, other countries were slow in adopting this tax. It was used for a brief period in the United States during and after the Civil War, and it was permanently enacted following the ratification in 1913 of the sixteenth amendment to the constitution. Austria adopted the income tax in 1849 and Italy in 1864; Australia, New Zealand, and Japan followed in the 1880s and Germany and the Netherlands in the 1890s. Elsewhere the income tax is a twentieth-century phenomenon. It spread quickly during and after World War i and became a mass tax in many countries during World War ii. Today the personal income tax raises substantial amounts of revenue in all industrialized countries of the free world and is employed, although to a lesser extent, in most underdeveloped countries.
Analysis of tax equity has been concerned largely with the distribution of tax burdens among persons in different economic circumstances, i.e., with vertical equity. Questions regarding the treatment of persons in essentially the same economic circumstances—the problems of horizontal equity —have only received close attention since the 1930s.
Vertical equity . Progressive taxation appeals intuitively to most people as an equitable method of distributing the tax burden by income classes, and economists and political theorists have devoted a great deal of intellectual effort to justify it on logical grounds.
An early theory of taxation that was widely held prior to the mid-nineteenth century was that taxes should be distributed in accordance with benefits received. The benefit theorists supported a minimum of government activity, possibly including defense and police and fire protection, but not much more. The benefits of such government services were assumed to be proportionate to income, and this was regarded as a major rationale for proportional income taxation. This theory of tax distribution proved to be untenable both because of its narrow view of the role of government and the arbitrary assumption it made regarding the distribution of benefits of government services.
In the latter half of the nineteenth century, progressive income taxation was justified by the sacrifice theories that emerged from discussions of “ability to pay.” Under this doctrine, ability to pay is assumed to increase as incomes increase, and the objective is to impose taxes on a basis that would involve “equal sacrifice” in some sense. If the marginal utility of income declines more rapidly than income increases, equal absolute sacrifice leads to progression, equal proportionate sacrifice to still more progression, and equal marginal sacrifice to leveling of incomes from the top down until the required revenues are obtained. The assumptions of sacrifice theories—that the relative utility of different incomes is measurable and that the relation between income and utility is approximately the same for all taxpayers—cannot be verified by actual data or experience. Nevertheless, the ability-to-pay idea has been a powerful force in history and has undoubtedly contributed to the widespread acceptance of progressive taxation.
The basic justification for the progressive personal income tax is now probably the socioeconomic objective of reducing great disparities of welfare, opportunity, and economic power arising from the unequal distribution of income. More specifically, the justification is based on two propositions: (a) it is appropriate public policy to moderate economic inequality, and (b) taxation of personal incomes at progressive rates is an efficient method of promoting this objective, since it does not involve direct intervention in market activities. The acceptable degree of progression varies from time to time and place to place; it depends on the distribution of pre-tax incomes and the post-tax distribution desired by the voters. In practice the re-distributive effects of the income tax have been moderate in all countries.
Horizontal equity . A personal income tax conforming strictly with the “equal treatment” principle would apply to all income from whatever source derived, making allowances only for the taxpayer and his dependents. In accordance with the “accretion” concept, income would be defined as consumption plus (or minus) the net increase (or decrease) in the value of an individual’s assets during the taxable period, perhaps modified to exclude gifts and inheritances that are ordinarily subject to separate taxes and, for practical reasons, to include capital gains when realized or when transferred to others through gifts or bequests. In practice most of the income taxes now in existence depart from this standard by a wide margin.
Differentiation of tax liability on the basis of family responsibilities is ordinarily made through a system of personal exemptions for the taxpayer and other members of his family. The personal exemption was originally regarded as a device to avoid taxing individuals and families with incomes that were not adequate to provide minimum levels of subsistence. Today personal exemptions are not high enough to cover a socially acceptable minimum level of subsistence in most countries; they serve primarily to remove low-income recipients from the tax rolls and also contribute to progression in the lower part of the income scale. At higher income levels the purpose of the personal exemption seems to be to moderate the tax burden as family size increases, although the degree of moderation varies greatly among countries. Special exemptions are allowed in some countries for particular groups of taxpayers (e.g., the aged); these exemptions are subsidies that could probably be handled more equitably through direct government outlays.
A second type of differentiation employed in most countries is based on the source of income. The provisions include credits for earned income and for dividends, preferential treatment for capital gains, exemptions for transfer payments and amounts set aside for retirement, omission of the rental value of owner-occupied homes, and numerous other special benefits. The earned-income credit is regarded as a convenient method of making rough allowances for depreciation of labor skills and for expenses of earning income from personal effort which are not recognized for tax purposes. The United States abandoned the earned-income credit in 1944 for simplification reasons, but it is still in existence in the United Kingdom, Australia, and other countries. Dividend credits are designed to moderate the so-called “double taxation” of corporate profits. Preferential treatment of capital gains grew out of the English concept of income, which excluded irregular receipts from income. This treatment is now rationalized on incentive grounds and also as a procedure to avoid applying the graduated rates, in the year of realization, to incomes accrued over a period of years. Transfer payments are excluded because they accrue largely to low-income people. Payments by employers into pension plans are not included in employees’ taxable income to promote the development of private pension plans. The rental value of owner-occupied homes is untaxed in most places because it is difficult to apply the income tax to nonmoney incomes.
The third type of differentiation is based on the use of income. Deductions are required under a “net” income tax for expenditures that are essential to earning income. However, deductions for a wide variety of personal expenditures and for some forms of saving are also permitted. In one country or another, allowances are made for such items as medical expenses, charitable contributions, interest on personal loans and mortgages, state and local taxes, casualty losses, child care in families of working parents, deposits in saving associations, premiums for life, sickness, and accident insurance, and payments into annuity, pension, or other retirement plans.
Personal exemptions are an important element of a progressive income tax, but there is little justification for most of the special exclusions, deductions, and credits based on the source or use of income. Such provisions narrow the tax base and require the use of higher tax rates to raise a given amount of revenue. This puts a premium on earning or spending incomes in forms receiving preferential treatment, interferes with business and investment decisions, and distorts the allocation of resources. Since the deviations from equal treatment tend to be arbitrary, they create dissatisfaction among taxpayers who are subject to discrimination and result in pressures for the enactment of additional special benefits, pressures which legislatures find it difficult to resist. This process has been called “erosion of the tax base” in the United States, where taxable income is at least one-third lower than it would be under a comprehensive income tax. Measures to broaden the base and to use the revenues for rate reduction have been proposed by tax experts, but it is evident from the public and Congressional response that progress along these lines will be slow.
Three major aspects of the personal income tax may be distinguished in appraising its economic effects: first, its automatic response to changes in total personal income; second, its effects on the allocation of personal income between consumption and saving; and, third, its impact on work and investment incentives.
Automatic flexibility . The role of the personal income tax as a built-in stabilizer is one of its most significant features. In the United States, at the rates prevailing in the 1950s and in the 1960s, the personal income tax automatically offset more than ten per cent of the reductions in personal incomes during contractions. The corresponding figure for the United Kingdom was perhaps twice as large, the difference being attributable primarily to the higher starting rate in the United Kingdom. Such changes in tax liability reduce fluctuations in disposable personal income and thus help to stabilize consumption.
Built-in flexibility operates in both the expansion and contraction phases of the business cycle, so that the personal income tax moderates the growth of incomes during a business recovery just as it cushions the fall in income during contractions. This symmetrical response of the income tax (and of other stabilizers) during a business cycle is unavoidable. It should not lead to the abandonment of the stabilizers but rather to the establishment of basic tax-expenditure relationships that would be consistent with a prompt return to high employment following periods of recession. Discretionary changes in tax rates and in expenditures may be needed to implement this objective.
The responsiveness of the income tax to changes in personal incomes is a useful characteristic for underdeveloped as well as for developed countries. An increasing proportion of the nation’s resources must be devoted to public and private investment to increase the rate of economic development. Since voluntary saving is usually inadequate, the bulk of the investment funds must be provided by government. A progressive income tax automatically provides some of the financing as incomes increase. Where development is associated with rising prices, the income tax serves the dual role of moderating inflationary pressures and of increasing the rate of national saving.
Effect on consumption and saving . A personal income tax applies to the income of an individual regardless of the allocation of this income between consumption and saving. By contrast, a general consumption or expenditure tax can be postponed or avoided by delaying or eliminating consumption. It follows that an income tax is less burdensome on consumption than an equal-yielding consumption or expenditure tax which is distributed in the same proportions by income classes. In practice, where the income tax is paid by the large mass of people, much of the tax yield comes from income classes where there is little room in family budgets for reducing consumption in response to tax incentives. Under these circumstances the differential effect of the two types of taxes on total consumption and saving is likely to be relatively small.
Graduated expenditure taxes have been proposed in recent years as a method of avoiding or correcting the effects of income tax erosion, particularly in the top income brackets where exemption or preferential treatment of capital gains permits accumulation of large fortunes without tax payment. Expenditure taxation, it is felt, would discourage lavish living by people with large amounts of property and thus increase saving and risk taking without resorting to regressive taxes. Despite its apparent advantages, the expenditure tax has not been widely used. Rates in excess of 100 per cent would be required to raise significant amounts of revenue from high-income taxpayers. Moreover, the expenditure tax is more difficult to administer than the income tax and also raises much more serious problems of compliance.
Work and investment incentives . It is difficult to evaluate the effect of personal income taxes on work and investment incentives. On the one hand, high tax rates reduce the net rewards of greater effort and risk taking and thus tend to discourage these activities; on the other hand, they may provide a positive stimulus to obtain more income because they cut down on the income left over for spending. These two effects tend to offset one another, and there is no basis for deciding which is more important.
Empirical studies have shed little light on this question. The evidence suggests that income taxation does not have a significant effect on the amount of labor supplied by workers and managers. Work habits are apparently not easily changed, and there is little scope in a modern industrial society for most people to vary the hours of work or the intensity of their efforts in response to changes in tax rates.
A highly graduated income tax applying to all property incomes might reduce incentives to take risk somewhat, since it is impossible to reimburse taxpayers for losses at precisely the same rate at which their incomes are taxed. However, the income tax actually applies to a small fraction of property income in all countries. The opportunity to earn income in the form of capital gains— which are either not taxed at all or are taxed at relatively low rates—is a great stimulant to risk taking in the face of high rates on other incomes. Moreover, risk investment is to a large extent undertaken by firms operating in the corporate form; such firms are generally permitted to retain earnings after payment of more moderate tax rates than those applying to investors in the top personal income tax brackets.
The base of the personal income tax is determined by the definition of income, the allowable deductions, and the personal exemptions. Within wide limits, these elements can be combined with various tax rates to produce a given amount of revenue. Many of the difficult issues in most countries are an outgrowth of local problems and developments. Nevertheless, several structural problems in income taxation appear to be common to practically all countries, and these will be discussed briefly in this section.
Tax treatment of the family . Throughout most of the history of the income tax, differentiation was made among taxpayers with different family responsibilities through the use of personal exemptions. Recently, there has been a trend toward the use of different tax rates to provide additional differentiation, particularly in the middle and higher tax brackets. In the United States, France, and West Germany, this has been accomplished by the adoption of the principle of “income splitting” between husband and wife or among all family members. Other countries achieve the same objective by applying different rate schedules to taxpayers in different family situations.
In France the income of the family is divided by the number of family units, with the taxpayer and his spouse counting as one unit each and each dependent child as an additional one-half unit. The tax is then calculated as if the income of the family were divided proportionately among the family units. In West Germany and the United States, splitting is extended only to husband and wife. By contrast, the United Kingdom has made the use of joint returns by husband and wife mandatory since the early days of its income tax. Under this system the graduated rates are applied to the couple’s combined income after allowance for personal exemptions and other deductions.
Income splitting between two persons doubles the width of the taxable income brackets and thus reduces the progression in tax burdens applying to married couples. The absolute size of the benefit depends entirely on the rate of graduation; it bears no relationship to the level of tax rates. For example, if rates increased one percentage point for every $1,000 of taxable income, income splitting would reduce the tax of a married couple with taxable income of $20,000 by $1,000. This would be true whether the starting rate was 1, 10, 20, or 50 per cent.
Income splitting is generally justified on the ground that husbands and wives usually share their combined income equally. For most families the largest portion of the budget goes for consumption, and savings are ordinarily set aside for the children or for the enjoyment of all members of the family. Two conclusions seem to follow if this view is accepted. First, married couples with the same combined income should pay the same tax irrespective of the legal division of income among them; second, the tax liabilities of married couples should be computed as if they were two single persons and their total income were divided equally between them. The first conclusion is now firmly rooted in the tax laws of most countries and seems to be almost universally accepted. It is the second conclusion on which opinions—and practices— still differ.
The case for the sharing argument is applicable to the economic circumstances of taxpayers in the lower income classes, where incomes are used almost entirely for the consumption of the family unit. At the top of the income scale the major rationale of income taxation is the reduction of the economic power of the taxpayer unit, and the use made of income in these levels for family pur poses is irrelevant. Obviously, these objectives cannot be reconciled if income splitting is extended to all income brackets.
Aside from reducing progression, the practical effect of income splitting is to produce large differentials in the taxes of single persons and married couples. Differentials by marital status that depend on the rate of graduation are difficult to rationalize. However, it is difficult to justify treating single persons with families more harshly than married persons in similar circumstances. As a remedy for this problem, France grants to a widow or widower the same total number of family units for splitting purposes as if the spouse had survived. The United States permits widows and widowers to split their incomes for two years after the death of the spouse and provides half the advantage of income splitting for single persons who maintain a household for children or other dependents or support their parents in a separate household.
One of the major reasons for the acceptance of income splitting may well be inadequate differentiation provided by the traditional types of personal exemptions among taxpayers in the middle and top brackets. Single people, it is felt, should be taxed more heavily than married couples because they do not bear the costs and responsibilities of raising children. But the allowance of income splitting for husband and wife clearly does not differentiate between taxpayers in this respect since the tax benefit is the same whether or not there are children. Nor does the extension of splitting to children give the correct answer, since the benefits depend on the rate of graduation as well as on family size.
The source of the difficulty in the income-splitting approach is that differentiation of family size is made through the rate structure rather than through the personal exemptions. It would be possible to differentiate among taxpayer units by varying the personal exemptions to take account not only of the number of persons in the unit but also of the size of income, with both a minimum and maximum. If this is unacceptable, the only alternative—other than income splitting which produces anomalous results—is to vary tax rates by marital status and family size, as a number of countries have already done.
Personal deductions. In principle, the use made of a given income should have no bearing on the amount of tax to be paid out of that income. In practice, some allowances are made almost everywhere for selected items of consumption or saving. These deductions may be divided into three major types: (1) those that provide supplement to the personal exemption; (2) those that subsidize particular activities or expenditures; and (3) those that improve coordination of Federal income taxes with state or provincial and local taxes, where they exist.
A strong case can be made for allowing some deductions for large, unusual, and necessary expenditures when the personal exemptions are low. Deductions for medical expenses are the best example of this type of expenditure. They are often involuntary, unpredictable, and may exhaust a large proportion of the taxpayer’s income. Expenditures for noninsured losses due to theft, fire, accident, or other casualties are of a similar nature. In keeping with the purpose of this type of deduction, it should be limited to an amount in excess of some percentage of income, which would be high enough to exclude all but extraordinary expenditures for these purposes.
Subsidy-type deductions are most common for contributions to charitable, religious, educational, and other nonprofit organizations. In many countries heavy reliance is placed on philanthropic institutions to supplement governmental activities and in some cases to provide services which governmental units do not perform. It may be argued that private philanthropy should not be encouraged at the expense of government funds. However, few people subscribe to this view because the activities of these organizations, with rare exceptions, are considered desirable and useful.
Subsidy-type deductions are also allowed in some countries for selected items of personal saving. Great Britain has permitted the deduction of a portion of life insurance premiums since the beginning of the income tax. West Germany allows deductions for personal insurance and for deposits in building and savings associations. A number of countries have recently enacted limited deductions for amounts set aside in annuities or retirement plans by self-employed persons and employees not eligible for company pension plans. The major motivation for these deductions appears to be to promote saving, but more particularly to encourage adequate provision for retirement and for catastrophic events that entail large outlays or loss of income. The deductions for personal contributions to retirement plans are also intended to remove the discrimination resulting from the exclusion usually granted to employer contributions to employee pension plans. The growth of allowances for particular types of saving has made substantial inroads into the philosophy of income taxation; in fact, these policies constitute a substantial movement toward the expenditure tax approach.
Suggestions have been made in recent years that the tax laws should permit a deduction for the cost of higher education. These suggestions reflect the importance of higher education for economic growth and the increased costs of a college education. On the one hand, a deduction allowed to parents would give the largest benefits to the highest income classes and would therefore be inequitable. On the other hand, some portion of expenditures for higher education is an investment which is not recognized for tax purposes as an expense of earning income. The appropriate treatment would be to regard the outlay by a parent as a gift to his child and to permit the child to write off a portion of this outlay over his earning career for, say, twenty years. However, there is no basis for estimating the proportion of educational outlays allocatable to investment, and the problems of administration and compliance would be substantial. [See Capital, Human.]
Deductions for income taxes paid to overlapping governmental units are required to prevent confiscation if one or more levels of government employ high rates in the upper end of the income scale. Where the rates are moderate, it is quite appropriate to levy two taxes on the same base without coordination. However, it may be desirable to permit deductions even if the rates are not confiscatory as a device to moderate interstate differentials. For example, with a Federal rate of 70 per cent and without deductibility of state taxes, the combined tax on residents of two states with rates of 5 and 10 per cent would be 75 and 80 per cent, respectively. By permitting taxpayers to deduct the state tax on their Federal returns, the combined rates are reduced to 71.5 and 73 per cent. (If the states also permit a deduction for Federal taxes, the combined rates are further reduced to 70.5 and 71 per cent. This type of mutual deductibility is unnecessary for coordination purposes, since the coordination achieved through single deductibility is quite adequate.)
A deduction for income taxes paid to state and local governments may be a practical necessity in a Federal system, but the same justification does not hold for state and local sales, excise, and property taxes. The latter deductions defeat the purposes of taxes levied to obtain payments from taxpayers for benefits received from state and local governments and reduce the progressivity of the combined tax system.
In the United States, where personal deductions have proliferated more than in any other country except perhaps West Germany, taxpayers are granted a “standard” deduction, in lieu of the itemized deductions, of up to 10 per cent of income (with a maximum of $500 on separate returns of married persons and $1,000 on all other returns). This device was adopted in 1944 for simplification reasons, in recognition of the fact that most personal deductions are small and few taxpayers keep adequate records to support them. To an important degree, the standard deduction violates the rationale of the itemized deduction; it reduces differentiation in tax liabilities while the itemized deductions are intended to introduce such differences for the purposes selected. The existence of both a standard deduction and itemized deductions suggests that there is some ambivalence toward many of the personal deductions in the United States income tax structure.
On balance, equity would be better served by avoiding erosion of the tax base through the use of numerous costly personal deductions. This should not preclude the adoption of a restricted list of deductions for unusually large and extraordinary expenditures to prevent hardships. Subsidy-type deductions are appropriate only if they promote a significant national objective and if the deduction route is the most efficient and equitable method of achieving that objective.
Capital gains and losses . As already indicated, an economic definition of income would include capital gains in full on an accrual basis. This method is impractical for three reasons: (1) valuations of many types of property cannot be estimated with sufficient accuracy to provide a basis for taxation; (2) most people would regard it as inequitable to pay tax unless income has actually been realized; and (3) taxation of accruals might force liquidation of assets to discharge tax liabilities. Thus, where capital gains are taxable, they are included in income only when realized.
Few countries tax the capital gains of individuals, but the United States has done so since the beginning of its income tax. Realized capital gains were originally taxed as ordinary incomes, but they have been subject to preferentially low rates since 1921. The provisions applying to such gains changed frequently during the 1920s and 1930s but were stabilized beginning in 1942. In general, capital gains on assets held for periods longer than six months are subject to half the rates on ordinary income, up to a maximum of 25 per cent.
The treatment of capital gains is likely to be a compromise among conflicting objectives. From the standpoint of equity, it is well established that capital gains should be taken into account in determining personal tax liability. Moreover, low rates or exemption of capital gains encourage the conversion of ordinary income into capital gains by devices that distort patterns of investment and discredit income taxation. On the other hand, the bunching of capital gains in the year of realization requires some provision to moderate the impact of graduation. On economic grounds full taxation of capital gains is resisted because it is believed that it would have a substantial “locking-in” effect on investors and reduce the mobility of capital. It is also argued that preferential treatment of capital gains helps to stimulate a higher rate of economic growth by increasing the attractiveness of investment generally and of risky investments in particular.
The “bunching” problem can be handled by prorating capital gains over the length of time the asset was held or by adopting a general averaging system applying to other types of income as well as to capital gains. However, unless the marginal rates were fairly low, the tax might still discourage the transfer of assets. Part of the difficulty is that adherence to the realization principle permits capital gains to be transferred tax-free either as a gift or at death. The solution to this problem is to treat capital gains as if they were constructively realized as a gift or at death, with an averaging provision to spread the gains over a period of years. Great Britain adopted the constructive realization principle when it added a capital gains tax to its tax structure. Under such a system the only advantage taxpayers have from postponing the realization of capital gains is the accumulation of interest on tax postponed. Unless the assets are held for many years, this advantage is small as compared to the advantage of the tax exemption accorded to the gains transferred at death; in any event, the interest on the tax postponed is subject to income tax when the assets are transferred. Under the circumstances, the incentive to hold gains indefinitely for tax considerations alone is very greatly reduced.
Capital losses are no easier to handle than capital gains. In principle, capital losses should be deductible in full either against capital gains or ordinary income. However, when gains and losses are recognized only upon realization, taxpayers can easily time their sales so as to take losses promptly when they occur and to postpone the realization of gains. There is no effective method of avoiding this asymmetry under any system of taxation applying to realized gains and losses. In the United States, capital losses of individuals may be offset against capital gains plus $1,000 of ordinary income in the year of realization and in subsequent years for an indefinite time period. This restrictive policy is perhaps most harmful to small investors, who are less likely than those in the higher brackets to have gains against which to offset their losses. The only solution to this problem is a pragmatic one which would be as liberal as possible for the small investor without opening the door to widespread abuse and large revenue losses.
Relation to the corporate income tax. Unless corporate incomes were subject to tax, individuals could avoid the personal tax by accumulating income in corporations. Short of an annual allocation of corporate incomes on a prorata basis—a method which is excellent in theory but not in practice—the equity and revenue potential of the personal income tax can be protected only by a separate tax on corporate incomes. However, the existence of two separate taxes on the same income creates a difficult equity problem. Concern over the “double taxation” of dividends is evident in the various devices used in different countries to alleviate its alleged discriminatory effects.
On the assumption that all or a significant portion of the corporate income tax rests on the stockholder, the effect of double taxation is to impose the heaviest burden on dividends received by stockholders with the lowest incomes. Assume a corporate income tax of 50 per cent and suppose a corporation pays out $50 in dividends. The corporate income before tax from which these dividends were paid amounted to $100. If this $100 had been subject to personal income tax rates only, the nontaxable individual would have paid no tax on it; the additional burden of the corporate income tax in this case is the full $50 corporate tax. By contrast, a stockholder subject to an eighty per cent rate pays a personal income tax of $40 on the dividend, and the total tax burden on the original $100 of corporate earnings is $90. But since he would pay $80 under the personal income tax in any case, the additional burden on him is only $10.
The simplest and most effective method of dealing with this problem would be to permit corporations to deduct all or a portion of their dividends in computing taxable income. This method would apply the regular corporate tax rate to undistributed profits and would reduce or eliminate the corporate tax on distributed earnings. It would also have two additional advantages: first, dividend and interest payments would be treated more nearly alike, thus reducing the discrimination against equity financing by corporations; second, the same proportion of the corporate income tax on distributed income would be eliminated for all taxpayers regardless of their personal income tax status.
Despite these advantages, undistributed profits taxation is not used widely. The United States experimented with it in the 1930s, but the experiment created a great deal of resentment (possibly because the differentiation between distributed and undistributed profits was made by the imposition of a penalty tax on the latter rather than by allowing a deduction for dividends). The major drawback of undistributed profits taxation is that it discourages internal financing by corporations and thus may reduce saving and investment. On the other hand, some believe it is unwise as a matter of policy to permit corporations to avoid the capital markets for financing their investment programs.
If dividend relief is given at the individual level, there are three possibilities. The first is the “withholding” method, under which all or a portion of the corporate tax is regarded as having been paid at the source by the stockholder. The taxpayer includes the tax paid at the source in his income and then receives a tax credit for that amount. This method was used in Great Britain from the enactment of the 1803 income tax until 1965. Tax burdens of shareholders on distributed corporate income are the same as the burdens under the undistributed profits tax approach.
The second alternative is to permit the taxpayer to exclude some or all of his dividends from his tax return, and the third is to permit him to take a credit against his final tax liability computed at a flat percentage of the amount of dividends he receives. The United States exempts the first $100 of dividends; and Canada uses the dividend-credit approach exclusively at a rate of 20 per cent. Great Britain now makes no special allowance for dividends.
Neither the exclusion nor the credit can be regarded as a satisfactory method of removing double taxation, since neither can remove the same proportion of the excess taxation of dividends throughout the income scale. In contrast, the undistributed profits approach and the withholding method remove the same proportion at all income levels.
The desirability of doing something about the double taxation of dividends is still in dispute. First, corporations are viable economic units with characteristics and behavior patterns that have very little relationship to the income and other characteristics of their stockholders. Moreover, stockholders in large, publicly held corporations have only indirect and remote influence on management policies. On these grounds, many experts believe that a modern tax system would be incomplete without a separate tax on corporate enterprises. Second, the argument for moderating or removing the double taxation of dividends assumes that the corporate tax rests on the corporation and, ultimately, the stockholder. If the corporate income tax is shifted forward in the form of higher prices (or backward in the form of lower wages), the case for integration collapses. In the present state of knowledge, the incidence of the corporation income tax is not clear.
If integration of the corporate and personal income taxes were considered appropriate, some solution of the capital gains problem would be an essential first step. Under a system of full taxation of capital gains, including constructive realization at death, generous provision might well be made for alleviating the double tax on distributed profits. Where capital gains are either not taxed at all or are taxed at very low rates, the case for integration is weak. No country has yet resolved all of these problems satisfactorily.
Fluctuating incomes . The use of an annual accounting period combined with progressive rates results in a heavier tax burden on fluctuating incomes than on an equal amount of income distributed evenly over the years. This type of discrimination is hard to defend on equity or economic grounds. Taxpayers do not and cannot arrange their business and personal affairs to conform with the calendar. Annual income fluctuations are frequently beyond the control of the taxpayer, yet he is taxed as if 12 months were a suitable horizon for decision making. In addition, in the absence of averaging, there are great pressures for moderating the impact of the graduated rates on fluctuating incomes by lowering the rates applicable to them. Reduced rates on capital gains are often justified on this basis, although the reductions more than compensate for the absence of averaging.
There may also be a connection between the treatment of fluctuating incomes and incentives to take risk. Even with generous provisions for offsetting losses against gains, business incomes are taxed more heavily than other incomes under a progressive, annual income tax because (a) they fluctuate more than other incomes and (£>) the losses do not come off the top of the taxpayer’s income during the loss-offset period and are therefore not credited at the maximum rate. On the assumption that there is a correlation between income variability and risk, a tax system using a one-year accounting period is more burdensome on venturesome than on safe investments and thus is more discouraging to risk taking than a tax system having a longer accounting period.
Experience with general-averaging systems has been disappointing, largely because the methods used have been based on a variant of the moving average. This requires large tax payments when incomes fall below the average and small payments when they rise above it. Taxpayers properly regard such an arrangement as highly inequitable. It is now known that the payment problem may be solved by making the averaging adjustment in the form of a refund. For example, taxpayers might be permitted to average their incomes once every five years and to receive a refund (or credit) for any amount of tax actually paid in excess of 105 or 110 per cent of the tax on the average income during the averaging period. The United States adopted a variant of this method in 1964, allowing individuals to average their incomes over a five-year period where the income in the current year exceeds the average of the four prior years by more than a third and this excess is more than $3,000.
Many averaging systems, varying from cumulative lifetime averaging for every taxpayer to averaging over fairly short periods for specific types of volatile incomes, have been explored in the literature. All averaging proposals would create problems of compliance and administration and might involve substantial revenue losses, particularly if applied to the mass of taxpayers. With the advent of electronic machines, it will be possible to solve most of the administrative problems, but the revenue implications may remain serious.
The personal income tax is still in the process of development. Methods of differentiating tax liabilities of single persons and families of different size are unsatisfactory. There is increasing recognition that capital gains and losses should enter the tax base, but the equity, economic, and administrative objectives of capital gains taxation are difficult to reconcile. The appropriate relationship between the personal and the corporate income tax continues to be disputed. Little progress has been made to alleviate the excessive burden of the income tax on fluctuating income. Finally, the concept of income subject to tax departs considerably in most countries from an economic definition of income, and too many special allowances are made for specific sources and uses of income.
Despite all of these problems, the personal income tax is the best tax yet devised, and it will continue to be an indispensable and significant element of all modern tax systems for the indefinite future.
Joseph A. Pechman
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The taxation of the income of corporations has come to be one of the major sources of fiscal revenue in most countries. According to the 1965 Yearbook of National Accounts Statistics of the United Nations, corporation tax receipts in 1962 equaled or exceeded 2 per cent of the national income in 32 countries, and represented 10 per cent or more of current government receipts in 19 countries. Of the major countries, Japan places the heaviest reliance upon the corporation income tax, receipts from this tax accounting for 22 per cent of current revenues and amounting to 6 per cent of the national income. Australia, Canada, New Zealand, the Republic of South Africa, and the United States all collect more than 15 per cent of their current revenues from this source, the amounts in each case representing more than 5 per cent of national income. In western Europe corporation income taxes typically represent 3-4 per cent of national income and 6-10 per cent of current government revenues. The corporation income tax tends to be less important, relative to national income and government revenues, in the developing countries than in the more advanced economies; but this is due mainly to the fact that the corporate sector itself is less important, rather than to a failure of the developing countries to levy the tax at all or to a tendency on their part to impose the tax at significantly lower rates than those applied by the more advanced countries.
This widespread and heavy reliance on the corporation income tax testifies to its administrative feasibility and political popularity. It is highly feasible administratively because the laws under which corporations are established generally require the maintenance of accounts on a standardized basis; thus the enforcement of the tax reduces to the problem of requiring honest and accurate accounts and of resolving a series of technical issues, such as the determination of which expenditures may be expensed and which must be capitalized, and the setting of allowable rates of depreciation for specific classes of assets. These problems have been handled in most countries by administrative decrees or regulations issued by the tax-collecting authority itself, operating under broad guidelines set out in the tax legislation.
The political appeal of the corporation income tax has two roots. First, the tax obviously conforms to popular conceptions of ability to pay, since the man in the street tends to view corporations as wealthy entities themselves and as being owned predominantly by wealthy stockholders. But second, and in many ways equally important as a source of political appeal, is the fact that the corporation income tax, by definition, cannot be a source of loss to a corporation. Those corporations which have no net income pay no corporation income tax; only “profitable” companies are required to bear this levy. By contrast, other forms of business taxation can themselves be responsible for converting what would otherwise be a net profit situation into one of net loss. Hence, even within the world of business, companies in a marginal or precarious financial situation are likely to prefer the taxation of corporate net income to other forms of business taxation, and the strong opponents of corporate income taxation are likely to be the more profitable companies with the most “ability to pay.”
The administrative and political advantages of the corporation income tax do not, however, imply that it is a good tax from the economic point of view. Quite to the contrary, it is readily demonstrable that, of the major revenue sources, this tax is one of the least justifiable on economic grounds. It entails an essentially arbitrary discrimination among industries or activities, it tends to inhibit the growth of the more dynamic sectors of the economy, and it probably causes a reduction in the over-all rate of capital formation.
All the discriminatory features of the corporation income tax stem from the fact that corporate net income is the tax base. By the definition of the tax, all unincorporated activities are exempt; and even within the corporate sector of the economy, the tax falls more heavily on activities with low ratios of debt to equity (because interest on debt is a deductible expense). The consequence of these discriminations is a distortion of the economic structure, favoring noncorporate over corporate activities and, within the corporate sector, a distortion favoring those activities which can readily be financed in large measure by debt capital over those which cannot. The tax may also discriminate within the corporate sector against capital-intensive activities and favor labor-intensive activities, but the existence of this effect depends on the incidence of the tax; it may be present but need not be.
The basis for these assertions is the fact that in all economies in the modern world there is a tendency toward the equalization of the rates of return that investors receive on capital in different industries or activities. This tendency can be frustrated by restrictions on the entry of capital into given areas, can be blunted by imperfect information, can be modified by considerations of difierential risk or convenience among different investment outlets, and can be obscured by random year-to-year variations in earnings—but it is always present. Stigler (1963, p. 23) found, for example, that whereas the mean rate of return (after taxes) on invested capital in U.S. manufacturing industries averaged 7.6 per cent in 1947-1954, the standard deviation of the rates of return by two-digit industries (about this mean) was only 1.6 per cent. Moreover, he found no significant evidence of a. risk premium (either positive or negative) when he related observed average rates of return in individual industries to the standard deviation of each industry’s rate of return. Stigler’s results accord well with what one would expect a priori from a reasonably well-functioning capital market. If higher-than-average rates of return to capital exist and persist in a given activity, then one would expect investment in that activity to increase and so drive down the rate of return; if lower-than-average rates of return prevail, one would expect investment to fall off, inducing an increase in the rate of return.
The following analysis will, accordingly, be based on a tendency toward equalization of aftertax rates of return to capital in different investment uses. Given this tendency, it is clear that the corporation income tax will produce an equilibrium pattern of net rates of return among industries only through its differential impact’s being reflected in differential gross rates of return. Thus, assuming that the net-of-tax rate of return on equity would, in a given capital-market situation, tend to stabilize at 6 per cent, and assuming that the rate of return to capital in the noncorporate sector and the rate of interest on debt would also tend to stabilize at 6 per cent, we have the following possible pattern of rates of return on capital, gross of a corporation income tax at a rate of 50 per cent:
|Corporate Industry A: 2/3 debt||8%|
|Corporate Industry B: 1/3 debt||10%|
|Corporate Industry C: 100% equity||12%|
The differentials in gross rates of return on capital induced by the corporation income tax have two kinds of effects: first, they are reflected in product prices and, consequently, in the levels of output of particular activities; second, they confront the different activities with different relative costs of labor and capital and, hence, induce decisions concerning the relative intensity of use of these resources which are uneconomic from the standpoint of the economy as a whole. For example, the net annual cost of $100,000 of capital, for a year, to Noncorporate Industry (see above), would be $6,000, while that to Corporate Industry C would be $12,000. If labor of a given class is paid $6,000 per year, Noncorporate Industry is induced to operate at a point where the marginal $100,000 of capital produces a yield equivalent to the marginal product of one man-year of labor, while Corporate Industry C will tend to operate at a point where $100,000 of capital will have a yield equivalent to the marginal product of two man-years of labor. Clearly, economic efficiency could be improved by a tax system which took an equal fraction of the income generated by capital in all lines of activity, regardless of whether they were corporate in structure or not, and regardless of their degree of access to debt financing.
Effect of other taxation . The foregoing sketch of the efficiency-effects of the corporation income tax implicitly viewed the tax as the only levy in the tax system that affected gross-of-tax rates of return differently in different activities. Actually, there are a variety of taxes and tax provisions in most countries which have such effects, and it is important in any analysis of real-world tax systems to consider the combined effect of all such provisions rather than attempt artificially to isolate one tax, such as the corporation income tax, from the overall structure of which it is a part.
Property taxes, for example, are often levied at different effective rates on real property of different types. More important, property taxes often are levied only on land and buildings. Thus machines, inventories, and such may escape the property tax; and corporate capital, in which machines and inventories play a larger role than in noncorporate capital, will then pay relatively less through property taxation than noncorporate capital. In this way the property tax may tend to offset somewhat the discrimination against the corporate sector that is implicit in the corporation income tax.
Similarly, in countries like the United States, where capital gains are taxed at rates lower than normal personal income tax rates, or in countries with no capital gains taxation at all, the effects of corporate income taxation as such are likely to be offset to some extent by the favored treatment of capital gains. This is so because the earnings of capital in unincorporated enterprises are taxed under the personal income tax as they are earned, at full personal income tax rates, while the personal income tax strikes only that portion of corporate earnings paid out in dividends at the full rate. Let D be the proportion of earnings paid out in dividends, tc be the corporate tax rate, t,, the personal tax rate, and t, be the effective rate of tax on capital gains. Then $1 of corporate earnings will pay a total personal-plus-corporate tax bill equal to
tc+ (l-tc)Dtp + (1 -tc)(l -D)tg.
This can turn out to be lower than tf, the total income tax paid on $1 of income of an unincorporated enterprise, provided that the rate of tax applicable to a marginal dollar of personal income is sufficiently higher than the corporate tax rate.
For example, assume that an individual is in the 70 per cent bracket of the personal income tax and is contemplating investing some savings in either a specific corporation, C, or a specific unincorporated enterprise, 17. Suppose that both investments are expected to have a gross-of-tax yield of 20 per cent. The net-of-tax return from the investment in U will be 6 per cent, while that from the investment in C will depend on tc, D, and t,,. Suppose tc is 40 per cent, D is 331/2 per cent, and t, is 15 per cent. Then, of $20 of earnings in C, $8 will be paid in corporation tax, and $2.80 in personal tax on dividends of $4. If the corporation’s savings of $8 out of earnings of $20 ultimately are fully reflected in capital gains, and if these are taxed at an effective rate of 15 per cent, then $1.20 will be paid in capital gains taxes. The total tax on $20 of income will be $12, and the net-of-tax rate of return from the investment in C will be 8 per cent—higher by 2 points than that on the investment in U.
Obviously, the effective rate of corporate-cum-personal tax on an investment will vary from individual to individual (depending on their marginal tax rates) and from corporation to corporation (depending on their dividend policies and on the degree to which their corporate savings are reflected in capital gains). Moreover, the effective rate of tax on capital gains will itself vary from situation to situation, since individuals can postpone realization of capital gains, thus postponing payment of capital gains tax and shrinking the present value of the tax paid on capital gains account. For example, if a share bought for $100 today rises in value at 8 per cent per year, capital gains tax payable upon sale r years in the future will be tg*[(1.08)n - 1], where tg* is the nominal rate of tax on capital gains, but the present value of this tax (evaluated at 8 per cent) will be tg*[l — (1/1.08)”]. This is what was meant above by the effective rate of tax on capital gains. It is clearly, from this example, a decreasing function of the length of time that the stock is held. In the United States, the effective rate of capital gains tax can in fact be zero, since assets held until the death of the owner pass to his heirs, who in turn are taxed only on increases in value that take place after they have inherited the property.
While the property tax and capital gains provisions tend somewhat to offset the distorting effects of the corporation income tax, the traditional treatment of income from owner-occupied housing works to reinforce the distortions implicit in the corporation income tax. Obviously, owner-occupied housing generates income in real terms, but traditionally this income has not been a part of the personal income tax base. As a consequence, this important part of the income generated by capital in the unincorporated sector of the economy pays neither corporate nor personal income tax, while the income generated in the corporate sector is subject to both.
Empirical estimation . Harberger (see Krzy-zaniak 1966) has attempted to derive rough estimates of the cost to the U.S. economy of the pattern of distortions created by the differential taxation of capital in different uses. He incorporates into a single model, which distinguishes between the corporate sector and the noncorporate sector, the effects of corporate income taxation, property taxation, capital gains taxation, and the exemption from personal income taxation of the imputed income from owner-occupied housing. Making conservative assumptions about the elasticities of response of the economy to the various distortions involved, Harberger estimates the “efficiency cost” of the U.S. pattern of taxation of income from capital at approximately $2 billion per year. This estimate concerns only the costs associated with the misallocation of a given capital stock, costs which would be zero if all income from capital were to be taxed at a given constant rate. It does not take into account the possible effects of the taxation of income from capital upon the size of the capital stock itself (through the influence of taxation on the rate of saving), nor does it fully incorporate the effects of various special provisions (e.g., percentage depletion) affecting specific industries. Hence, it is a conservative estimate in this respect as well.
The incidence of the corporation income tax has long been the subject of debate among economists, a state of affairs which is likely to continue for some time. Underlying this debate are some genuine differences, both analytical (reflecting different assumptions about the behavior of firms) and empirical (reflecting differing views about, for example, the quantitative response of saving to the disturbances engendered by the imposition of the tax). However, expositions of the effects of the corporation income tax at times contain serious conceptual and analytical errors which should long since have been laid to rest.
Perhaps the main source of confusion has been the conception of the incidence of the tax as falling either (a) on stockholders, or (b) on consumers, or (c) on workers, or on some combination of these three. There are three errors involved in this traditional trichotomy. The first has to do with the use of the term “stockholders” rather than “owners of capital”; the second relates to the distinction between consumers and workers; and the third concerns the assumption, which is usually implicit when the trichotomy is stated, that none of the three groups will gain as a consequence of the tax.
The distinction between stockholders and owners of capital. The idea that the burden of the corporation income tax will fall on the stockholders of the affected corporations is a valid one within the confines of standard short-run equilibrium analysis. This is because in the short run, with the capital of each corporation considered as a fixed factor of production, the earnings of equity capital represent the residual share. This residual share is assumed, in traditional short-run models of competitive and of monopolistic behavior, to be maximized by the firm. So long as the demand and cost conditions facing the firm are unchanged— the conventional assumption—the output which generated maximum profit before the tax was imposed will also yield maximum profit in the presence of the tax.
Although the above analysis is correct for the short run, a major change occurs when longer-run adjustments are allowed for. Here the appropriate assumption is that the after-tax rate of return is equalized between the corporate and the noncorporate sectors. Any fall in the rate of return perceived by the owners of shares will therefore also be perceived by the holders of other kinds of titles to capital, and the isolation of stockholders as the relevant group when assessing the incidence of the tax is no longer correct. The relevant group becomes owners of capital, once attention is focused on the longer-run incidence of the tax.
The distinction between consumers and workers. Once the above is recognized, the error implicit in the distinction between consumers and workers becomes apparent. Since all income-earners in the community are owners of either labor or capital resources or both, the reduction in real income implicit in the tax must reflect the sum of the reductions in the real incomes of these two groups. That is to say, a distribution of the burden of the tax between people in their role as owners of capital, on the one hand, and people in their role as sellers of labor services, on the other, is exhaustive, leaving no room for an additional burden to be borne by consumers.
This is not to say that, within each group, different individuals will not bear different burdens because of differences in their consumption patterns. In general, those, whether capitalists or workers, who consume a greater-than-average proportion of “corporate” products as against “noncorporate” products will be relatively harder hit as a consequence of the tax than those who have the opposite bias in their consumption pattern. But the extra benefits accruing to those consumers with relatively “noncorporate” consumption patterns must, because of the deviations of these patterns from the average, exactly offset the extra burden borne by those with relatively “corporate” consumption patterns. (This statement is precisely correct if only the first-order effects of the change in tax regime are taken into account. When second-order effects are considered, there emerges an “excess burden” of the tax, deriving from the distortion of consumption patterns and resource allocation which results from the tax. Excess burden, however, is conventionally left out of account in discussions of incidence, for otherwise the sum of all burdens allocated would exceed the yield of the tax; that is, incidence is conventionally defined as dealing only with first-order effects.)
There is, nevertheless, a way in which sense can be made out of a statement like “The tax is wholly passed on to consumers.” For if analysis reveals that the real incomes accruing to labor and capital fall by equal percentages as a result of the tax, then it is equally convenient to describe the tax as being borne fully by people in their role as consumers. And if labor’s real income falls by 10 per cent as á consequence of the tax, while capital’s falls by 20 per cent, it is just as convenient to regard the tax burden as being a 10 per cent reduction of the real income of consumers as such (the percentage point fall common to the two groups), plus an additional 10 per cent reduction falling upon the owners of capital. But if this approach is taken, there is no burden to be allocated to labor in the example just cited, just as there would be none to allocate to capital if its real income fell by 10 per cent and labor’s by 20 per cent. Thus the idea of a three-way division of the burden remains illogical even when a plausible device is found for ascribing some of it to consumers.
The “no-gain” fallacy. The third error involved in typical presentations of the trichotomy—the implicit assumption that no group will gain as a consequence of the imposition of a corporation income tax—is perhaps the most serious of all, since it leads to a gross misapprehension of the nature of its incidence. It is not at all true that the share of the total burden of the tax which falls on capital must lie between zero and 100 per cent; a much more plausible range for capital’s share runs from a.* to l/bc (where ak is the proportion of the national income accruing to capital and bc is the fraction of the capital stock which is occupied in the corporate sector), though even this range can easily be exceeded.
To demonstrate the plausibility of the suggested range, assume that, with fixed and fully employed stocks of labor and of capital and holding the wage rate constant as the numeraire, the net-of-tax return to capital remains unchanged as a consequence of the tax. The nominal income of both labor and capital is therefore unchanged, but the real income of both groups falls because the prices of products of the corporate sector must rise to accommodate the tax. Labor and capital must therefore suffer equiproportionally as a consequence of the tax, capital’s fraction of the total burden being a,e, its share in the national income.
The other end of the range is generated when the gross-of-tax rate of return to capital remains unchanged as a consequence of the tax. The net-of-tax rate of return must therefore fall by the percentage rate of the tax imposed. But the equilibrium condition for the capital market assures that if the net-of-tax rate of return falls by this percentage in the corporate sector, it must fall by the same percentage in the noncorporate sector. Since the fall in the return to capital in the corporate sector just reflects the tax paid, the parallel fall in the noncorporate sector reflects that capital is bearing more than the full burden of the tax, the ratio of capital’s loss to the full burden of the tax being the ratio of total capital to corporate capital, or l/bc In this case, therefore, labor gains an amount equal to the reduction in real income per unit of capital times the amount of capital in the noncorporate sector.
The “plausible limits” just outlined can be derived from a two-sector model with homogeneous (of first degree) production functions, on the assumption that the elasticity of substitution between labor and capital is infinite in one sector or the other. If this elasticity is infinite in the untaxed (noncorporate) sector, then so long as some production takes place in that sector in the post-tax equilibrium, the relationship between the return to a unit of capital and the wage received by a unit of labor must be the same as in the pretax equilibrium. Capital and labor therefore must bear the same percentage losses of real income as a result of the tax. When, on the other hand, the elasticity of substitution between labor and capital is infinite in the corporate sector, the post-tax gross-of-tax return per unit of capital must bear the same relationship to the wage of labor as prevailed before the tax was imposed. Hence the net-of-tax return per unit of capital must fall, in both sectors, relative to the wage of labor, by the percentage of the tax, and capital must accordingly bear (l/bc) times the full burden of the tax.
Strikingly, these same “plausible limits” come into play when the elasticity of substitution is zero in one of the two sectors and non-zero in the other. When the corporate sector has a zero elasticity of substitution between labor and capital, the reduction in its output resulting from the tax leads to the ejection of labor and capital from that sector in the fixed proportions given by its technical coefficients of production. Suppose that the corporate sector uses labor and capital in the ratio of 1:2; as it contracts, it must therefore eject the factors in these proportions. If, now, the noncorporate sector was, in the pretax equilibrium, using the two factors in just these proportions, it will be able to absorb the “rejects” from the corporate sector without any change in relative factor prices. And since factor prices in the noncorporate sector are already net-of-tax, this means that both factors must suffer in the same proportion as a consequence of the tax, just as in the case of an infinite elasticity of substitution in the noncorporate sector.
The above result occurs when labor and capital were initially used in the same proportions in the two sectors, and it must be modified when the initial proportions differ. If the corporate sector ejects labor and capital in the ratio of 1:2, while the noncorporate sector was initially using them in the ratio 1:1, the noncorporate sector (which is assumed to have a non-zero elasticity of substitution) must alter its factor proportions so as to absorb relatively more capital. Capital’s return must therefore fall relative to labor’s, in order for equilibrium to be restored; and capital will bear more than the fraction ak of the total burden of the tax. Conversely, if the noncorporate sector were initially more capital-intensive than the corporate sector, using the factors, say, in the proportions 1:3, the relative price of labor would have to fall so as to enable this sector to absorb the “rejects” from the corporate sector; and capital would end up bearing less than a* of the total burden of the tax.
Thus, when the elasticity of substitution between labor and capital is zero in the corporate sector, capital will bear the fraction a/, of the total burden if the two sectors have equal factor intensities; will bear more than ak when the corporate sector is the more capital-intensive of the two; and will bear less than a/, when the corporate sector is the more labor-intensive of the two. Exactly how much more or less than ak capital will bear depends upon the extent of the difference in factor proportions between the two industries, on the elasticity of substitution between labor and capital in the noncorporate sector (which determines the ease with which it can absorb new factors in proportions different from those initially used), and on the elasticity of substitution on the demand side between corporate products and noncorporate products (the greater this elasticity, the sharper the decline in demand for corporate products as a consequence of the tax, the larger the ejection of resources by this industry, and therefore the greater the shift in relative factor prices required to restore equilibrium).
When, on the other hand, the elasticity of substitution between labor and capital is zero in the untaxed industry and non-zero in the taxed industry, capital tends to bear more than the full burden of the tax. In this case, when the initial factor proportions are the same in both industries, the fixity of proportions in the untaxed industry assures that they will remain the same even after the tax has worked out its full effects. The relative returns to labor and capital, being governed in this case by the proportions in which the factors are used in the taxed industry, will remain the same, gross-of-tax, as they were in the pretax equilibrium. Capital’s return net-of-tax will fall by the amount of the tax, but, as in the case of infinite elasticity of substitution in the taxed industry, the reduction will occur for capital used in either industry. The total reduction in capital’s earnings will be (l/bc) times the yield of the tax, reflecting a very substantial “overbearing” of the tax by owners of capital and a corresponding net gain to those whose income accrues principally from the sale of labor services.
The above result (for a zero elasticity of substitution in the untaxed industry) is modified when the initial factor proportions are different in the two sectors. If the corporate sector is initially more labor-intensive than the noncorporate sector, the ejection of capital and labor resources in the proportions in which the latter sector will absorb them will make the corporate sector still more labor-intensive. A readjustment of factor prices against labor and in favor of capital will have to occur, and capital will end up bearing less than (l/bc) times the observed yield of the tax. Conversely, if the corporate sector is initially more capital-intensive than the noncorporate sector, and has a zero elasticity of substitution, factor proportions will have to alter to make the corporate sector still more capital-intensive, requiring a shift of the gross-of-tax ratio of factor prices against capital. Capital will then bear more than (l/fcc) times the observed yield of the tax.
When capital bears 100 per cent of the burden. Falling well within the “plausible limits” of incidence defined by ak and l/bc is the case in which capital bears 100 per cent of the burden of the tax. This result therefore cannot be regarded as being an extreme outcome, as the conventional use of the capital-labor-consumer trichotomy implies. Added insight into the plausibility of capital’s bearing the full burden of the tax can be gained from an analysis of the case in which each industry is characterized by a Cobb—Douglas production function and in which the elasticity of substitution in demand between the products of the two sectors is unity. Letting X represent the quantity of the product of the corporate sector, Y the quantity of the product of the noncorporate sector, Px and Py their respective prices, and Z the national income, the unit elasticity of substitution between X and Y implies
(1) XPx = αZ; YPy= (l-a)Z,
where a is the fraction of Z which is spent on X. Competitive behavior of producers of X and of Y, together with the Cobb-Douglas functions X = KβalphaLalpha(1-β), Y = KΓyLy1-Γ), where β and y are constants, lead to the relations
Here Kx and Ky represent the amounts of capital used in the X and Y industries, respectively, and Lx and Ly refer to the corresponding amounts of labor. The price of labor is denoted by PL, this being the same in the two industries. The cost of the services of a unit of capital is denoted by P»» for the corporate sector and by Pk for the noncorporate sector, the former including the corporation income tax and the latter, of course, not including it. If T is the rate of corporation income tax applied to the earnings of capital in sector X, then Pt = Ptr(l — T), since the after-tax earnings (as distinct from the before-tax cost) of a unit of capital are assumed to be brought to equality in both industries through the workings of the capital market.
It can be seen from relations (1) and (2) that labor will always earn a constant fraction of the national income, regardless of whether a corporation income tax exists or not. 1’his already guarantees that exactly the full burden of the corporation tax must in this case be borne by capital. The precise way in which the burden reaches all units of capital can be seen by analyzing the relations derived from (1) and (2):
(3) KxPkz = βαZ; KyPk = γ(1 - α)Z.
From these it results that [KxPkz/KyPk] is a constant equal to βα/[Γ(l — Γ)]. But since Pk = Pkx(l - τ), this means that K,./[K;/(1 - r)] will also be a constant—that is, the ratio (Kr/Ky) will vary directly with (1 — r). If, with no tax at all, there were 150 units of capital in each sector, a tax of 50 per cent will eventually result in there being 100 units of capital in X and 200 in Y. The 200 units of capital in Y will earn the same fraction of national income as was previously earned by the 150 units of capital in Y; hence the net-of-tax return to capital will have been reduced by a quarter, say, from $1.00 to $.75 per unit. The 100 units of capital in X will cost entrepreneurs $1.50 per unit and will therefore have the same total cost as the 150 units employed in X at a unit cost of $1.00 before the tax was imposed. But the aftertax earnings of capital in X will, like those of capital in Y, have fallen from $1.00 to $.75 per unit. Overall, capital will have lost $75, represented by the reduction of $.25 per unit spread over all 300 units, and this amount will be precisely equal to the yield of the tax to the government.
The result obtained in the above example applies not only to all cases fulfilling relations (1) and (2), which are derived on the basis of unit elasticities of substitution in demand between the two products, and in production between the two factors in each industry. It has been shown elsewhere (see Harberger 1962) that the same result obtains so long as the three critical elasticities of substitution are equal, regardless of their magnitude.
The general-equilibrium, two-sector model. All the cases presented above are special cases of a general-equilibrium, two-sector model of the incidence of taxation, in which the incidence of the corporation income tax is shown to depend in a specific way on the three critical elasticities of substitution and on the relative factor intensities of the two sectors. This model, based on the assumptions that the supplies of capital and labor are not influenced by the presence or absence of the tax, that competition prevails in both the corporate and noncorporate sectors, and that per-unit net-of-tax earnings of each productive factor are equalized between sectors, was first presented by Harberger (1962) and further elaborated by Mieszkowski (1967). They have adapted the model to explore the implications of various possible types of monopolistic and oligopolistic behavior in the corporate sector; the results of the original model have proved quite insensitive to plausible allowances for noncompetitive behavior.
The chief weakness of the model appears, at this writing, to be the assumption that the path of the capital stock through time is independent of the rate of corporate taxation. If, through a tax-induced reduction in the net rate of return on capital and/or through a tax-induced shift in the distribution of disposable income, the rate of saving is affected, the relative supplies of capital and labor will gradually diverge from the path they would have followed in the absence of a corporation income tax, with consequent effects on the distribution of income. The difficulties confronting attempts to resolve this issue are twofold. First, a dynamic rather than a comparative-static approach is required, which, while not a serious obstacle as such, involves additional parameters whose magnitudes are difficult to estimate and requires the specification of the precise nature of the dynamic structure of the economy. A great deal of further work is needed before our understanding of the economy’s workings can advance to the point where these dynamic aspects can be treated with a degree of precision comparable to that with which problems of comparative statics are handled today.
The second difficulty is conceptual rather than practical. In a comparative-static approach to incidence, excess-burden being neglected, the sum of the changes in real income of the separate groups of the economy is a global reduction in real income equal to the proceeds of the tax; this is no longer true when a dynamic framework is employed. If the rate of saving is reduced by the corporation income tax, the future incomes accruing to individuals are reduced not only because the tax has to be paid each year, but also because less has been saved in the years since the tax was introduced. But it would be wrong, in estimating the incidence of the tax, to count both (a) the full reduction of real income in the year the tax is paid and (fc) the future reduction in real income stemming from the reduction in savings induced by the tax. If one counts (a), one has already accounted for the present value of the future reduction in real income. To take explicit account of the future effects of changes in the savings pattern, one would properly have to convert the entire calculation of incidence to a consumption rather than an income basis and count (c) the current reduction in consumption resulting from the tax paid today plus (d) the future reduction in consumption occasioned by the reduction in future incomes stemming from the current tax-induced reduction in the rate of saving.
When the above difficulties are considered, it appears that the current-income approach (i.e., counting only (a) as the measure of incidence) is preferable, on grounds of both clarity and convenience, to approaches attempting to introduce dynamic responses into the measurement of incidence. Nevertheless, the dynamic responses in question here are of substantial interest in their own right, even if they are not linked to the analysis of incidence. The study of this aspect of the effects of corporation income taxation has only recently begun, the most important early efforts being those of Krzyzaniak (1966) and Sato (1967).
Arnold C. Harberger
Goode, Richard B. 1951 The Corporation Income Tax. New York: Wiley.
Harberger, Arnold C. 1959 The Corporation Income Tax: An Empirical Appraisal. Volume 1, pages 231-250 in U.S. Congress, House, Committee on Ways and Means, Tax Revision Compendium. Washington: Government Printing Office.
Harberger, Arnold C. 1962 The Incidence of the Corporation Income Tax. Journal of Political Economy 70:215-240.
Harberger, Arnold C.; and Bailey, Martin J. (editors) 1968 The Taxation of Income From Capital. Washington: Brookings Institution.
Krzyzaniak, Marian (editor) 1966 Effects of the Corporation Income Tax: Papers Presented at the Symposium on Business Taxation. Detroit, Mich.: Wayne State Univ. Press. → See pages 107-117, “Efficiency Effects of Taxes on Income From Capital,” by Arnold C. Harberger.
Mieszkowski, Peter 1967 On the Theory of Tax Incidence. Journal of Political Economy 75:250-262.
Musgrave, Richard A. 1959 The Theory of Public Finance: A Study in Public Economy. New York: McGraw-Hill.
Musgrave, Richard A.; and Krzyzaniak, Marian 1963 The Shifting of the Corporation Income Tax: An Empirical Study of Its Short-run Effect Upon the Rate of Return. Baltimore: Johns Hopkins Press.
Sato, Kazuo 1967 Long-run Shifting of the Corporation Income Tax. Unpublished manuscript.
Stigler, George J. 1963 Capital and Rates of Return in Manufacturing Industries. National Bureau of Economic Research, General Series, No. 78. Princeton Univ. Press.
yearbook of national accounts statistics. → Published by the United Nations since 1958. Contains detailed estimates of national income and related economic measures for some 76 countries.
Property taxes are general and recurring taxes on owners or users of property, based on the capital value or the annual rental value of the assets. They are considered distinct forms of taxation, although many other taxes reach some facet of property ownership or use, including taxes on the income from property, taxes on realized appreciation in property values (capital gains), taxes in a number of European countries on net wealth, wealth transfer taxes or succession duties, and taxes on selected types of personal property, such as motor vehicles.
Property taxation is widespread and is typically used by local rather than national governments. It provides the overwhelming bulk of local government tax revenues in the United States, in the other developed English-speaking countries, in the Netherlands, and in a number of the developing countries, especially those exposed to the British tradition. The tax is also important to local governments in Belgium, Denmark, France, Germany, and Japan, countries in which it provides roughly 20 to 30 per cent of local government tax revenues.
Property taxes are most important relative to the over-all fiscal system in the English-speaking countries, where the role of local governments tends to be a large one. In Canada and the United States in recent years, the property tax has accounted for more than 45 per cent of the tax revenues of all subnational governments (including states or provinces), about 16 per cent of the total tax revenues of all governments, and more than 4 per cent of national income. It accounted for more than 13 per cent of Ireland’s total taxes; more than 11 per cent of Britain’s; and 6 to 8 per cent in Australia, New Zealand, South Africa, Denmark, and Japan.
In most countries, the tax applies to land and/or buildings only, but in the United States, some types of personal property are subject to the property tax in all but four states. Business and farm equipment and inventories are commonly taxed, and account for perhaps 75 per cent of the personal property tax base. Motor vehicles are subject to this tax in more than half the states, and household effects are taxed somewhat more rarely. Intangible personal property—securities, bank deposits, etc.—is infrequently taxed; intangibles have provided only about 2 per cent of property tax revenues recently, and all personal property about 19 per cent. In some Canadian provinces, personal property is taxed, but it provides only 1 per cent of revenues nationally; in Japan, personal property provides nearly 40 per cent of revenues.
The most common basis for taxing real property is its annual rental value, in practice usually gross rents assessed as of some earlier date, with statutory rather than actual allowances for expenses. Real property is taxed on the basis of its capital value mainly in the United States, Canada, South Africa, Germany, Austria, and Denmark. The major difference between the customary annual rental value system, such as the British, and the American-Canadian capital value variant is the treatment of land and vacant improvements. In the British system, the tax is based on the rental value of property in its present, actual use, and vacant properties therefore are not taxed. In the American system, in theory, property is valued at market value or some fraction thereof. Market value is, in an equilibrium situation, the capitalized value of expected net returns from property in its most profitable lawful use, not its present use. The capital value basis therefore tends to favor optimal use of land somewhat more than the customary annual value basis does.
The evolution of European property taxes (and their American descendant) from feudal dues into a general tax on property, and their subsequent narrowing to taxes on land and buildings, has been traced by Seligman (1895). Jensen (1931, chapter 2) gives a similar history of the American property tax. The importance of the property tax in revenue systems has declined over the years, with the growing role of national as compared with local finance. In the United States (and in Canada, as well) the property tax has also been displaced by the adoption of consumption and income taxes by state governments, beginning after 1910 but especially in response to the collapse of property values in the early 1930s. Subventions from state tax revenues increasingly replaced local property taxes, and the property tax as a proportion of total state-local taxes declined from 80 per cent in the 1920s to less than 50 per cent by 1946. However, since 1950, despite very rapid increases in the total scale of state-local finance, the property tax has maintained approximately the same relative importance (U.S. Bureau of the Census 1964).
Experience in the United States . In part, the recent buoyancy of the American property tax is related to the large role of receipts from housing in the tax. Estimates are that in 1957 housing provided about 41 per cent of tax revenues and about 44 per cent in 1962. Real estate taxes on housing amount to an average of one-sixth or more of annual rental receipts, or of cash expenditures for housing in the case of owner-occupants. This is in effect an excise tax at a rate far higher than that on any other broad category of consumer expenditure in the United States. Housing property taxes equal, on the average, about 1.5 per cent of property values (U.S. Bureau of the Census 1963a).
Slightly less than 10 per cent of American property taxes is derived from real and personal farm property. Relative to property values, farm property taxes are lower than those on nonfarm housing or business property—less than 1 per cent in recent years. However, farm property taxes equal nearly 10 per cent of net farm income, and only a slightly smaller fraction of national income originating in agriculture.
Roughly 45 per cent of the tax comes from non-farm business property. Business property taxes are especially high, however measured, for railroad, pipeline, and other public utility companies. These firms are markedly real-property intensive enterprises and are, furthermore, politically vulnerable to discriminatory taxation. In 1957, estimated property tax payments were equal to 6.3 per cent of net output for railroads and public utilities, 1.4 per cent for manufacturing, and 1.8 per cent for other nonfarm business property.
The American property tax is not a single uniform tax institution but, in reality, thousands of different taxes reflecting differences in the legal coverage of the tax, the economic tax base available, the expenditure requirements to be financed, and the resulting tax rates among the 82,000 governmental units which rely upon the property tax. The tax tends to be of least importance in state-local fiscal systems in the southeastern United States and most important in New England, the Great Lakes states and the northern Plains states. The varying role of state taxes and state aid to local government explains much of this variation, with the property tax more important in those parts of the country where the state government’s financial role is smallest.
Because urban government is costly, property tax rates are higher in urban than in rural areas and higher in the more urbanized states, notably in New England and the Middle Atlantic states, where tax rates frequently exceed 2.5 per cent of the market value of taxable property. In contrast, tax rates in most southern and Mountain states average less than 1 per cent (U.S. Advisory Commission . . . 1962, tables 37 and 41). Urbanization does not explain all the differences, however, since property tax rates in large northeastern cities are distinctly higher than in large cities elsewhere, and those in southern cities distinctly lower (U.S. Bureau of the Census 1963a). These large regional differences do not seem to have had major effects on location of industry, however, in view of the relative rates of growth of states with high and low property and other business taxes (Due 1961, p. 171).
Within large urban areas in the United States, tax rate differences are considerable among the great numbers of separate taxing jurisdictions operating in most individual metropolitan areas, and no doubt they do affect locational patterns. In the older parts of the country, per capita taxable property values tend to be lower in central cities than in their suburbs, expenditure requirements higher, and effective tax rates higher. This will tend to spur migration of business and high income residents from central city locations to suburban ones if tax differentials against the central cities are widening, as appears to be the case.
Among suburban taxing jurisdictions, property tax rates are usually lower and the level of public services higher in communities with higher property values per capita—either because they are dormitory suburbs with high-value houses or because they contain heavy concentrations of nonresiden-tial property, a situation which encourages land use planning designed to maximize the fiscal position of individual suburbs (Netzer 1962, p. 193). The results may be both inefficiency in location patterns and, to the extent that racial and other barriers limit intrametropolitan mobility, adverse effects on interpersonal equity. However, these intrametropolitan property tax differentials may be narrowing over time; the evidence is mixed in this regard.
Shifting and incidence . In theory, taxes on the value of sites—bare land—rest on the owners of the sites at the time the tax is initially levied or increased. The tax cannot be shifted forward to other users of the land, since shifting can occur only if supply can be reduced, which is not possible for land. Prospective purchasers of the sites, faced with a new or higher annual tax burden, will reduce their bids, and the higher tax will be capitalized in the form of lower land prices. There are some complications in this analysis, as Simon (1943) points out, but it is generally accepted.
In general, property taxes on improvements and on tangible personal property used in business can be expected to be shifted forward to final consumers of business services and occupants of housing. This is because the taxes will discourage new real investment in these forms, and over time the reduced supply of capital assets will raise their prices. Owner-occupants of housing will themselves bear higher property taxes because there is no way they can be shifted.
This, at any rate, is the theoretical conclusion in partial equilibrium analysis. A general tax on capital could conceivably be shifted backward to owners of capital, in the form of lowered rates of return on the whole stock of capital, provided that the supply of savings is not responsive to interest rates. Another complication is the time lag required to shift taxes on physical capital forward, since the annual increments are usually small fractions of the total stock. In addition, the partial and unequal nature of the property tax limits shifting. Firms competing in national markets are able to shift local property taxes only to the extent that these taxes are common to their competitors or reflect the value of public services financed by these taxes. But, on the whole, most business property taxes are probably shifted forward and much of the remaining portion possibly shifted backward to land owners, by reducing local land values.
Empirical studies of the incidence of the American property tax by income class based on these “shifting” assumptions have generally agreed that the property tax is, on balance, regressive when compared with current money income. Because of the forward shifting of a substantial part of business property taxes, property taxes on nonresiden-tial property are, in part, equivalent to a general consumption tax, regressive through much of the income range. Property taxes on owner-occupied housing and on rented housing appear to be even more regressive than taxes on nonresidential property. This is mainly because housing consumption outlays constitute a larger proportion of lower than of higher current money incomes.
In combination, residential and nonresidential property taxes are markedly regressive for the lowest income groups but only mildly regressive in the middle ranges of the income distribution. If no allowance is made for income tax savings due to the deductibility of property taxes, the latter are progressive for the highest income groups. When measured on the basis of a broader income definition, or one which averages income over a longer time span, the property tax is very nearly proportional in its incidence. The benefits from expenditures financed from the property tax are distinctly progressive in their incidence, notably in connection with education, as Morgan and his colleagues (1962) show.
On balance, therefore, the American property tax is no mean contributor to income redistribution from the richer income groups to the poorer ones, considered in the aggregate. However, in view of the wide dispersion about the means within income classes and of the many geographic differences, the redistributive effects with regard to individual households are highly uneven; the tax contains a substantial element of interpersonal inequity, however progressive or proportional it may be in the aggregate.
Allocative effects . In general, the American property tax (and property taxes in Canada, Britain, Ireland, and other high property tax countries) tends, over time, to shift resources in the aggregate from private construction to education and other public services. This general effect of the tax, like other economic effects, may not be visible in the empirical evidence, since it can readily be overwhelmed by other factors, such as housing subsidies and the like.
Property taxes also discriminate among inputs, encouraging the substitution of other inputs for real property; to the extent that firms and industries are limited in their opportunities to substitute, the property tax is then discriminatory among industries. Railroads are perhaps the best example of this. The competitive decline of the rails in the face of new transport technology was no doubt inevitable, but it was hastened by the property tax. Railroads are inherently real-property intensive and thus are subject to heavier taxes of this type than are their air, water, and road competitors. Rising property tax rates in the postwar years contributed to a rate of increase in rail charges which hardly assisted the carriers in their efforts to compete.
The American property tax tends to discourage housing in general, since it imposes taxes on this use of the consumer’s dollar which are markedly higher than those on most other uses. Although property taxes are frequently very high in dormitory suburbs, whether measured by house value or by personal income, the deterrent effect there may be small, since the tax is directly tied to school and other expenditure benefits realized by householders. However, in large cities, the tie to expenditure benefits is tenuous for many housing consumers, and property taxes amounting to large fractions of gross rental receipts—25 per cent or more in large northeastern cities—probably inhibit the construction of new rental housing and the rebuilding of the older cities. In any event, property tax rebates or reductions for selected classes of new housing have proved to be among the most effective stimulants yet devised.
Administration—Assessment problem. The fundamental administrative problem in property taxation is that of valuing or assessing property. In a number of countries, including Britain, valuation is done by a central government agency. In the United States, however, assessment of most classes of property is made (except in Hawaii) by local assessors; according to the U.S. Advisory Commission on Intergovernmental Relations (1963, p. 101), there are probably eighteen thousand assessment districts in the country. The quality of local assessors and assessment varies widely; it has been vigorously criticized by students of the problem since the last quarter of the nineteenth century. Some assessors are elected, part-time amateurs using primitive methods and tools; other assessment organizations are large, professional agencies applying all the technological aids available. In the best-administered jurisdictions in the United States, owners of single-family houses with similar market prices are likely to have assessments which vary by less than 10 to 15 per cent; in the worst the average variation may be far in excess of 50 per cent.
Some observers, such as the Advisory Commission, noting the important revenue role of the property tax, have urged its administrative rehabilitation. This involves limiting the coverage of the tax to classes of property which can be discovered and valued practicably, devising large enough assessment districts so that all can be served by full-time professional staffs, and greatly enlarging the role of the states in the provision of technical assistance to and supervision of local assessment.
Other observers are much more pessimistic. They note the inherent difficulties of valuing widely differing assets, only a few of which are actually sold within a short span of time and some of which—like large industrial plants—are never sold. They regard the standard of “good” assessment—assessments for similarly market-valued properties differing in the aggregate by no more than 20 per cent from the average—as an un-acceptably low level of performance as compared with sales and income tax administration. They
query whether some of the most glaring disparities in assessment practices—such as discrimination among classes of property within a city—are not in reality accommodations to a level of taxation which, if applied uniformly, would be economically and/or politically intolerable.
Prospect . Despite its inequities, its questionable impact on economic efficiency, and the poor quality of its administration (at least in the United States), the property tax persists and in revenue terms has been holding its own in the past few years in the United States and in a number of other countries. Part of the reason for this is that property tax revenues have risen rapidly in recent years, along with the level of economic activity. The market value of taxable property—the economic base of the tax—has risen almost as rapidly as gross national product in the postwar period, an apparent interruption to a long-term downward trend in capital-output ratios. Burkhead (1963, p. 70) concludes that the property tax is a far more responsive source of local government revenue than its traditional critics have allowed.
Site value tax (”single tax”). Perhaps the most vigorously advocated alternative to the prevalent systems of real property taxation is the site value tax, first propounded as “the single tax” by Henry George in 1879. The equity argument for site value taxation is that bare site values, or location rents, are created by population growth and general community improvements rather than by the actions of individual landowners, and that therefore taxation of this “unearned increment” is highly equitable. The resource allocation argument is that the site value tax applies to a surplus—the differential returns available from conducting an activity at particular sites—and therefore is economically neutral. Taxation does not reduce the supply of sites, but lowers their after-tax capitalized net returns, or price. But this neutrality is in contrast with the existing property tax, which, by applying to improvements as well as to site values, discourages new construction in general. The existing tax, moreover, tends to encourage low intensity uses, or holding of land idle for speculation, since taxes are lower if improvements are minimal. As noted earlier, the British type of property tax has this effect to a marked degree. Shifting to a site value tax would tend to foster improvements in general, and would discourage withholding of land from use, relative to present property tax practices in most places.
Site value tax advocates have tended to claim much more than this for their proposal. Some, for example, argue that site value taxation by itself can cure most of the ills of the large older cities. Opponents have presented three principal arguments against it. The first is the difficulty of separating site values and improvement values in the case of improved property; this appears to be a real difficulty administratively but not conceptually. The second is an equity argument: large windfall losses and gains would stem from a shift from the present system to the site value tax and would be intensified by the fact that many present landowners have not been the recipients of the “unearned increments” but have paid prices reflecting these to previous owners. The third is the problem of revenue adequacy. It has been estimated that to replace the present yield of American taxes on real property with a tax solely on site values would absorb more than the entire (before-tax) rent of land. These arguments suggest that a partial replacement is perhaps the maximum possibility.
Differentially higher taxation of land, or complete exemption of improvements from general ad valorem taxes on real estate, is practiced in the United States only in Pittsburgh and Hawaii but is widespread in Australia, New Zealand, South Africa, and Canada. In Australia and New Zealand, most local taxing units have exempted improvements from taxation, this trend beginning in the 1890s. In South Africa, most local authorities have either differential taxation or complete exemption of improvements. In Canada, differential taxation is widespread in the four western provinces. Because of so many environmental differences other than the property tax, it is difficult to discern whether the advantages claimed for the site value tax have been realized in these places. Most economists, however, agree that the site value tax should have better resource allocation effects than the prevalent property tax institutions.
Burkhead, Jesse 1963 State and Local Taxes for Public Education. Syracuse Univ. Press.
Due, John F. 1961 Studies of State-Local Tax Influences on Location of Industry. National Tax Journal 14, June: 163-173.
Heilbrun, James 1966 Real Estate Taxes and Urban Housing. New York: Columbia Univ. Press.
Jensen, Jens P. 1931 Property Taxation in the United States. Univ. of Chicago Press.
Morgan, James N. et al. 1962 Property Taxes and the Benefits of Public Education. Pages 288-308 in Michigan, University of, Survey Research Center, Income and Welfare in the United States: A Study. New York: McGraw-Hill.
Netzer, Dick 1962 The Property Tax and Alternatives in Urban Development. Regional Science Association, Papers and Proceedings 9:191-200.
Netzer, Dick 1966 Economics of the Property Tax. Washington, D.C.: Brookings Institution.
Robert Schalkenbach Foundation, New York 1955 Land-value Taxation Around the World. Edited by Harry Gunnison Brown et al. New York: The Foundation.
Seligman, Edwin R. A. (1895) 1928 Essays in Taxation. 10th ed., rev. New York: Macmillan. → See especially pages 19-65, ’The General Property Tax.”
Simon, Herbert A. (1943) 1959 The Incidence of a Tax on Urban Real Property. Pages 416-435 in American Economic Association, Readings in the Economics of Taxation. Homewood, 111.: Irwin.
U.S. Advisory Commission ON Intergovernmental Relations 1962 Measures of State and Local Fiscal Capacity and Tax Effort. Report M-16. Washington: Government Printing Office.
U.S. Advisory Commission ON Intergovernmental Relations 1963 The Role of the States in Strengthening the Property Tax. 2 vols. Report A-17. Washington: Government Printing Office.
U.S. Bureau OF THE Census 1963a Census of Housing: 1960. Volume 5: Residential Finance. Washington: Government Printing Office. → Contains data on real estate taxes in relation to property value, income, and rental receipts. This census is taken decennially.
U.S. Bureau OF THE Census 19636 Census of Governments: 1962. Volume 2: Taxable Property Values. Washington: Government Printing Office.
U.S. Bureau OF THE Census 1964 Census of Governments: 1962. Volume 4, no. 4: Compendium of Government Finances. Washington: Government Printing Office. → Contains comprehensive data on property tax revenues and all other federal, state, and local government financial data for 1962, by states and counties. This census is taken quinquennially, in years ending in 2 and 7.
Taxes on the production or sale of commodities are among the oldest taxes known; they play a significant role in the tax structures of most countries of the world. Despite rapid expansion of income taxation in the last century and widespread acceptance of the argument that by usual standards such taxation is superior, the sales and excise taxes have not only maintained their position but in many countries have increased in importance. Despite the long experience with these taxes, major disputes about them continue—on such questions as shifting and incidence, relative effects on economic welfare through resource reallocation, and effects on economic development and the maintenance of full employment.
Sales and excise taxes have traditionally been classified as forms of indirect taxation, although this term has fallen into disuse because there is no generally accepted delineation between such taxes and those labeled direct. On a somewhat different basis of classification, they are designated as consumption taxes (as distinguished from income, wealth, or other taxes), under the assumption, questioned below, that their burden is distributed in relation to consumer expenditures.
The distinction between excises and sales taxes is based on the scope of coverage. Excises apply to particular commodities or related groups of commodities (such as tobacco products), while sales taxes apply to broad categories of commodities, typically to all commodities other than those specifically exempted. Obviously, a broad system of excises, such as that of Spain, does not differ basically from a sales tax and can have broader coverage than a sales tax limited to certain categories, such as the British purchase tax, or one with widespread exemptions, such as those of the Canadian provinces. However, commodity taxes usually fall clearly into one category or the other, and the distinction is useful for purposes of analysis. The terminology as outlined is not universally employed; for example, excises are sometimes referred to as selective sales taxes, and some proposals for a federal sales tax in the United States have referred to the proposed levy as a general excise tax. But the concepts given are now those most commonly employed.
Historical development . Excises are among the oldest forms of taxation, dating back, in their rudimentary form, to ancient Rome. The first use in England came in 1643. France was a major user, especially under Colbert, in the seventeenth century. Except for a few early attempts, the United States did not employ excises until the Civil War, when an extensive system was introduced for war-financing purposes. Only the liquor and tobacco taxes survived, however. Ultimately, other excises were introduced: during World War I, the depression era, and World War II. Since World War II, the taxes have slowly been reduced, and most of the remaining ones, except those on liquor, tobacco, motor fuel and motor vehicles, and telephone service, were repealed in 1965. The states have confined excises largely to liquor, tobacco, and motor fuel, and these three categories are also the major revenue producers among the federal excises and the excises of other countries. In the newly developing economies excises are typically introduced as supplements to the customs duty system when domestic production of liquor and tobacco products is first undertaken.
Sales taxation dates back to the Spanish alcabala, introduced in the fourteenth century. Because this tax was blamed for the commercial decline of Spain, it was not adopted by other countries, and the sales tax did not come into widespread use until the twentieth century. The financial problems during and immediately after World War i led Germany, France, Italy, other Continental countries, and Canada to impose the tax. More countries followed in the depression years and during World War ii; among the most recent national sales taxes are those of Sweden and Denmark. The movement in the United States began in the depression years of the 1930s, when the states were squeezed between declining revenues from other taxes and increasing expenditure needs. Following the success of Mississippi with the tax in 1932, some 29 states levied a sales tax prior to World War n, although six subsequently allowed it to expire. In the postwar era the pressures of rising expenditures led additional states to impose the tax. There has also been a trend toward higher rates and broader coverage. The sales tax movement in the provinces of Canada has been similar to that in the United States.
Forms of excise and sales taxes. Excise taxes may be collected at the manufacturing, wholesaling, or retail level; the manufacturing level is by far the most common because the relatively small number of firms facilitates control. Excises may have specific rates, applied per unit of the physical product, as, for example, motor fuel taxes; or ad valorem rates, applying to the sale price. The former are easier to administer, if the product is highly standardized, but may be regarded as less equitable, since the tax rate does not rise in relation to value, and the yield of the tax is not automatically responsive to price changes. Excise taxes are also often classified in terms of general purpose or philosophy. Those on products such as liquor and tobacco, the use of which the government seeks to penalize as a matter of policy, are known as sumptuary taxes. Typically, these are highly productive of revenue. Luxury excises are ones designed to distribute tax burden in relation to ability to pay, as measured by purchase of luxury articles. Another group of widely used excises is directly related to motor vehicle use and is designed to distribute the costs of highways on the benefit principle. The United States provides a more direct link between the yield of these taxes and the costs of financing highways than do most countries.
The most significant classification of sales taxes is on the basis of stage of collection. Multiple-stage sales taxes are those which apply at two or more stages in the production and distribution channels. The complete turnover tax version applies at all stages in production and distribution: to the sales of materials and parts, as well as to all sales of the finished products—by manufacturers, distributors, and retailers. In practice the turnover taxes in use are not entirely complete or uniform. Lower rates are sometimes applied to sales by wholesalers (e.g., Germany), and retail sales may be excluded (e.g., Belgium). The turnover tax suffers from several major defects: integrated firms are favored over nonintegrated ones, thus encouraging integration; and the over-all tax on a particular product depends upon the number of stages in the production and distribution channels through which it passes.
The single-stage taxes are confined to one stage in production and distribution and avoid the disadvantages arising from the multiple application of the turnover tax. There are three major versions. The manufacturers sales tax, as used in Canada, applies to the sale by the manufacturer of finished products. The wholesale sales tax applies to the last wholesale transaction, that is, the purchase by the retailer. The retail sales tax applies to the final sale at retail. Each of these forms of tax will operate satisfactorily. On the whole, the retail tax, while collected from a much larger number of vendors than the others, gives rise to the fewest problems, because it can be applied to the actual selling price in virtually all instances. Avoidance of discrimination among various types of distribution channels is very difficult with the other single-stage taxes, since the taxable price is influenced by the structure of distribution. With a manufacturers tax, a manufacturer selling at retail is subject to a higher tax on a given product than one selling to a wholesale distributor. Attempts to meet this problem lead to serious complications in the tax. Nonretail taxes also tend to pyramid on the way to the final consumer, because of application of percentage markups. The retail tax, however, is not suitable in a country in which most retailing is conducted on a very small-scale, noncommercial basis, through family shops and market stalls.
The most recent version of the sales tax, the value added tax, as employed in France and accepted as the ultimate standard form of sales tax for the European Common Market countries, involves the application of tax to each firm in the production and distribution channels but only taxes the value added by the firm (in practice, the tax rate is applied to the firm’s gross sales, and from this figure is subtracted the tax paid during the period on goods purchased by the firm). Thus, the evils of the turnover form of tax are avoided, since the type of distribution channel will not affect the amount of tax liability, while the direct impact of the tax is spread out over a much wider range of taxpayers than is the case with the single-stage taxes, and much of the tax is collected from large firms at stages prior to retailing. This form may facilitate exclusion of capital goods from the tax. However, it offers little if any general advantage over the retail sales tax in situations where administration of the latter is feasible.
Present use . It is not feasible to present a detailed survey of existing sales tax structures. Table 1, however, gives a general outline for the major countries. Sales taxes are now employed by all countries of western Europe except Spain (which has an extensive system of excises), although the British purchase tax is of restricted scope. The tax is used by many states in India; by Pakistan, Indonesia, and the Philippines; and by Australia and New Zealand. In Latin America, the tax is used in Brazil by both the national government and the states, and it is a significant revenue source in Chile, Argentina, Uruguay, Ecuador, and Mexico. In Canada the tax is used both by the dominion government (manufacturers sales tax) and by nine provinces (retail taxes). In the United States the retail sales tax is employed in 43 states, but the federal government uses only a limited list of excises. Countries in early stages of economic development find customs duties the most satisfactory form of commodity tax.
Virtually every country of the world uses some form of excise tax, particularly on liquor, tobacco, and motor fuel; others, especially those not using sales taxes, also apply excises to various luxury goods. No simple summary of excise systems is possible.
It is very difficult to make precise comparisons between countries of relative dependence on various
|Table 1 — Sales taxation in major countries, 1967|
|Type of tax||Basic percentage rate|
|Italy||turnove, to retail||3|
|Germany||turnove, through retail||4|
|Belgium||turnove, to retail||6|
|Netherlands||turnove, to retail||5|
|Luxembourg||turnove, through retail||2|
|United Kingdom||wholesale, selected commodity groups||varying|
|Finland||wholesale and retail||10|
|Austria||turnover, through retail||5.25|
|United States (43 states)||retail||2 to 5|
|(9 provinces)||retail||5 to 8|
|Mexico||turnover||1.8 plus state supplements|
|South and Central America:|
|(federal)||manufacturing||varying, 2 to 10|
|(most states)||turnover||2 to 5|
|India (states)||turnover or,retail||wide variation|
|Australia||wholesale||varying, 10 to 30|
taxes. In the United States, sales taxes generally yield about 25 per cent of the revenues of the states in which they are levied, but in a few states they yield as much as 50 per cent. Excises yield about 11 per cent of federal revenue. The Canadian federal sales tax yields about 18 per cent of total federal tax revenue; the provincial sales taxes, 26 per cent of provincial tax revenue.
The turnover tax provides 42 per cent of the German federal revenues; other figures of sales tax yield include 35 per cent in France, 21 per cent in Italy, 40 per cent in Belgium, 19 per cent in the Netherlands.
Shifting and incidence . Traditionally it has been argued that both excises and sales taxes are typically shifted forward, through price increases, to the consumers of the products and thus are borne in relation to consumer spending on the taxed commodities. In purely competitive markets, with a fixed stock of goods on hand in the market period there will be no initial change in price, and temporarily the burden will be borne by the producers. But output and supply will fall, and the market price will rise. Over a long-run period the exact amount of the tax will shift forward, if the industry is one of constant cost conditions. Under increasing cost conditions, the ultimate increase in price will be less than the amount of the tax and a portion of the burden will be borne by the owners of specialized resources used in the industry, the prices of which decline as the volume of the product sold is reduced because of the higher commodity prices.
In nonpurely competitive markets the pattern of incidence is less clear. Typically—and there is considerable empirical evidence of this—prices will be raised immediately in response to the imposition of the tax, since firms take the initiative in setting their own prices and will likely adjust prices upward when they experience a general increase in costs. As long as the various competing firms follow the same policy, the increase is likely to be profitable. There are certain to be exceptions, however. If some firms fail to increase, the others will find an increase unprofitable. The over-all demand for some products may be so elastic that increases are unprofitable. Over a longer period there will be a greater tendency for price to rise by the amount of the tax, since prices must cover average cost. Here again, however, there will be exceptions. A monopolist or a group of firms following a concerted policy and having obtained, prior to the tax, maximum excess profits for the group will find it profitable in most instances to absorb a portion of the tax, since raising price by the full amount would result in a loss in revenue greater than the reduction in cost due to reduced output. It may be argued that a general sales tax can be shifted more easily than excises, since there is less danger of a loss in sales to untaxed commodities. The common practice (often required by law), under retail sales taxes, of adding the tax to the customer’s entire bill, rather than readjusting individual prices, undoubtedly facilitates shifting.
The argument that sales taxes are borne primarily by consumers has been questioned in recent years. Rolph (1952) maintained that a sales tax is borne in the same fashion as a flat-rate income tax, namely, in proportion to factor incomes. Rolph assumed perfectly competitive markets and perfectly inelastic supplies of the factors of production, and he disregarded the use of the revenue received from the tax. Thus, factor demand and factor prices fall. His conclusions, however, have been questioned, particularly in regard to the assumption about the use of the revenues. Buchanan (1960), and Rolph in more recent writings (Rolph & Break 1961, chapter 13), have argued that regardless of the assumption made about the use of the revenue, a sales tax cannot be borne by consumers because a tax rests on consumers only if the general price level increases and general price level increases cannot be attributed to taxes but only to monetary considerations. Musgrave (1959, chapters 10, 15, 16) maintains that the distribution of tax burden depends, not upon the direction of change in prices, but rather upon the relative changes in commodity and factor prices and concludes that a sales tax confined to consumer goods is borne in relation to consumption, whether commodity prices rise and factor prices remain unchanged or factor prices fall while commodity prices remain unchanged. He argues, however, that if the tax applies to both consumption and investment goods, the burden is distributed in the same fashion as that of a proportional income tax, regardless of the direction of change in price levels. Despite this extended theoretical controversy, policy discussions relating to sales taxes generally assume that the tax is, for the most part, shifted to consumers.
The excess burden argument . For a number of years the prime criticism advanced against excise taxes and, to a lesser extent, sales taxes of restricted scope has been that of “excess burden.” A tax on a particular commodity shifts purchases to untaxed commodities, thus resulting in a loss in economic welfare without an offsetting gain to the government. The pioneer statements were those of Hotelling (1938) and Joseph (1939). Critics pointed out that the thesis was valid only if the original revenue allocation was an optimum one and the pattern of income distribution the prefererred one. Other critics, such as Wald (1945), argued that income taxes, by affecting the choice between work and leisure and choices among various economic activities, likewise adversely affected economic welfare. But in a recent study of the question, by Harberger (The Role of Direct and Indirect Taxation in the’ Federal Revenue System 1964), the conclusion is reached that, on the basis of reasonable relevant assumptions, it is likely the excess burden of excises is greater than that of income taxes, primarily because of the limited response of work effort to income tax burdens.
General evaluation . The controversy over the relative desirability of commodity and income taxation has continued for many years with no lessening of intensity. Much of the debate centers on relative economic effects. Supporters of increased reliance on sales and excise taxes argue that income taxes retard economic growth and produce unemployment by discouraging savings, investment in business expansion, and work effort, especally on the part of business executives and professional men. Since sales taxes do not have progressive rates and may be avoided by saving rather than consuming, they do not directly penalize the gains from additional effort or business expansion and give some positive incentive to save more and consume less (except when savings are made for the purchase of goods in the future with the tax still in operation).
The opponents of sales taxation question the seriousness of the adverse effects of the income tax and argue that the greater relative impact of sales taxes on consumption will reduce national income and increase unemployment in situations in which there is some tendency toward unemployment because of inadequate total spending. A sales tax, by concentrating its burden more heavily on persons spending high percentages of their incomes and by providing some limited incentive to save more, may increase the potential rate of capital formation at full employment, but the tax may make it much more difficult to attain full employment and may thus lessen the actual rate of economic growth. Furthermore, to the extent to which the income tax does have adverse effect on the economy, this may be attributed in large measure to the high progressivity of rates and may be eliminated much more simply by changes in the income tax structure than by a shift to a sales tax. The differences attributed to the two forms of taxes are largely a result of the differences in rate structure, rather than in the base of the taxes.
In recent years the emphasis of the discussion has centered on the possibility of the replacement of the corporate income tax by the value added tax. The change has been advocated in large measure on the argument that the foreign exchange position of the country would be improved. Full export rebates would be granted for the value added tax, whereas no rebate is given for the corporate income tax, nor can one be given without violating present GATT (General Agreement on Tariffs and Trade) rules. The argument that the corporate tax places American exporters at a disadvantage, however, has validity only to the extent that the tax is reflected in higher prices of the products. The change proposed would temporarily aid American exports, whether the tax is now shifted or not, but such a change could easily invite retaliatory moves by other countries, especially if the tax is now not shifted.
Increased use of commodity taxation also has equity implications, and much of the opposition to the taxes has always been based on equity grounds. The income tax can be made progressive relative to income and can be adjusted in terms of various circumstances, such as size of family, which are considered to affect taxpaying ability. On the other hand, a sales tax with a broad coverage is regressive relative to income, because the higher-income groups save a greater percentage of their income, on the average, and spend more on nontaxable services. The tax likewise tends to burden large families more heavily, compared with smaller families, at given income levels (Hansen 1962). Food exemption, however, appears to eliminate regressivity (Davies 1961), but it fails to bring the precise adjustment to tax capacity that can be attained with an income tax. Some persons have suggested that the correct basis for comparing burdens is that of permanent income [see Consumption Function], rather than actual income (Davies 1961). On this basis, even a broad-based sales tax is not regressive. But it may also be argued that actual year-by-year income is the better basis for measuring tax burdens. The significance of the equity argument is, of course, one of value judgment; to many persons the use of some regressive taxes in a tax structure that is progressive over-all is not objectionable. But in terms of usually accepted standards of equity, major reliance on such taxes is undesirable.
Sales and excise taxes are also justified on administrative grounds—as being easier to enforce than income taxes. With improved income tax administration, this argument has lost most of the merit it once had. Furthermore, since the issue is one of using a sales tax along with, not in lieu of, an income tax, the over-all administrative task is obviously greater with a sales tax than without one.
In countries with a federal government, a final argument for sales taxation is the need of the states for autonomous revenue sources, in light of federal domination of the income tax field.
On the question of the choice between sales and excise taxes, the former are less discriminatory against individuals, in terms of their preferences, than excises and are less likely to distort resource allocation. On the other hand, excises, limited to particular commodities, may be easier to administer, may accomplish certain desired goals in tax policy (such as the placing of special burdens on highway users or consumers of tobacco and liquor), and may provide a more acceptable overall distribution of burden. But to raise significant revenue, either rates must be relatively high or many commodities of widespread use must be brought within the scope of the tax, and then the excise system comes to resemble a sales tax.
John F. Due
Buchanan, James M. 1960 Fiscal Theory and Political Economy. Chapel Hill: Univ. of North Carolina Press.
Davies, David G. 1961 Commodity Taxation and Equity. Journal of Finance 16:581-590.
Due, John F. 1957 Sales Taxation. London: Routledge; Urbana: Univ. of Illinois Press.
Due, John F. 1963a State Sales Tax Administration. Chicago: Public Administration Service.
Due, John F. 1963b Sales Taxation and the Consumer. American Economic Review 53:1078-1084.
Hansen, Reed R. 1962 An Empirical Analysis of the Retail Sales Tax With Policy Recommendations. National Tax Journal 15, March: 1-13.
Hotelling, Harold 1938 The General Welfare in Relation to Problems of Taxation and of Railway and Utility Rates. Econometrica 6:242-269.
Joseph, Margaret F. W. 1939 The Excess Burden of Indirect Taxation. Review of Economic Studies 6:226-231.
Morgan, Daniel C. 1964 Retail Sales Tax: An Appraisal of New Issues. Madison: Univ. of Wisconsin Press.
Musghave, Richard A. 1959 The Theory of Public Finance: A Study in Public Economy. New York: McGraw-Hill.
Organization For European Economic Cooperation, European Productivity Agency 1958 The Influence of Sales Taxes on Productivity, by C. Campet. Paris: The Organization.
The Role of Direct and Indirect Taxation in the Federal Revenue System. 1964 Princeton Univ. Press. → A conference report of the National Bureau of Economic Research and the Brookings Institution.
Rolph, Earl R. 1952 A Proposed Revision of Excise-tax Theory. Journal of Political Economy 60:102-117.
Rolph, Earl R.; and Break, George F. 1961 Public Finance. New York: Ronald Press.
Sullivan, Clara K. 1965 The Tax on Value Added. New York: Columbia Univ. Press.
U.S. Congress, House, Committee ON Ways AND Means 1964 Excise Tax Compendium: Compendium of Papers on Excise Tax Structure. ... 6 parts in 2 vols. Washington: Government Printing Office.
Wald, Haskell P. 1945 The Classical Indictment of Indirect Taxation. Quarterly Journal of Economics 59:577-596.
Walker, David 1955 The Direct-Indirect Tax Problem: Fifteen Years of Controversy. Public Finance 10, no. 2:153-176.
Taxes upon the transfer of property at death are known as estate taxes if they are imposed on the value of the decedent’s estate as a whole with little or no regard to the status and number of heirs, and as inheritance taxes if they are imposed upon the heirs individually. The estate tax consequently employs a single rate scale applied to the entire estate, while the inheritance tax is calculated separately on the amount received by each heir. The inheritance tax commonly employs a series of rate scales that vary with the degree of relationship of the heir to the decedent.
The tax on gifts made during life (gifts inter vivos) can likewise in principle be divided into a tax collected from the donor and a tax collected from the donee. In practice, only the tax on the donor is employed, and even that is used sparingly, most taxing jurisdictions not levying a tax on gifts inter vivos at all. Some gift taxes are cumulative, in the sense that a progressive rate scale is applied to the sum of gifts made by a given donor over his lifetime, as is the U.S. federal gift tax (Harvard Law School 1963a, chapter 3). Other gift taxes apply the graduated rate scale only to gifts made during a given year, as is the case in the German Federal Republic (Harvard Law School 1963b, chapter 4).
The death tax and the gift tax could be integrated either as a cumulative tax on all transfers made by a given donor during his lifetime or as a cumulative tax on all accessions to a given donee either through gift or inheritance. The cumulative integrated tax on donors has been proposed from time to time in the United States; as yet no country has employed it. The cumulative donee tax, or accessions tax, was in force for a short time in Japan—from 1950 to 1953 (Japan, Ministry of Finance 1963, pp. 9, 91), and exists in an incomplete form in Colombia and Italy (Shoup 1966, p. 13).
History. Taxes on the transfer of property at death have a long fiscal history. The Roman vicésima heredltatum, “the twentieth penny of inheritances,” is mentioned in Adam Smith’s Wealth of Nations (1776, book 5, chapter 2, appendix to arts. 1 and 2). In the United Kingdom, the tax dates back to 1694, but not until 1779-1780 did it attain something like its modern form (Palgrave [1894-1896] 1963, vol. 1, pp. 490-493). The U.S. federal government levied an inheritance tax during the Civil War and again during the Spanish-American War (Shultz 1926, pp. 151-155). The present U.S. federal estate tax dates from 1916; many of the state death taxes have longer histories (ibid., chapters 8, 9). Virtually all of the industrialized nations now employ some form of death tax, and it is also common in underdeveloped countries (see United Nations 1954).
The death duty predates the modern type of mass income tax and also the modern general sales tax. In many instances it has a longer history even than the more restricted income taxes of the period before World War n. The widespread and early use of the death tax can be explained largely by the fact that property had to be listed and valued in any event—for transfer to the state or to feudal overlords, under prevailing doctrines regarding land tenure; or to members of the family of the deceased possessing certain minimum rights in the property; or to other inheritors. The occasion thus proved a convenient one for computing a tax base and collecting a tax. Valuation remains, however, a vexing problem with respect to much of the transferred property.
Revenue . Although the history of the death tax has been impressive in terms of longevity and spread, its revenue role has been much less so. Today it rarely accounts for more than one per cent of total tax revenues in any country, despite the fairly steep graduation that characterizes most of the rate structures. While the income tax has been transformed in some countries into a tax that strikes almost every family and while social security payroll taxes and the general sales taxes, both inventions of the twentieth century, have added enormously to fiscal revenues, the estate and inheritance taxes have remained confined to only a small percentage of the populace. Most households in most countries have little or no property, at least relative to their incomes. In the more prosperous countries death taxes have high exemptions, and the starting rates are low. Thus, in the United States in 1961, for example, only some 45,000 out of 1,400,000 adult deaths resulted in estates subject to the federal estate tax (U.S. Department of Health, Education and Welfare 1963, vol. 2, part B, pp. 9-78, table 9-3). No movement has developed in any country to convert the death tax into a mass tax imposed on virtually everyone who dies possessed of property. In any event, conversion to a mass tax would not produce the striking percentage increase in yield that has been experienced under the income tax, since wealth is far more concentrated than income.
Avoidance . Sophisticated avoidance techniques, particularly in the United States and the United Kingdom, restrict the yield of the death tax. Under Anglo-Saxon property law concepts, trusts and life estates can be so set up as to skip one or more generations in the passage of property subject to death duties. In the United Kingdom, where expiration of a life estate gives rise, in principle, to full taxation of the corpus on which the life interest is based, tax has been avoided by several devices, notably the discretionary trust. This can be so formulated that owing to the discretion lodged in the hands of trustees as to who shall receive the life payments, it is not legally certain upon the death of one life tenant that any one of the others obtains any greater interest in the property than he had before (Harvard Law School 1957, chapter 3; Wheatcroft 1965, pp. 68-69, 132-137). In the United States, expiry of a life estate or similar property right does not give rise to inclusion of the corpus in the taxable estate of the decedent. Special statistical studies made by the U.S. Treasury have shown that in the wills of wealthy decedents the life estate that skips at least one generation is common (Shoup 1966, chapter 3; Jantscher 1967, chapters 4-7). These particular avoidance techniques are apparently not available in continental European countries because of the absence of the Anglo-Saxon concept of the trust.
In many countries, including the United Kingdom, gifts made during life (gifts inter vivos) are not taxable. In some of these countries, as also in the United States, gifts made within a certain number of years before death, or deemed made in contemplation of death, are included in the taxable estate. Thus, in the United Kingdom gifts made within five years of death are included, in part, in the taxable estate.
Where gifts are subject to a separate gift tax, as in the United States, the lower rate scale of the gift tax and the opportunity for splitting the property into two parts, each of which can obtain the benefit of low brackets (gift tax and estate tax), not to mention certain other technical features, leave a broad avenue for substantial tax reduction by gifts during life. In fact, however, even the most wealthy property holders seem to avail themselves of this possibility far less than a priori reasoning might suggest; the British consequently do not appear to believe that the revenue from their death tax is appreciably imperiled by the absence of a gift tax.
Contributions to charitable, educational, religious, and similar organizations are completely exempt under the U.S. federal estate tax, in contrast to the restricted exemptions, if any, granted in other countries. Once more, the opportunity for complete escape has been utilized rather less than one might expect (Harriss 1949; Shoup 1966, pp. 60-65).
The mobility of elderly wealthy persons is another restraining influence on heavy death taxation. Recently, both the United Kingdom and the United States have altered their death tax laws to include in the tax base real estate located abroad. This change has added pressure on elderly wealth-holders to change their residence and perhaps even citizenship as they reach extreme old age. Again, the number of such decisions will probably prove to be minor compared with the prospective tax saving.
In some respects the death duty offers fewer opportunities for avoidance than does the usual income tax. In the United States, state and local securities are fully subject to inclusion in the decedent’s taxable estate even though during his lifetime the interest on such obligations is exempt from the federal income tax. Property values arising from capital gains are fully included for U.S. estate tax purposes and also for the death duties in Britain, while under the income tax they are given preferential treatment. The percentage depletion provisions in the United States that have caused so much comment with respect to the income tax are, of course, not operative for the death tax.
Effect on consumption . Per dollar of revenue, the death tax probably decreases consumption spending less than most other taxes on households. This is so because the decedent-to-be seems unlikely to decrease his standard of living appreciably in order to improve the prospects of his heirs, prospects that have been impaired by the death tax. The future heirs, in turn, seem unlikely to reduce their current standard of living merely because they are aware that they will later receive less than if no death tax were in force. With respect to the period following transfer of the property at death, it has been cogently argued by Ricardo and others that the heirs tend to look upon the capital that they should preserve as being simply the amount they receive after death tax. They thus feel under no pressure to try to rebuild the estate to a level closer to what it would have been without such a tax (Shoup  1960, chapters 3, 15). Doctrinal discussion in Anglo-Saxon economic literature over the past century and a half has centered more on the reaction of the decedent-to-be than on the heirs, prospective or actual, and some difference of opinion has developed on this score (Fiekowsky 1959, chapters 1, 3). McCulloch, for example, expressed the opinion that the property owner would attempt to build up his estate somewhat in an effort to recoup for his heirs a part of the value that would be lost by the estate tax. Present-day thought, however, does not follow McCulloch, especially in view of the apparent indifference of wealthy persons as evidenced by their failure to transfer much property during life in order to save tax money for their heirs (Shoup 1966, Appendix F).
On the other hand, it is not at all certain that this failure to take advantage of what appear to be bargain tax rates during life necessarily indicates indifference. The welfare of one’s heirs is weighed against other considerations, some more admirable than others. As modern medicine has enhanced the possibility that an elderly person may live to extreme old age, sometimes under very expensive medical and hospital care, the risk that his financial resources may be exhausted before his death has become correspondingly greater. Dread of dependence on his children and loss of flexibility in arranging for his later years, even if expensive medical care is not a problem, are powerful forces in causing a wealthy decedent-to-be to cling to his wealth, particularly when he believes that he has already given enough to his children to start them in life with substantial advantages and conjectures that further wealth would do them more harm than good. To these motives must be added sometimes a desire to retain psychological control over prospective heirs, and sometimes a gradual drift into senility before the individual can be persuaded to think about death and act on his thoughts. Simple inertia explains much, especially on the part of some elderly women who have little interest in property management, and extremely busy men of affairs who do not pause long enough even to sign a will. Family jealousies also play an occasional role in restraining gifts during life.
The transferor or the heir might recoup some of the death or gift tax by increasing his money-making efforts. The high income tax rates to which this class of persons is commonly subject make this method of capital preservation, as compared with restricting one’s consumption, a difficult one.
Effect on distribution . The distribution of wealth and income, as indicated by a Lorenz curve, has probably been made more nearly equal to a modest degree during the past thirty years or so of graduated death taxation in the United States and the United Kingdom, compared with what it would have been if the same revenue had been raised, for example, by an increment to general sales taxes (Fiekowsky 1959, chapter 3). The result seems not to have been as substantial, however, as has been hoped for by proponents of the tax, to whom a chief virtue of death duties is their presumed tendency to limit accumulation of extreme fortunes and to reduce inequality generally. The explanation for this disappointment, if such it is, lies largely in the number of avoidance devices indicated above and partly in the relatively high level of exemption (for the U.S. federal estate tax it is $60,000) and low rates in the initial ranges. No practical support has developed for the Rignano plan or its variants, which would tax especially heavily and eventually confiscate inheritances that came from inheritances, after two or three or four generations. It is instructive to recall that an inventor of one of these variants, Hugh Dalton, made no move to introduce it into the British law while he was chancellor of the exchequer in the late 1940s (Dalton 1923, pp. 114-118 in 1936 edition; p. 232 in 1954 edition).
Death taxes are said to have forced small, closely held family firms to restrict their rate of growth in order to accumulate liquid assets sufficient to pay the tax upon the death of the founder or other large family owner, or alternatively to have induced them to merge with large firms whose stock is actively traded on exchanges so that liquid assets for payment of the tax could be obtained without restricting growth of the business (Somers 1958, pp. 201-210). The extent to which these effects have in fact materialized is not clear. In the United States the law has recently been amended to guarantee the estate the privilege of a ten-year installment payment provision if the company in question meets certain tests. In any case, an extended period of payment can be granted at the discretion of the tax administration.
Present trends . Among the current trends in death and gift taxation, the most noticeable one seems to be a tendency to personalize the estate tax, so that the amount of tax will vary depending particularly upon the relationship of the heir to the decedent. In this way, the estate tax may become more and more like an inheritance tax. The U.S. federal estate tax allows exemption of up to 50 per cent of an estate with respect to transfer to the surviving spouse, and pressure is growing to exempt completely interspousal transfers and to give some tax reduction for transfers to children.
Another trend, this time working toward an increase in revenue, is evidenced in current discussions of methods by which skipping one or more generations can be reduced, through taxing expiry of life estates and inhibiting the use of discretionary trusts. The task is much more difficult than this brief discussion might indicate, because of the intricacies of property law and the consequent opportunities to avoid even the most complex anti-avoidance measures. However, additional legislation on these subjects may be expected in both the United States and the United Kingdom during the next few years. In the view of some, the death and gift tax system should be so constructed that no matter by what route property is transferred to a generation distant in time, the present value of taxes on the transfers would come to the same thing, as under the proposal by Vickrey of a bequeathing power tax (Vickrey 1947, chapter 8). To achieve this end, however, is to relinquish the relationship of heirs to decedent as grounds for differentiation of the tax.
No trend is apparent with respect to the level of exemptions and the rate and type of graduation. Both the exemption and rate structure have shown great stability over time in most countries; in the United States, for example, the present rate scale dates from 1942. Graduation by brackets, as in the income tax, is characteristic of most death taxes, but the British prefer to graduate by a series of effective (average) rates. Such graduation facilitates an equitable division of the tax between the executors of the estate and owners of parcels of property that, although not appearing in the decedent’s estate, are nevertheless aggregated with his estate in determining the tax rate applicable to such parcels and to the estate (an example is property that was transferred as a gift inter vivos within five years of death).
Jurisdictional problems either among states in a federation or among countries continue to occupy much time and thought of tax lawyers and legislators, but exert little influence on total revenues. In the United States the federal-state issue has been met by allowing up to a certain amount of state death taxes paid to be credited directly against the federal tax, with the consequence that all of the states of the United States, excepting Nevada, impose either the estate or the inheritance tax or both, sometimes indeed rather beyond the limits of the federal credit. The United States has concluded tax conventions with many other countries, chiefly to avoid double taxation of properties of nonresident aliens.
Legal and administrative complications arise through linkages of death and gift taxes with the income tax. In the U.S. federal law, a transfer of property may be an inter vivos gift for gift tax purposes but not for income tax purposes; it is not evident, however, that complete uniformity is desirable. Another linkage arises with respect to capital gains. At present, a capital gain accrued at death is not made subject to the income tax, nor is a capital loss recognized. The heirs take over the property with a new basis for computing capital gain or loss on a future sale. This basis is the value of the property in the decedent’s estate. Accordingly, a capital gain on property held until death is never subject to the income tax, and a capital loss is never allowed. An attempt by the executive to persuade Congress to eliminate this combination of loophole and hardship in the Tax Reform Bill of 1963 failed. Property given during life, on the other hand, does not have its basis stepped up (or down) in this manner; this fact helps explain the reluctance to pass on appreciated property during life rather than at death.
No taxes have had a better reputation to less effect. Favorable comments on death and gift taxation can be found in the most conservative quarters, but these taxes remain minor and of little concern to politicians and voters. In certain academic circles some doubt is beginning to arise whether many of the aims of the estate and gift taxes could not better be achieved by a low-rate annual tax on individual net wealth, which would not be vulnerable to the devices now being employed to skip generations.
Carl S. Shoup
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Wheatcroft, G. S. A. (editor) 1965 Estate and Gift Taxation: A Comparative Study. British Tax Review Guides, No. 3. London: Sweet & Maxwell. → A study of estate and gift taxation in Australia, Canada, Great Britain, and the United States.
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TAXATION is the imposition by a government of a compulsory contribution on its citizens for meeting all or part of its expenditures. But taxation can be more than a revenue raiser. Taxes can redistribute income, favor one group of taxpayers at the expense of others, punish or reward, and shape the behavior of taxpayers through incentives and disincentives. The architects of American tax policy have always used taxes for a variety of social purposes: upholding social order, advancing social justice, promoting economic growth, and seeking their own political gain. The need for new revenues has always set the stage for pursuing social goals through taxation, and the need for new revenues has been most intense during America's five great national crises: the political and economic crisis of the 1780s, the Civil War, World War I, the Great Depression, and World War II. In the process of managing each of these crises, the federal government led the way in creating a distinctive tax regime—a tax system with its own characteristic tax base, rate structure, administrative apparatus, and social intention.
In the United States, progressive taxation—taxation that bears proportionately more heavily on individuals, families, and firms with higher incomes—has always enjoyed great popularity. Progressive taxation has offered a way of reconciling the republican or democratic ideals with the high concentrations of wealth characteristic of capitalist economic systems. During national crises, political leaders have been especially intent on rallying popular support. Consequently, the powerful tax regimes associated with great national crises have each had a significant progressive dimension.
The Colonial Era and the American Revolution, 1607–1783
Before the American Revolution, taxation was relatively light in the British colonies that would form the United States. Public services, such as education and roads, were limited in scale, and the British government heavily funded military operations. In 1763, after the expensive Seven Years' War, the British government initiated a program to increase taxes levied on Americans, especially through "internal" taxes such as the Stamp Act (1765) and the Townshend Acts (1767). But colonial resistance forced the British to repeal these taxes quickly, and the overall rate of taxation in America remained low until the outset of the Revolution, at least by contemporary British standards.
Tax rates and types of taxation varied substantially from colony to colony, and even from community to community within particular colonies, depending on modes of political organization and the distribution of economic power. British taxing traditions were diverse, and the various colonies and local communities had a rich array of institutions from which to choose: taxes on imports and exports; property taxes (taxes on the value of real and personal assets); poll taxes (taxes levied on citizens without any regard for their property, income, or any economic characteristic); excise (sales) taxes; and faculty taxes, which were taxes on the implicit incomes of people in trades or businesses. The mix varied, but each colony made use of virtually all of these different modes of taxation.
Fighting the Revolution forced a greater degree of fiscal effort on Americans. At the same time, the democratic forces that the American Revolution unleashed energized reformers throughout America to restructure state taxation. Reformers focused on abandoning deeply unpopular poll taxes and shifting taxes to wealth as measured by the value of property holdings. The reformers embraced "ability to pay"—the notion that the rich ought to contribute disproportionately to government—as a criterion to determine the distribution of taxes. The reformers were aware that the rich of their day spent more of their income on housing than did the poor and that a flat, ad valorem property levy was therefore progressive. Some conservative leaders also supported the reforms as necessary both to raise revenue and to quell social discord. The accomplishments of the reform movements varied widely across the new states; the greatest successes were in New England and the Middle Atlantic states.
During the Revolution, while state government increased taxes and relied more heavily on property taxes, the nascent federal government failed to develop effective taxing authority. The Continental Congress depended on funds requisitioned from the states, which usually ignored calls for funds or responded very slowly. There was little improvement under the Articles of Confederation. States resisted requisitions and vetoed efforts to establish national tariffs.
The Early Republic, 1783–1861
The modern structure of the American tax system emerged from the social crisis that extended from 1783 to the ratification in 1788 of the U.S. Constitution. At the same time that the architects of the federal government forged their constitutional ideas, they struggled with an array of severe fiscal problems. The most pressing were how to finance the revolutionary war debts and how to establish the credit of the nation in a way that won respect in international financial markets. To solve these problems, the Constitution gave the new government the general power, in the words of Article 1, section 8, "To lay and collect Taxes, Duties, Imposts, and Excises."
The Constitution, however, also imposed some restrictions on the taxing power. First, Article 1, section 8, required that "all Duties, Imposts and Excises shall be uniform throughout the United States." This clause prevented Congress from singling out a particular state or group of states for higher rates of taxation on trade, and reflected the hope of the framers that the new Constitution would foster the development of a national market. Second, Article 1, section 9, limited federal taxation of property by specifying that "No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census." The framers of the Constitution never clearly defined "direct" taxation, but they regarded property taxes and "capitation" or poll taxes as direct taxes. The framers' goals were to protect the dominance of state and local governments in property taxation, and to shield special categories of property, such as slaves, against discriminatory federal taxation.
As the framers of the Constitution intended, property taxation flourished at the state and local levels during the early years of the Republic. Most of the nation's fiscal effort was at these levels of government, rather than at the federal level, and the property tax provided most of the funding muscle.
Differences persisted among states regarding the extent and form of property taxation. Southern states remained leery of property taxation as a threat to the land and slaves owned by powerful planters. These states also had the most modest governments because of limited programs of education and internal improvements. One southern state, Georgia, abandoned taxation altogether and financed its state programs through land sales.
Northern states, in contrast, generally expanded their revenue systems, both at the state and local levels, and developed ambitious new property taxes. The reformers who created these new property taxes sought to tax not just real estate but all forms of wealth. They described the taxes that would do this as general property taxes. These were comprehensive taxes on wealth that would reach not only tangible property such as real estate, tools, equipment, and furnishings but also intangible personal property such as cash, credits, notes, stocks, bonds, and mortgages. Between the 1820s and the Civil War, as industrialization picked up steam and created new concentrations of wealth, tax reformers tried to compel the new wealth to contribute its fair share to promoting communal welfare. By the 1860s, the general property tax had, in fact, significantly increased the contributions of the wealthiest Americans to government.
At the federal level, a new tax regime developed under the financial leadership of the first secretary of the Treasury, Alexander Hamilton. His regime featured tariffs—customs duties on goods imported into the United States—as its flagship. Tariffs remained the dominant source of the government's revenue until the Civil War.
To establish precedents for future fiscal crises, Hamilton wanted to exercise all the taxing powers provided by Congress, including the power to levy "internal" taxes. So, from 1791 to 1802, Congress experimented with excise taxes on all distilled spirits (1791); on carriages, snuff manufacturing, and sugar refining (1794); and with stamp duties on legal transactions, including a duty on probates for wills (1797)—a first step in the development of the federal estate tax. In addition, in 1798 Congress imposed a temporary property tax, apportioned according to the Constitution, on all dwelling houses, lands, and large slave holdings.
Excise taxes proved especially unpopular, and the tax on spirits touched off the Whiskey Rebellion of 1794. President George Washington had to raise 15,000 troops to discourage the Pennsylvania farmers who had protested, waving banners denouncing tyranny and proclaiming "Liberty, Equality, and Fraternity."
In 1802, the administration of President Thomas Jefferson abolished the Federalist system of internal taxation, but during the War of 1812, Congress restored such taxation on an emergency basis. In 1813, 1815, and 1816, Congress enacted direct taxes on houses, lands, and slaves, and apportioned them to the states on the basis of the 1810 census. Congress also enacted duties on liquor licenses, carriages, refined sugar, and even distilled spirits. At the very end of the war, President James Madison's secretary of the Treasury, Alexander J. Dallas, proposed adopting an inheritance tax and a tax on incomes. But the war ended before Congress acted.
The Era of Civil War and Modern Industrialization, 1861–1913
The dependence of the federal government on tariff revenue might have lasted for at least another generation. But a great national emergency intervened. The Civil War created such enormous requirements for capital that the Union government had to return to the precedents set during the administrations of Washington and Madison and enact a program of emergency taxation. The program was unprecedented in scale, scope, and complexity.
During the Civil War, the Union government placed excise taxes on virtually all consumer goods, license taxes on a wide variety of activities (including every profession except the ministry), special taxes on corporations, stamp taxes on legal documents, and taxes on inheritances. Each wartime Congress also raised the tariffs on foreign goods, doubling the average tariff rate by the end of the war. And, for the first time, the government levied an income tax.
Republicans came to the income tax as they searched for a way to hold popular confidence in their party in the face of the adoption of the new regressive levies—taxes that taxed lower income people at higher rates than the wealthy. Republicans looked for a tax that bore a closer relationship to "ability to pay" than did the tariffs and excises. They considered a federal property tax but rejected it because the allocation formula that the Constitution imposed meant taxing property in wealthy, more urban states at lower rates than in poorer, more rural states. The Republican leadership then took note of how the British Liberals had used income taxation in financing the Crimean War as a substitute for heavier taxation of property. They settled on this approach, and the result was not only an income tax but a graduated, progressive tax—one that reached a maximum rate of 10 percent. This was the first time that the federal government discriminated among taxpayers by virtue of their income. The rates imposed significantly higher taxes on the wealthy—perhaps twice as much as the wealthy were used to paying under the general property tax. By the end of the war, more than 15 percent of all Union households in the northeastern states paid an income tax.
After the Civil War, Republican Congresses responded to the complaints of the affluent citizens who had accepted the tax only as an emergency measure. In 1872, Congress allowed the income tax to expire. And, during the late 1860s and early 1870s, Republican Congresses phased out the excise taxes, except for the taxes on alcohol and tobacco.
Republicans, however, kept the high tariffs, and these constituted a new federal tax regime. Until the Under-wood-Simmons Tariff Act of 1913 significantly reduced the Civil War rates, the ratio between duties and the value of dutiable goods rarely dropped below 40 percent and was frequently close to 50 percent. On many manufactured items the rate of taxation reached 100 percent. The system of high tariffs came to symbolize the commitment of the federal government to creating a powerful national market and to protecting capitalists and workers within that market. The nationalistic symbolism of the tariff in turn reinforced the political strength of the Republican Party.
After the Civil War, continuing industrialization and the associated rise of both modern corporations and financial capitalism increased Democratic pressure to reform the tariff. Many Americans, especially in the South and West, came to regard the tariff as a tax that was not only regressive but also protective of corporate monopolies. One result was the enactment, in 1894, of a progressive income tax. But in 1895 the Supreme Court, in Pollock v. Farmers' Loan and Trust Company, claimed, with little historical justification, that the architects of the Constitution regarded an income tax as a direct tax. Since Congress had not allocated the 1894 tax to the states on the basis of population, the tax was, in the Court's view, unconstitutional. Another result of reform pressure was the adoption in 1898, during the Spanish-American War, of the first federal taxation of estates. This tax was graduated according to both the size of the estate and the degree of relationship to the deceased. The Supreme Court upheld the tax in Knowlton v. Moore (1900), but in 1902 a Republican Congress repealed it.
State and local tax policy also began to change under the pressure of industrialization. The demand of urban governments for the funds required for new parks, schools, hospitals, transit systems, waterworks, and sewers crushed the general property tax. In particular, traditional self-assessment of property values proved inadequate to expose and determine the value of intangible property such as corporate stocks and bonds. Rather than adopt rigorous and intrusive new administrative systems to assess the value of such, most local governments focused property taxation on real estate, which they believed they could assess accurately at relatively low cost. Some states considered following the advice of the reformer Henry George and replacing the property tax with a "single tax" on the monopoly profits embedded in the price of land. Farm lobbies, however, invariably blocked such initiatives. Instead, after 1900, state governments began replacing property taxation with special taxes, such as income taxes, inheritance taxes, and special corporate taxes. Beginning in the 1920s, state governments would continue this trend by adding vehicle registration fees, gasoline taxes, and general sales taxes.
The Establishment of Progressive Income Taxation, 1913–1929
Popular support for progressive income taxation continued to grow, and in 1909 reform leaders in Congress from both parties finally united to send the Sixteenth Amendment, legalizing a federal income tax, to the states for ratification. It prevailed in 1913 and in that same year Congress passed a modest income tax. That tax, however, might well have remained a largely symbolic element in the federal tax system had World War I not intervened.
World War I accelerated the pace of reform. The revenue demands of the war effort were enormous, and the leadership of the Democratic Party, which had taken power in 1912, was more strongly committed to progressive income taxes and more opposed to general sales taxes than was the Republican Party. In order to persuade Americans to make the financial and human sacrifices for World War I, President Woodrow Wilson and the Democratic leadership of Congress introduced progressive income taxation on a grand scale.
The World War I income tax, which the Revenue Act of 1916 established as a preparedness measure, was an explicit "soak-the-rich" instrument. It imposed the first significant taxation of corporate profits and personal incomes and rejected moving toward a "mass-based" income tax—one falling most heavily on wages and salaries. The act also reintroduced the progressive taxation of estates. Further, it adopted the concept of taxing corporate excess profits. Among the World War I belligerents, only the United States and Canada placed excess-profits taxation—a graduated tax on all business profits above a "normal" rate of return—at the center of wartime finance. Excess-profits taxation turned out to generate most of the tax revenues raised by the federal government during the war. Thus, wartime public finance depended heavily on the taxation of income that leading Democrats, including President Wilson, regarded as monopoly profits and therefore ill-gotten and socially hurtful.
During the 1920s, three Republican administrations, under the financial leadership of Secretary of the Treasury Andrew Mellon, modified the wartime tax system. In 1921 they abolished the excess-profits tax, dashing Democratic hopes that the tax would become permanent. In addition, they made the rate structure of the income tax less progressive so that it would be less burdensome on the wealthy. Also in 1921, they began to install a wide range of special tax exemptions and deductions, which the highly progressive rates of the income tax had made extremely valuable to wealthy taxpayers and to their surrogates in Congress. The Revenue Acts during the 1920s introduced the preferential taxation of capital gains and a variety of deductions that favored particular industries, deductions such as oil- and gas-depletion allowances.
The tax system nonetheless retained its "soak-the-rich" character. Secretary Mellon led a struggle within the Republican Party to protect income and estate taxes from those who wanted to replace them with a national sales tax. Mellon helped persuade corporations and the wealthiest individuals to accept some progressive income taxation and the principle of "ability to pay." This approach would, Mellon told them, demonstrate their civic responsibility and help block radical attacks on capital.
The Great Depression and New Deal, 1929–1941
The Great Depression—the nation's worst economic collapse—produced a new tax regime. Until 1935, however, depression-driven changes in tax policy were ad hoc measures to promote economic recovery and budget balancing rather than efforts to seek comprehensive tax reform. In 1932, to reduce the federal deficit and reduce upward pressure on interest rates, the Republican administration of President Herbert Hoover engineered across-the-board increases in both income and estate taxes. These were the largest peacetime tax increases in the nation's history. They were so large that President Franklin D. Roosevelt did not have to recommend any significant tax hikes until 1935.
Beginning in 1935, however, Roosevelt led in the creation of major new taxes. In that year, Congress adopted taxes on wages and the payrolls of employers to fund the new social security system. The rates of these taxes were flat, and the tax on wages provided an exemption of wages over $3,000. Thus, social security taxation was regressive, taxing lower incomes more heavily than higher incomes. Partly to offset this regressive effect on federal taxation, Congress subsequently enacted an undistributed profits tax. This was a progressive tax on retained earnings—the profits that corporations did not distribute to their stockholders.
This measure, more than any other enactment of the New Deal, aroused fear and hostility on the part of large corporations. Quite correctly, they viewed Roosevelt's tax program as a threat to their control over capital and their latitude for financial planning. In 1938, a coalition of Republicans and conservative Democrats took advantage of the Roosevelt administration's embarrassment over the recession of 1937–1938 to gut and then repeal the tax on undistributed profits.
World War II, 1941–1945: From "Class" to "Mass" Taxation
President Roosevelt's most dramatic reform of taxation came during World War II. During the early phases of mobilization, he hoped to be able to follow the example of Wilson by financing the war with taxes that bore heavily on corporations and upper-income groups. "In time of this grave national danger, when all excess income should go to win the war," Roosevelt told a joint session of Congress in 1942, "no American citizen ought to have a net income, after he has paid his taxes, of more than $25,000." But doubts about radical war-tax proposals grew in the face of the revenue requirements of full mobilization. Roosevelt's military and economic planners, and Roosevelt himself, came to recognize the need to mobilize greater resources than during World War I. This need required a general sales tax or a mass-based income tax.
In October of 1942, Roosevelt and Congress agreed on a plan: dropping the general sales tax, as Roosevelt wished, and adopting a mass-based income tax that was highly progressive, although less progressive than Roosevelt desired. The act made major reductions in personal exemptions, thereby establishing the means for the federal government to acquire huge revenues from the taxation of middle-class wages and salaries. Just as important, the rates on individuals' incomes—rates that included a surtax graduated from 13 percent on the first $2,000 to 82 percent on taxable income over $200,000—made the personal income tax more progressive than at any other time in its history.
Under the new tax system, the number of individual taxpayers grew from 3.9 million in 1939 to 42.6 million in 1945, and federal income tax collections leaped from $2.2 billion to $35.1 billion. By the end of the war, nearly 90 percent of the members of the labor force submitted income tax returns, and about 60 percent of the labor force paid income taxes, usually in the form of withheld wages and salaries.
In making the new individual income tax work, the Roosevelt administration and Congress relied heavily on payroll withholding, the information collection procedures provided by the social security system, deductions that sweetened the new tax system for the middle class, the progressive rate structure, and the popularity of the war effort. Americans concluded that their nation's security was at stake and that victory required both personal sacrifice through taxation and indulgence of the corporate profits that helped fuel the war machine. The Roosevelt administration reinforced this spirit of patriotism and sacrifice by invoking the extensive propaganda machinery at their command. The Treasury, its Bureau of Internal Revenue, and the Office of War Information made elaborate calls for civic responsibility and patriotic sacrifice.
Cumulatively, the two world wars revolutionized public finance at the federal level. Policy architects had seized the opportunity to modernize the tax system, in the sense of adapting it to new economic and organizational conditions and thereby making it a more efficient producer of revenue. The income tax enabled the federal government to capitalize on the financial apparatus associated with the rise of the modern corporation to monitor income flows and collect taxes on those flows. In the process, progressive income taxation gathered greater popular support as an equitable means for financing government. Taxation, Americans increasingly believed, ought to redistribute income according to ideals of social justice and thus express the democratic ideals of the nation.
The Era of Easy Finance, 1945 to the Present
The tax regime established during World War II proved to have extraordinary vitality. Its elasticity—its ability to produce new revenues during periods of economic growth or inflation—enabled the federal government to enact new programs while only rarely enacting politically damaging tax increases. Consequently, the World War II tax regime was still in place at the beginning of the twenty-first century. During the 1970s and the early 1980s, however, the regime weakened. Stagnant economic productivity slowed the growth of tax revenues, and the administration of President Ronald Reagan sponsored the Emergency Tax Relief Act of 1981, which slashed income tax rates and indexed the new rates for inflation. But the World War II regime regained strength after the Tax Reform Act of 1986, which broadened the base of income taxation; the tax increases led by Presidents George H. W. Bush and William J. Clinton in 1991 and 1993; the prolonged economic expansion of the 1990s; and the increasing concentration of incomes received by the nation's wealthiest citizens during the buoyant stock market of 1995–2000. Renewed revenue growth first produced significant budgetary surpluses and then, in 2001, it enabled the administration of president George W. Bush to cut taxes dramatically. Meanwhile, talk of adopting a new tax regime, in the form of a "flat tax" or a national sales tax, nearly vanished. At the beginning of the twenty-first century, the overall rate of taxation, by all levels of government, was about the same in the United States as in the world's other modern economies. But the United States relied less heavily on consumption taxes, especially value-added taxes and gasoline taxes, and more heavily on social security payroll taxes and the progressive income tax.
Becker, Robert A. Revolution, Reform, and the Politics of American Taxation, 1763–1783. Baton Rouge: Louisiana State University Press, 1980. Sees conflict within the colonies and states as an important part of the American Revolution.
Beito, David T. Taxpayers in Revolt: Tax Resistance during the Great Depression. Chapel Hill: University of North Carolina Press, 1989. A neoconservative approach to the history of taxation during the New Deal era.
Brownlee, W. Elliot. Federal Taxation in America: A Short History. Washington, D.C., and Cambridge, U.K.: Wilson Center Press and Cambridge University Press, 1996. Includes a historiographical essay.
Brownlee, W. Elliot, ed. Funding the Modern American State, 1941–1995:The Rise and Fall of the Era of Easy Finance. Washington, D.C., and Cambridge, U.K.: Cambridge University Press, 1996.
Fischer, Glenn W. The Worst Tax? A History of the Property Tax in America. Lawrence: University Press of Kansas, 1996. The best single volume on the history of property taxation.
Jones, Carolyn. "Class Tax to Mass Tax: The Role of Propaganda in the Expansion of the Income Tax during World War II." Buffalo Law Review 37 (1989): 685–737.
King, Ronald Frederick. Money, Time, and Politics: Investment Tax Subsidies in American Democracy. New Haven, Conn.: Yale University Press, 1993. Stresses a post–World War II victory for a "hegemonic tax logic" based on the needs of American capitalism.
Leff, Mark. The Limits of Symbolic Reform: The New Deal and Taxation, 1933–1939. Cambridge, U.K.: Cambridge University Press, 1984. Interprets President Franklin Roosevelt's interest in progressive taxation as symbolic rather than substantive.
Ratner, Sidney. Taxation and Democracy in America. New York: Wiley, 1967. The classic interpretation of the expansion of income taxation as a great victory for American democracy.
Stanley, Robert. Dimensions of Law in the Service of Order: Origins of the Federal Income Tax, 1861–1913. New York: Oxford University Press, 1993. Regards the income tax as an effort to preserve the capitalist status quo.
Stein, Herbert. The Fiscal Revolution in America. Rev. ed. Washington, D.C.: AEI Press, 1990. Explores the influence of "domesticated Keynesianism" on fiscal policy, including the Kennedy-Johnson tax cut of 1964.
Steinmo, Sven. Taxation and Democracy: Swedish, British, and American Approaches to Financing the Modern State. New Haven, Conn.: Yale University Press, 1993. A model study in comparative political economy applied to international tax policy.
Steuerle, C. Eugene. The Tax Decade: How Taxes Came to Dominate the Public Agenda. Washington: Urban Institute, 1992. The best history of the "Reagan Revolution" in tax policy.
Wallenstein, Peter. From Slave South to New South: Public Policy in Nineteenth-Century Georgia. Chapel Hill: University of North Carolina Press, 1987. The best fiscal history of a single state.
Witte, John F. The Politics and Development of the Federal Income Tax. Madison: University of Wisconsin Press, 1985. The leading history of the income tax from a pluralist point of view.
Zelizer, Julian E. Taxing America: Wilbur D. Mills, Congress, and the State, 1945–1975. Cambridge, U.K.: Cambridge University Press, 1998. Interprets the powerful chair of the House Ways and Means Committee as a reformer.
See alsoBudget, Federal ; Capitation Taxes ; Debts, Revolutionary War ; Excess Profits Tax ; Hamilton's Economic Policies ; Inheritance Tax Laws ; Negative Income Tax ; Poll Tax ; Pollock v. Farmers' Loan and Trust Company ; Revenue, Public ; Revolution, American: Financial Aspects ; Sales Taxes ; Social Security ; Stamp Act ; Tariff .
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The Chicago Manual of Style
American Psychological Association
TAXATION. Early modern Europe was home to a bewildering array of taxes. The church collected tithes, lords exacted feudal dues, towns imposed customs duties, and rulers levied state taxes. Although there were multiple channels by which fiscal resources were extracted and redistributed throughout society, this essay will focus on state taxation, which expanded most dramatically in this period. To meet growing costs of war and debt, rulers across Europe raised taxation to unprecedented levels, forming what historians call "tax states." The tax state was not wholly powered by a modern centralized bureaucracy, but it had a profound effect on early modern politics and society. On the one hand, it reinforced social inequality, as rulers created fiscal alliances with elites and levied taxes on the common people. On the other hand, the tax state shaped early modern politics, as revenue-hungry sovereigns clashed with representative institutions and provoked popular tax rebellions. Even as popular tax revolts subsided in the eighteenth century, ideas linking taxation, citizenship, and political representation fueled revolution in the British colonies and in France.
THE RISE OF THE TAX STATE
Taxation was essential to the development of the modern state. In the Middle Ages, kings mainly "lived of their own," that is, supported themselves with revenues from the royal domain, which included income from crown lands and various feudal and regalian dues. Over the early modern period, however, European monarchies expanded beyond the medieval domain to levy taxes. Tax revenues mounted steadily across Europe in the sixteenth century, even taking high population growth and inflation into account, and soared to new heights in the seventeenth and eighteenth centuries. Not all European countries followed this trend; Brandenburg-Prussia relied heavily on domain revenue as late as the eighteenth century. But the overall pattern is clear: the early modern tax state eclipsed the medieval domain state and considerably expanded the financial resources of rulers.
The tax state was a child of war. In this period of "military revolution," as armies grew spectacularly in size and required increasingly intensive training and elaborate supply networks, the costs of war skyrocketed. French military expenses increased five to eight times during the seventeenth century; Spanish war expenditure peaked in the 1650s; the English budget increased, in real terms, at least sixteen-fold between the late sixteenth and early eighteenth centuries; expenditure in Denmark and the United Provinces also accelerated dramatically. Consequently, rulers across Europe scrambled to find revenue by increasing "ordinary" taxes and creating new "extraordinary" ones that, with time, would be deemed ordinary as well. Monarchs became keenly aware of the fact that projecting power abroad depended on financial strength at home.
For ambitious sovereigns, however, there seemed never to be enough tax revenue available to finance military campaigns. Thus, in the city-states of Italy and the Netherlands, and then in unified monarchies, rulers began to borrow and accumulate debt. This recourse to credit, in turn, contributed to the growth of taxation, because short-term war debt was often consolidated into long-term debt serviced with tax revenue. If, in the sixteenth century, taxes were used principally to pay for burgeoning state administrations as well as war, in the seventeenth and eighteenth centuries, the vast majority of tax revenue was spent on military campaigns and the increasingly large debts they generated. As a result, belligerent states in the seventeenth and eighteenth centuries confronted a spiral of war, debt, and taxation that, as we shall see, profoundly shaped the political life of the age.
Although the fiscal weight of the state grew rapidly in the early modern period, it should not be inferred that states developed modern centralized bureaucracies of the kind associated with "absolutism." Today, historians stress the limits of the absolute state and emphasize how powerful monarchs like Louis XIV (ruled 1643–1715) had to negotiate with elites and regional and local institutions.
In practice, even "absolute" sovereigns could not tax at will. Although there was little theoretical recognition of the citizen's right to consent to taxation before the eighteenth century, rulers regularly sought the consent and cooperation of corporate institutions to reduce resistance to the tax levy. In addition to dealing with law courts, church organizations, and municipal governments, monarchs consulted with a host of representative bodies that flourished in the early modern period. The Spanish monarchy negotiated with the Castilian Cortes; the Holy Roman emperor dealt with the Imperial Diet (just as territorial princes in the German lands worked with provincial diets); French kings summoned the Estates-General and provincial Estates; and the English crown consulted Parliament. Representative bodies haggled over the weight and form of taxes but usually found it in their interest to compromise with monarchs, who rewarded their acquiescence with fiscal and administrative privileges. Representative institutions were also willing to compromise at times, because the elite social groups they represented (clergy, nobility, urban notables) were heavily invested in state debt and did not want to interfere with taxes that funded their interest payments. In this respect, there was an inherent tension between the financial interests of ordinary taxpayers, who wished to minimize the tax burden, and those of wealthier state creditors, who feared that poor tax yields might jeopardize returns on their investments.
Negotiations between rulers and corporate bodies did not, however, always run smoothly. In seventeenth-century England, fiscal strife combined with religious conflict to produce a constitutional crisis and civil war. When the early Stuart kings sought to levy new subsidies, forced loans, and ship money, Parliament reacted by asserting its right to consent to taxation. In 1640, after Charles I refused to work with Parliament, the crisis turned into a bloody civil war in which the king was executed. Ironically, the English Civil War and the Glorious Revolution of 1688, both of which secured for Parliament a central role in the English constitution, ultimately made it easier for the English state to raise taxes. Eighteenth-century England and the Netherlands experienced the highest rates of taxation in Europe, owing in large part to the sense of legitimacy that representative institutions in both countries bestowed on tax levies.
Elsewhere in Europe, the relationship between monarchs and corporate bodies evolved differently. In the Fronde of 1648, the Parlement of Paris challenged the fiscal policies of the crown, but it was not nearly as successful as the English Parliament. The French monarchy not only quelled the Fronde, but stopped calling the Estates-General after 1614–1615 and replaced many provincial Estates with more easily controlled royal officers. But even in "absolutist" France the monarchy did not completely prevail, for the surviving provincial Estates (in Languedoc and Brittany, for instance) continued to drive hard bargains with kings and to administer taxes in their regions down to 1789. Yet another scenario unfolded in Castile, the heart of the Spanish empire, where the once instrumental Cortes faded from power in the seventeenth century as the Spanish monarchy grew weaker.
Just as we should be careful not to infer that the rise of the European tax state automatically reflected the development of absolutist institutions, we should not assume that rising tax levels were the result of increasingly efficient and centralized administrations. On the contrary, early modern tax systems were extremely fragmented. Many rulers relied on tax farming, a practice whereby taxes were franchised to semiprivate financiers who paid fixed sums of money in return for the right to collect taxes. These tax farmers were allowed to pocket the difference between the amounts of revenue they collected and the lump sums they had advanced. Not all taxes were farmed. Rulers also entrusted the task of levying certain taxes to official state administrators, but even in this case administrators could not collect taxes without the active participation of villages and local heads of household. Consider the example of the taille, the main direct tax in France from the fifteenth century to the French Revolution. Every year, the global sum of the taille was divided among the kingdom's parishes. Each parish was assigned a lump sum of money and was held responsible for collecting and forwarding that sum to tax receivers. Royal financial officials supervised the levy, pressuring recalcitrant villages and adjudicating disputes, but the crucial tasks of drawing up tax rolls and collecting revenue were left to parish assessors and collectors appointed by local village assemblies. Without the participation of thousands of village assemblies across France, even the mighty French crown would not have been able to levy the taille.
FORMS AND SOCIAL INCIDENCE OF TAXATION
The burden of the tax state was not shouldered equally by all social groups. Although it is difficult to determine with precision who paid taxes in early modern Europe, it is safe to say that the two main types of taxes, direct and indirect, were generally regressive. In both cases, common people—the peasants and artisans who made up the majority of the population—paid higher proportions of their income than did wealthy elites.
Indirect taxes, which many monarchs and town magistrates preferred because they were less intrusive than direct taxes, predominated in urban and commercial areas of Europe such as England, Italy, and the Netherlands. Taking the form of tolls, excise taxes on consumer goods, and taxes on salt, tobacco, and other goods sold by state monopolies, indirect taxes fell on consumers in a highly regressive fashion. Levied on such staples as grain, meat, beer, wine, and salt, indirect taxes imposed a proportionally heavy burden on urban workers who had to purchase basic commodities with relatively little disposable income. In the towns of Castile, where excise taxes on wine and oil could double the price of such goods, wage earners suffered a reduction of purchasing power on the order of 30–50 percent. In Paris, whose residents enjoyed privileges with respect to direct taxes, indirect taxation was rather heavy. It has been calculated that in 1789, the average Parisian head of household needed fifty-six days to work off his taxes. During periods of economic growth, indirect taxes were easier to bear, but in bad times, when wages stagnated or unemployment rose, they could become quite oppressive.
Levied on landed income and property, we might expect direct taxes to have been less regressive. But this was not usually the case, because the wealthy and powerful often held the privilege of exemption. Consider once again the example of the principal direct tax in France, the taille. The most remarkable feature of the taille was the number of people who did not have to pay it. In much of France, clergymen, nobles, bourgeois, venal officeholders, royal administrators, and residents of certain provinces and towns enjoyed at least partial exemption from the taille. This meant that the weight of the tax fell overwhelmingly on the peasantry. It has been estimated that in the late seventeenth century the taille and other direct taxes absorbed on average one-fifth of the peasantry's gross production. Wealthier peasants appear to have carried most of this burden, but the poorest peasants had a difficult time scraping together enough cash to pay even the tiniest assessments. In a hierarchical society riddled with privilege, the taille was so closely associated with low status that Cardinal Richelieu (1585–1642) believed it unwise to relieve the common people of this burden because "they would lose the mark of their subjection and consequently the awareness of their station." Similar sentiment existed in Sweden, the German lands, and Castile, where the payment of direct taxes was also a sign of common birth.
If regressive taxation reflected the steep social hierarchy of the early modern period, so too did the ways in which the state spent the tax revenue it collected. As historians have recently emphasized, monarchs not only drew the lion's share of tax revenue from peasants and artisans but, with state spending, redistributed that revenue up the social hierarchy to nobles, officeholders, and other elites. In seventeenth-century Languedoc, as much as a third of the province's tax revenue passed directly to regional notables in the form of pensions, salaries, and interest payments. Extracting and redistributing tax revenue on a massive scale, early modern states doubly reinforced the social inequalities of the age.
POPULAR TAX REVOLTS
Given the weight and incidence of taxation, it may come as no surprise that levies encountered a good deal of popular resistance in the early modern period. The medieval notion that a king was supposed "to live of his own" did not quickly fade, leading many to believe as late as the seventeenth century that regular taxation was a dangerous innovation. In such a climate, any attempt to create a new tax or increase an old one, even when the justification of military defense was invoked, could be met with great skepticism. Ever dubious and resourceful, taxpayers found ways to evade or at least minimize their fiscal obligations. Heads of households escaped full liability for direct taxes by hiding or falsely reporting their wealth or, in the case of powerful individuals, by exerting influence over local tax assessors. As for indirect taxes, smugglers formed vast underground networks that circumvented customs and excise taxes to supply consumers with untaxed commodities at lower prices.
Resistance could also take the more direct form of open revolt. In addition to, and sometimes linked to, the challenges to taxation mounted by representative institutions, popular tax revolts broke out sporadically across Europe throughout the early modern era. From the late sixteenth to the mid-seventeenth century, when intense warfare was coupled with economic and demographic crisis, a particularly destabilizing series of tax rebellions erupted in the German lands, Spain, Portugal, Naples, England, and France. It is important to note that these revolts were not irrational explosions of violence carried out by the hopelessly poor. Rather, as recent research emphasizes, revolts were deliberate political acts in which a variety of social groups participated.
The revolts that shook France in the first half of the seventeenth century are particularly well studied, and they suggest how and why uprisings occurred. It should be stated at the outset that rebellions in this period were not aimed solely at taxes; crowds also gathered to protest military conscription, the billeting of troops, high food prices, seigneurial dues, and religious heresy. But from 1630 to 1660 tax revolts were by far the most prominent form of protest in France. In this period of economic, military, and fiscal turmoil, taxpayers assembled on numerous occasions to submit petitions for tax relief to authorities. When such acts of protest proved unsuccessful, crowds gathered to keep tax officials at bay—by force if necessary. Moved by a sense of communal justice, taxpayers enacted mock trials and burned tax officials in effigy, broke into or burned down tax collectors' houses, and verbally or physically harassed collectors to run them out of town. Although the most violent incidents of collective action involved beating or stoning officials, such activity was not revolutionary in the modern sense of the term. Appealing to God, king, and custom rather than revolutionary principle, crowds believed that their attempts to block new taxes (or sudden tax increases) were part of a larger plan to restore the traditional order. "Long live the king without the salt tax," French protesters cried, looking backward to a time when the crown supposedly did not impose harmful fiscal innovations. Just because revolts were backward-looking, however, does not mean that they failed to achieve practical results. Revolts did achieve temporary successes, when tax collectors were chased out of town or when controversial tax initiatives were withdrawn. But revolts were just as likely to provoke brutal repression by the royal army.
One of the most extraordinary features of tax revolts was the participation of different social groups. It is not surprising that destitute peasants, artisans, and day laborers joined the fray, since taxation threatened to take what little cash they possessed. But in seventeenth-century France, wealthier peasants and artisans, local elites, and even nobles were similarly moved to participate in revolts or at least abet them from behind the scenes. Wealthier peasants paid the bulk of direct taxes and so had a strong interest in stopping tax increases. Noble landlords saw rebellion as a means to retain regional liberties and expand their power, but they, too, had a financial interest in tax revolts, for they competed with the crown for the economic surplus produced by the peasantry. Although nobles paid comparatively little in taxes, they understood that higher taxes on the peasantry would lead to lower rents and feudal dues. Thus, when Louis XIII (ruled 1610–1633) dramatically increased taxes in the 1620s and 1630s, many nobles supported popular sedition. Not all joined in, for some elites feared that revolt would cut off royal revenue and endanger the financial perquisites they received from the crown, but for many the prospect of losing revenue from their land outweighed other considerations.
REFORM AND REVOLUTION IN THE EIGHTEENTH CENTURY
Although traditional tax revolts died down in the eighteenth century, taxation became a key issue in the American and French Revolutions. In both cases, revolution stemmed from the tremendous fiscal burden that weighed on Britain and France as the two countries engaged one another in a series of protracted, global, and costly wars that have been likened to a second Hundred Years' War. For both countries, the financial response to the burden of war would have far-reaching political consequences.
From the Glorious Revolution of 1688 to the defeat of revolutionary France in 1815, Britain ascended to great power status on the wings of a "financial revolution" in which Parliament guaranteed the security of a permanent and rapidly expanding national debt. Although historians once believed that the spectacular growth of English public credit compensated for the country's supposedly weak tax system, today they attribute much of the success of English credit to the efficiency and reliability of taxes. At bottom, England's tax system was effective because elites consented to taxation through their representatives in Parliament. In the 1690s, for example, Parliament agreed to the levy of a land tax on the propertied classes that would spare no landowner, be he gentleman or cleric. The land tax was significant not only because it touched elites and provided an important source of revenue, especially to 1714, but also because it secured the political power of Parliament—and the landed gentry that the institution represented—in a new constitutional order. The English monarchy learned that it had much to gain financially by consulting Parliament; Parliament learned to tolerate the fiscal and administrative expansion of the English state in return for the right to scrutinize public finances. At the end of the eighteenth century, Parliament replaced the land tax with a modern income tax, a remarkable innovation that required all heads of household with annual incomes above fifty pounds to declare their wealth for assessment.
We should be careful, however, not to exaggerate the fiscal generosity of English elites. The land tax, which Parliament never allowed to be administered by a royal bureaucracy, was applied unevenly and fell dramatically over the century in proportion to total tax revenue. Likewise, the income tax was quickly repealed once France was defeated. The two taxes demonstrate that while English elites were willing to contribute direct taxes to a state in which they enjoyed representation, they did not intend to pay too much for this political privilege. Indeed, despite notable innovations in direct taxation, crown and Parliament ensured that indirect taxation, in particular the regressive excise tax, would become the true backbone of the eighteenth-century English fiscal system. Climbing to dizzying heights over the century, the excise tax raised the vast majority of the revenue that funded the loans of the Seven Years' War (1756–1763) and the American War of Independence (1775–1783). Backed by parliamentary statute and staffed by an astonishingly modern bureaucracy, the excise administration made English consumers pay for the nation's international power.
If Britain excelled in the fiscal rivalry that characterized eighteenth-century international relations, it did so despite the rebellion of its North American colonies. In light of the critical role Parliament played in lending legitimacy to English taxes, it is not all that surprising that North American colonials balked when the crown attempted to impose new taxes in the wake of the costly Seven Years' War. In the absence of colonial representation in Parliament, and with the elimination of the French threat in North America, colonials perceived the new taxes and duties of the late 1760s and early 1770s as the work of a despotic government. "No taxation without representation," they exclaimed, insisting that all British taxpayers had a right to national political representation. With the spread of such constitutional ideas, what began as a tax revolt quickly turned into republican revolution.
Taxation was also an important cause of the French Revolution. Because French kings periodically repudiated debts (and were therefore known as risky borrowers), the French royal debt was more expensive to service than English national debt, putting additional stress on the French tax system. As in England, France increasingly relied on indirect taxes over the eighteenth century, but French indirect taxes never reached the proportions of total tax revenue that English indirect taxes did. Direct taxes remained essential in France, and it was here that the French crown initiated its most ambitious reforms. The crown not only conducted land surveys in certain provinces to improve the repartition of the taille; it also created new universal taxes (the capitation, dixième, and vingtième ) aimed at individuals, including nobles, who had formerly enjoyed the privilege of tax exemption. (The creation of universal taxes in France was part of a general trend among eighteenth-century European governments to end noble tax privileges; similar reforms were instituted in Artois, Flanders, Luxembourg, Savoy, Holland, and Prussia). Although French universal taxes bolstered direct tax revenues, they were woefully inadequate to the task of funding military expenditure and debt. Even when combined with rising indirect tax revenue, they did not substantially raise the incidence of real, per capita taxation.
Looked at another way, however, the new universal taxes proved all too successful. Because they did indeed strike nobles and other privileged groups, they alienated elites who, unlike their counterparts across the channel but much like Britons in North America, did not enjoy representation in a national legislature. As a result, French courts of law became increasingly sensitive to the issue of taxation and publicized the need for an institutional bulwark against the monarchy. Seeking to fend off increases in universal taxes from the Seven Years' War on, courts disseminated subversive concepts of national sovereignty, political representation, and the rights of citizenship. In 1789, revolutionaries drew on this and other fiscal-political rhetoric to launch both a constitutional revolution, in which a National Assembly would seize the power to tax from the monarchy, and a social revolution, in which the Third Estate would claim political rights based on its tax contributions to the state. Once in power, revolutionaries abolished indirect taxes, expunged vestiges of privilege from direct taxation, and formally linked taxation and citizenship by extending political rights to taxpayers. By the late eighteenth century, taxation had become invested with revolutionary significance.
See also Absolutism ; Military ; Popular Protest and Rebellions ; Representative Institutions ; Revolutions, Age of ; State and Bureaucracy .
Beik, William. Absolutism and Society in Seventeenth-Century France: State Power and Provincial Aristocracy in Languedoc. Cambridge, U.K., and New York, 1985.
Bercé, Yves Marie. History of Peasant Revolts: The Social Origins of Rebellion in Early Modern France. Translated by Amanda Whitmore. Cambridge, U.K., 1990.
Bonney, Richard, ed. Economic Systems and State Finance. Oxford and New York, 1995.
——. The Rise of the Fiscal State in Europe, c. 1200–1815. New York, 1999. A useful collection of essays on early modern public finance in several European countries.
Bossenga, Gail. "Taxes." In A Critical Dictionary of the French Revolution. Edited by François Furet and Mona Ozouf. Translated by Arthur Goldhammer. Cambridge, U.K., 1989.
Brewer, John. The Sinews of Power: War, Money and the English State, 1688–1783. London and Boston, 1990. A compelling study of the fiscal changes behind England's rise to power in the eighteenth century.
Collins, James B. Fiscal Limits of Absolutism: Direct Taxation in Early Seventeenth-Century France. Berkeley, 1988.
Herlihy, David, and Christiane Klapisch-Zuber. Tuscans and Their Families: A Study of the Florentine Catasto of 1427. New Haven, 1985.
Hoffman, Philip T., and Kathryn Norberg. Fiscal Crises, Liberty, and Representative Government, 1450–1789. Stanford, 1994. Analyzes the relationship between fiscal and political development in England, the Netherlands, Spain, and France.
Kwass, Michael. Privilege and the Politics of Taxation in Eighteenth-Century France: Liberté, Égalité, Fiscalité. Cambridge, U.K., and New York, 2000.
Mathias, Peter, and Patrick O'Brien. "Taxation in Britain and France, 1715–1810." Journal of European Economic History 5 (1976): 601–650.
Tilly, Charles. The Contentious French. Cambridge, Mass., 1986. Contains descriptions and analysis of French tax revolts in the sixteenth and seventeenth centuries.
Tracy, James D. "Taxation and State Debt." In Handbook of European History, 1400–1600: Late Middle Ages, Renaissance, and Reformation. 2 vols. Edited by Thomas A. Brady Jr., Heiko A. Oberman, and James D. Tracy. Leiden and New York, 1994.
"Taxation." Europe, 1450 to 1789: Encyclopedia of the Early Modern World. . Encyclopedia.com. (February 20, 2018). http://www.encyclopedia.com/history/encyclopedias-almanacs-transcripts-and-maps/taxation-0
"Taxation." Europe, 1450 to 1789: Encyclopedia of the Early Modern World. . Retrieved February 20, 2018 from Encyclopedia.com: http://www.encyclopedia.com/history/encyclopedias-almanacs-transcripts-and-maps/taxation-0
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Elderly persons are treated very well by the U.S. federal tax system and by the tax systems of many states and localities. They get an extra federal standard deduction, Social Security benefits are taxed lightly or not at all, pensions get special relief, and state and local property tax burdens are often offset by income tax relief. It is not, however, easy to provide a simple, widely accepted philosophical justification for taxing an elderly person at a lower rate than a younger person with the same income.
These tax concessions may simply reflect the political power of elderly voters. People sixty-five and over constituted 16.5 percent of the voting age population in the 1996 election, but provided over 20 percent of the votes. Their political importance will grow considerably when an increasing number of baby boomers reach age sixty-five in the years following 2010.
Despite the political power of older voters, it is hard to believe that significant tax breaks would be possible without the tacit support of the younger population. Older people are popular. Many are peoples’ grandparents, and young people certainly hope to survive to an age at which they too can enjoy the tax concessions granted older adults.
However, it must be noted that the benefits conveyed to older Americans have a considerable cost—a cost that will rise as the population ages. The related revenue loss must be added to the much larger benefits appearing on the spending side of the budget. Social Security is now the largest single federal program and Medicare spending will soon exceed defense spending. Those over sixty-five absorb about 50 percent of the civilian, noninterest expenditures of the federal government. Although the tax preferences given to older Americans are quite small relative to the benefits received on the spending side of the budget, they do add up. They also imply that younger workers are forced to pay higher taxes than they would otherwise. Given American hostility to higher taxes, it is probable that the benefits conveyed to older adults on both the spending and tax side of federal, state, and local budgets tend to crowd out other government activities in areas such as defense, child welfare, and highways.
Federal tax law
The most important federal tax break involves the taxation of Social Security. Benefits are completely excluded from taxable income for lower-income elderly taxpayers. Single taxpayers with $25,000 to $34,000 in income, and couples between $32,000 and $44,000, receive 50 percent or more of their benefits tax-free, while singles with incomes above $34,000 and couples above $44,000 must pay taxes on up to 85 percent of benefits. A complex formula is used to phase in the taxation of benefits, and it has the peculiar result that over certain ranges of income the marginal tax rate on an extra dollar of non-Social Security income is higher than on an extra dollar of benefits. During the phase-in ranges, Social Security recipients are also subjected to very high marginal tax rates on extra earnings or on extra income from investments, because every extra dollar of such income has a double impact on a person’s tax bill. It is subject to taxation itself, and it adds to the portion of Social Security benefits that will be taxed. This could create disincentives to work and to save. The exclusion of Social Security benefits from ordinary taxable income cost the federal government $17.1 billion in lost revenue in fiscal year 1999.
It has been proposed that it would be proper to include 85 percent of Social Security benefits in taxable income for everyone. The other 15 percent reflects the estimated return of principal invested out of after-tax dollars in a typical private pension plan that enjoys no tax advantages. However, the creation of IRAs, Keoghs, 401(k) plans, and the like has made tax law much more favorable to private retirement savings. Contributions to such plans are deducted from taxable income and withdrawals are fully taxed. Only contributions in excess of the limits imposed for such plans are deprived of tax advantages and contributions of this type are uncommon.
If Social Security is seen as a typical tax-advantaged retirement plan and treated like most other retirement saving plans, it would be appropriate to subject 50 percent of benefits to taxation while allowing 50 percent to be tax free. That is because the 50 percent of the payroll tax that is paid by employers is deducted from their taxable income, while the 50 percent that is paid by employees is financed out of after-tax income.
On the other hand, it might not be appropriate to regard Social Security as a typical retirement plan, because the level of benefits is only loosely related to the payment of payroll taxes. People with lower lifetime earnings receive a higher rate of return than those with higher earnings, dependent spouses receive an extra benefit equal to 50 percent of that of the principal earner, and the return on one’s payroll tax contribution can depend on when income was earned. Consequently, it may be more accurate to regard Social Security as a transfer program that distributes money from high to low earners rather than as a pension program. But there is no consistent rule governing the taxation of transfer payments. For example, unemployment insurance benefits are included in taxable income, while welfare payments are not.
The taxation of benefits obviously reduces their net value, particularly for those affluent taxpayers who are in the highest tax brackets. Thus, the taxation of benefits can be seen as an indirect approach to means-testing Social Security since the tax imposes the largest burden on the most affluent beneficiaries. Given the rapidly rising economic burden that will be imposed by Social Security once baby boomers start to retire, there may be a strong argument for subjecting 100 percent of benefits to taxation as a way of strengthening means-testing.
It should be noted that the taxation of Social Security benefits is a relatively recent phenomenon. Before 1983, benefits were not taxed at all. After that time, a maximum of 50 percent of the benefit was brought into taxable income. The proportion brought into taxable income was not raised to 85 percent for more affluent taxpayers until 1993.
A less important federal tax concession provides an extra standard deduction to each individual age sixty-five and older. In 1999, this equaled $1,000 for single taxpayers and $800 each for married taxpayers. The associated revenue loss was $1.8 billion in fiscal 1999. There is also a nonrefundable tax credit for low-income retirees whose retirement income is mostly taxable, but this credit is rarely used.
Because the use of the standard deduction declines as income rises, the extra standard deduction is most valuable, on average, to lower-income elderly taxpayers. Only about 10 percent of elderly couples with incomes between $20,000 and $30,000 itemize deductions while itemized deductions are used by a substantial majority of those with incomes above $80,000. However, only 15 percent of elderly couples had incomes that high in 1998.
The elderly receive Medicare and Medicaid benefits tax-free, as well as an untaxed subsidy for the purchase of insurance for physician services. Although it would be practically possible to tax such items, it would be extremely unpopular politically. It should be noted that employer-provided health insurance is also tax-free, as are Medicaid benefits.
As noted earlier, private saving for retirement is now highly favored by the federal tax system. Employers’ contributions to defined benefit plans are not, for the most part, considered to be taxable income to the employee. Employer and employee contributions to defined contribution plans are deductible up to specified limits that differ from plan to plan. The tax saving associated with the deduction for contributions into a retirement account is sufficient to pay the tax on future withdrawals if the tax saving is invested at the same rate of return as the rest of the account—and if withdrawals are taxed at the same tax rate as was applicable when the contribution was made. Put another way, it is equivalent, under these very special assumptions, to eliminating the entire tax on income saved for retirement. If the retiree is in a lower tax bracket when funds are withdrawn than when funds were contributed, he or she receives a tax subsidy for retirement saving. That is to say, the after-tax return on the retirement account becomes greater than the before-tax rate of return.
The law provides for a confusing array of defined benefit and defined contribution accounts that have different deduction limits and are subjected to different tax rules. The regulation of such accounts, especially defined benefit plans, is also extremely complicated. The system badly needs simplification.
Whether tax-favored, private retirement accounts improve the income of retirees depends on the extent to which the tax incentives actually increased the retirement savings of people while they were working. There is profound disagreement among economists on this point. Some believe that the tax concessions induce a sizeable increase in retirement saving. Others argue that the savings deducted from taxable income largely represents either transfers from other accounts or saving that would have occurred even in the absence of tax concessions. The naysayers believe that the increase in private saving is less than the associated revenue loss to the federal treasury.
State income taxation
Tax burdens on older adults vary greatly from state to state. Many replicate federal law in allowing an extra standard deduction, and some do not tax Social Security benefits at all. Many also exclude a large portion of other types of retirement income. This creates a severe inequity between people whose income flow is in the form of pensions and people who get exactly the same income from interest and dividends that are fully taxed. Table 1 describes selected tax provisions that especially affected elderly taxpayers in different states in 1998. It does not include provisions related to property taxes.
The combination of federal and state income tax burdens
The total income-tax relief given older adults can be very important. The precise amount of the relief, however, depends on how income is received. In Tax Benefits for the Elderly (2000) Rudolph Penner presents a number of examples, loosely based on data from the Statistics of Income (U.S. Treasury, Internal Revenue Service). One example involves a retired couple age sixty-five or older with $67,372 in income (in 1998) who get 24 percent of their income from Social Security, 40 percent from pensions and annuities, 30 percent from interest and dividends, and 5 percent from earnings. In Hawaii, such a couple would pay about $5,500 less in taxes than a younger couple receiving the same total income from wages. The tax liability of the older couple is thus reduced by 36 percent, or by 8.1 percent of income. In South Carolina, the elderly couple would receive a tax cut of about $4,000, or 6.0 percent of income. In Georgia, the benefit is about $2,100, or 3.2 percent of income. None of the above figures count property tax concessions. In all cases, the tax cut for older couples would be much lower if almost all income came from wages and interest and dividends.
For lower incomes, the percentage cut in the tax liability is usually higher, although the absolute value of the cut declines. Assuming $28,323 of income, with 37 percent derived from Social Security, 33 percent from pensions and annuities, 15 percent from interest and dividends, and 15 percent from earnings, the percentage tax cuts in Hawaii, Georgia, and South Carolina are 12.1 percent, 9.8 percent, and 9.2 percent, respectively. Because the percentage cut tends to grow at lower income levels, it can be said that the tax concessions given to elderly persons tend to be progressive. However, it must be reemphasized that they also tend to be erratic. A person who decides to work after the normal retirement age and who does not benefit from a tax-free pension will, in many states, receive much less of a tax break than a retired person with exactly the same income from Social Security and private pensions. Because people tend to retire earlier if they have a more generous pension, the tax concessions provided for retirement income undoubtedly encourage some to retire earlier than they would without the tax concession.
Property tax relief
Many states provide income tax relief related to property taxes paid at the state and local level. Often, the relief is restricted to elderly persons. In some states, such as Washington, people as young as sixty-one can qualify. The disabled often also qualify.
There are two types of relief. The first is often referred to as a circuit breaker and is confined to low-income taxpayers. For example, Connecticut, Nebraska, New Jersey, Ohio, and Washington all have special provisions of this type focused on the elderly, but in all cases, the relief phases out at relatively low income levels. The second type of relief provides a property tax exemption that does not depend on income. Alabama, Kentucky, Mississippi, South Carolina, and West Virginia have provisions of this type targeted at the elderly. For example, an exemption of assessed value up to $20,000 is provided in West Virginia. The average residential property-tax rate in the state is about 1.2 percent, so that the amount of relief for average property owners is $240. Generally, property-tax relief consists of relatively small concessions compared to the income-tax relief described earlier.
Estate and inheritance taxes are imposed at the time of death and are extremely important to affluent elderly persons. The federal estate tax exempts $675,000 of lifetime taxable transfers of wealth, and this amount is now scheduled to rise in steps described in a tax law passed in May of 2001. The first increase is to $1,000,000 in 2002 and 2003, and ultimately the exemption is increased to $3.5 million in 2009. With a modicum of estate planning, couples can double the basic exemption although the new law will impose limits on this privilege in future years. After the exemption is exhausted, a tax rate of 37 percent is currently applied—a rate that gradually rises to 55 percent on taxable estates greater than $3 million, but these rates are to be lowered in the future. The federal estate tax is supposed to disappear altogether in 2010 and then to be reimposed in 2011, but that, as well as scheduled exemptions and rate reductions, could be changed many times before then.
Because of the large exemption, only 2 percent of estates pay the federal estate tax, but that figure greatly understates its effects. Only one member of a couple actually pays the tax, but it is of concern to both. Moreover, many avoid paying only because of judicious planning. Perhaps more important politically, many aspire to be rich enough to be affected, although few will attain the requisite amount of wealth.
For whatever reason, the tax is extremely unpopular and many who have no hope of paying it still regard it as being extremely unfair. Many consider it to be a tax on those who are frugal, hard working, and altruistic toward their descendants. Although special provisions ease the burden of the tax on those wishing to convey farms and small businesses to family members, many do not think that the special provisions are lenient enough and complain that the need to pay the tax forces sales of property. However, such sales are actually extremely rare.
Proponents of the tax praise its progressivity and see it as a tool for extracting taxes from those who have been skilled at avoiding income taxes through their lifetime, either legally or illegally. It is also seen as a device for preventing great concentrations of wealth.
The federal estate tax law now allows a 100 percent credit up to a certain limit against the federal estate tax for estate taxes levied by states. The limit on the credit is related to the taxable value of the estate. Because a state estate tax levied up to the limit does not impose any extra cost on taxpayers, all states impose so-called pick-up taxes that exploit the entire federal limit. The new law gradually reduces these credits and repeals them entirely in 2005.
Thirteen states and Puerto Rico levy inheritance taxes in addition to pick-up taxes, while four states have additional estate taxes. An inheritance tax depends on the size of the bequest left to an individual heir, whereas an estate tax depends on the total value of the estate left by the decedent, regardless of how it is spread among heirs. Estate and inheritance tax rates and basic exemptions vary greatly from state to state and often depend on the relationship between the beneficiary and the decedent, with close relatives being favored.
A strong trend has developed at the state level toward reducing or eliminating estate and inheritance taxes because they are so unpopular politically. In 1989, eighteen states levied inheritance taxes and eight levied estate taxes in addition to pick-up taxes. In January 1999, only fourteen states had inheritance taxes and four still had estate taxes. New York has been reducing its very heavy estate tax by raising exemptions and cutting rates.
Effects of state and local tax policy on location decisions
States have an additional reason to lower their estate and inheritance taxes. They do not want to pressure affluent elderly taxpayers into moving to states that have only pick-up taxes or very-low estate and inheritance taxes.
More generally, states and localities tend to use tax policy to compete for older Americans. They are considered to be attractive residents, especially those who are more affluent, because they are law abiding, often attract other forms of economic activity, and do not impose costs on local school systems.
Duncombe, Robbins, and Wolf (2000) have investigated the effect of state and local fiscal policy on the migration of retirees. They have found that inheritance, income, and property tax policies have more effect on location decisions than expenditures on social services and law enforcement. However, it takes very large tax cuts to provoke even tiny amounts of in-migration. The authors conclude the revenue losses are likely to far outweigh any economic and fiscal benefits derived from attracting older adults. In a much older study, Voss, Gunderson, and Manchin (1988) also concluded that tax factors are significant, but not overwhelmingly important. Both studies suggest that amenities offered by a state, such as climate, are much more important in affecting the migration patterns of older adults. Both studies also do statistical analyses that result in the perverse conclusion that high estate taxes seem to attract certain types of older migrants. This obviously fallacious result would seem to provide a further indication that tax burdens are a relatively unimportant determinant of where older people choose to live.
Federal, state, and local tax systems tend to treat elderly taxpayers very generously. The costs of this generosity will rise rapidly after 2010 when the number of elderly persons will grow at an extremely rapid rate and the number of workers will stagnate because of the continuation of low birth rates that began in the 1960s.
The devices used to provide tax relief to older adults often have erratic and inequitable effects. People with the same income can face quite different tax bills depending on how the income is received. If it is deemed desirable to provide tax relief to older individuals, it would be more equitable to do it with an extra exemption, a tax credit, or lower tax rates for all those over a certain age, say sixty-five, rather than concentrating relief on specific types of income likely to be received by old people, such as Social Security or pensions. Whether one chooses a credit, an extra deduction, or a lower tax rate would depend on how one believes that the tax relief should be shared by different income groups. Superficially, it appears somewhat odd to provide any tax relief at all to very affluent older taxpayers. However, the current tax and transfer system, along with private policies such as means tests for college financial assistance, already contain numerous disincentives for accumulating wealth. It is necessary therefore, to be cautious as to how far we should go in continually making the system more progressive.
Rudolph G. Penner
See also Estate Planning; Pensions; Retirement Planning; Savings; Social Security.
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Nalebuff, B., and Zeckhauser, R. J. ‘‘Pensions and the Retirement Decision.’’ In Pensions, Labor, and Individual Choice. Edited by David A. Wise. Chicago: University of Chicago Press, 1985. Pages 283–316.
National Conference of State Legislatures. Fiscal Affairs: State Death Taxes. Available on the World Wide Web at www.ncsl.org
Penner, R. ‘‘Tax Benefits for the Elderly.’’ The Retirement Project Occasional Paper No. 5. Washington, D.C.: The Urban Institute, 2000.
Poterba, J. M.; Venti, S. F.; and Wise, D. A. ‘‘How Retirement Savings Programs Increase Saving.’’ The Journal of Economic Perspectives 10, no. 4 (1996): 91–112.
U.S. Office of Management and Budget. ‘‘Tax Expenditures.’’ Analytic Perspectives: The Budget of the United States Government, Fiscal Year 2001. Washington, D.C.: U.S. Government Printing Office, 2000.
U.S. Treasury, Internal Revenue Service. Individual Income Tax Returns 1998. Washington, D.C.: IRS, 2001.
Voss, P.; Gunderson, R.; and Manchin, R. ‘‘Death Taxes and Elderly Interstate Migration.’’ Research on Aging 10 (1988): 420–450.
"Taxation." Encyclopedia of Aging. . Encyclopedia.com. (February 20, 2018). http://www.encyclopedia.com/education/encyclopedias-almanacs-transcripts-and-maps/taxation
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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.
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.
SEE ALSO Earned Income Tax Credit; Inheritance Tax; Negative Income Tax; Tax Credits; Tax Evasion and Tax Avoidance; Tax Relief; Taxes, Progressive; Taxes, Regressive; Transaction Taxes
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. Final Report. 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.
"Taxes." International Encyclopedia of the Social Sciences. . Encyclopedia.com. (February 20, 2018). http://www.encyclopedia.com/social-sciences/applied-and-social-sciences-magazines/taxes
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Taxation is the imposition of a mandatory levy on the citizens and/or the businesses of a country by their government. In almost every country, the government derives a majority of its revenues for financing public services from taxation. Most individuals will feel the impact of quite a number of taxes during their lifetimes. In addition, taxes have become a powerful instrument for policy makers around the world to use in attaining economic and social goals. As a result, the system of taxation in the United States and elsewhere has an impact on almost every business and investment decision that is made.
NATURE AND HISTORY OF U.S. TAXATION
In 1936, the U.S. Supreme Court defined a tax as "an exaction for the support of the Government." In this regard, there is no direct relationship between the exaction of revenue by the government and any benefit to be received by the taxpayer. As a result, a taxpayer, such as a corporate shareholder, cannot trace his or her tax payment to any particular governmental asset or program. Taxes may be distinguished in a similar fashion from licenses and from fees, which are payments made to the government for some special privilege granted or service rendered (such as a marriage license or a camping fee). They can also be distinguished from regulations and from penalties, which are charges imposed by government to eliminate or control a specific activity.
For taxes to pass constitutional muster, they must be levied on the basis of predetermined criteria. Not only must taxes be determined objectively, but also taxpayers must be able to calculate their tax liability ahead of time. Since most taxes are levied on a recurring or predictable basis, individuals can also engage in tax planning or in tax avoidance. In other words, they are free to conduct their lives in a way that minimizes the amount that must be transferred to the government in taxes.
Despite the adage that nothing is certain in the world but death and taxes, taxation has not always been the chief source of revenue for governments. While the primary goal of taxation is to provide the resources necessary to fund governmental expenditures, any taxing authority that has the power to control the money supply, such as the U.S. government, can satisfy its revenue needs merely by creating money. Complete reliance on this governmental power, however, would stimulate excess demand in the economy, which in turn would cause price inflation. Taxes, on the other hand, raise revenue with the opposite effect because they drain money from the private sector, causing a reduction in private consumption or investment expenditures.
Reflecting one of the rallying cries of the American Revolution—"No taxation without representation"—the system of taxation in the United States closely parallels the tax regime of England. At the time of its adoption in 1789, the U.S. Constitution gave Congress the power to levy and collect taxes. Promptly exercising this authority, Congress enacted was the Tariff Act of 1789, imposing a system of duties on imports called excise taxes. As a result, tariffs became the federal government's principal source of revenue.
As the scope of governmental activities and programs increased, additional sources of revenue were necessary to supplement the tariff system. However, the Constitution required that any direct tax imposed by Congress had to be apportioned among the states on the basis of their relative populations. Because the sizes of the states' populations differed, any tax on income would result in a different tax rate for the citizens of each state. Despite the apportionment requirement, Congress enacted the first federal income tax in 1861 to finance the vastly increased expenditures brought on by the Civil War.
While the original federal income tax was allowed to expire after the Civil War, it did lead to the successful effort to amend the Constitution. The Sixteenth Amendment to the Constitution became effective on February 25, 1913, providing that: "The Congress shall have 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." Without hesitation, Congress enacted the Revenue Act of 1913, on October 3, 1913 and made it retroactive to March 1, 1913.
As historical conditions changed and the federal government's need for additional revenues increased, Congress exercised its income taxing authority by the passage of many new revenue acts. Since each new piece of legislation simultaneously reenacted previous revenue acts and added new amendments to the law, it became necessary to research over one hundred separate statutory sources to determine what tax law was currently in effect. Eventually, in 1939, Congress resolved the confusion by systematically arranging all of the tax laws into the Internal Revenue Code of 1939, a permanent codification of the law that does not require reenactment.
MAJOR TYPES OF U.S. TAXES
Since its establishment in 1913, the income tax has played the dominant role in providing the funds with which the federal government operates. An income tax is an extraction of some of the taxpayer's economic gain, usually on a periodic basis. The federal government and almost every state government impose a tax on the income of individuals, corporations, estates, and trusts. A final tax reckoning, which involves the reporting of income and payment of taxes due, is made at the end of each year. However, in order to ensure tax collections, Congress has created a pay-as-you-go requirement, through a combination of payroll withholdings and estimated tax payments during the year.
Income is generally defined as any permanent increment to wealth. It does not include loans or any other temporary increments. As a general rule, Congress considers any incremental wealth to be taxable income, unless specific statutory authority excludes it. These increments to wealth can take many forms, such as cash, property other than cash, and services that are rendered to the taxpayer. While state governments set their own tax rules and rates, a majority of the states use the same definition of gross income as the federal government.
Unlike federal and state income taxes, wealth-transfer taxes are not significant revenue producers. Historically, the primary function of wealth-transfer taxes has been to hinder the accumulation of wealth by family units. Since 1976, the federal estate tax and the federal gift tax have been combined into one tax, known as the unified transfer tax. This unified system eliminates the distinction previously made between taxable lifetime transfers and transfers at death. Under this system, the value of a decedent's taxable estate is treated as his or her final gift.
Like federal income taxes, the tax rates on unified transfers are progressive. This means that an increasing percentage rate is applied to increasing increments of the tax base. Unlike the annual assessment of federal income taxes, the federal transfer tax is computed cumulatively on gifts made during a lifetime as well as on transfers at death. In addition, many states impose an inheritance tax on the right to receive property at death. Unlike an estate tax, which is imposed according to the value of property transferred at death, an inheritance tax is imposed on the recipient of property from an estate, although many wills provide that the estate should pay any inheritance taxes imposed on recipients of property.
In addition to income taxes and wealth transfer taxes, the federal government and most states impose some form of employment tax. The most common form of state employment tax is levied on wages, with the proceeds used to finance that state's unemployment compensation benefits program. In addition to its own unemployment tax, the federal government also imposes a Social Security tax on employers, employees, and self-employed individuals. The federal government uses proceeds from the Federal Insurance Contribution Act (FICA) tax to finance the payment of Social Security benefits as well as Medicare health insurance. If an employee will be eligible for Social Security and Medicare, the FICA tax is paid by both the employee and by his or her employer. Although subject to a different tax rate, self-employed individuals are required to pay FICA taxes on their net earnings from self-employment.
With only a few exceptions, state and local units of government in the United States also use the income tax and wealth transfer taxes as a source of revenue. In addition, these taxing jurisdictions have customarily relied on two other tax sources that generally escape taxation by the federal government:
- The annual assessment of property tax has traditionally been the backbone of the local revenue system. It is a tax on the value of property—usually only real property, such as land and buildings—owned within a jurisdiction by nonexempt individuals or organizations.
- In addition, most states and many local units of government impose sales taxes. This is a tax on the gross receipts from the retail sale of tangible personal property, such as automobiles and clothing, and certain services. Each taxing authority determines its own tax rate as well as the services and articles to be taxed. The seller collects the tax at the time of the sale, and then periodically remits the revenue to the appropriate taxing authority.
In the United States and other democracies, a majority of citizens—or their duly elected representatives—vote to impose taxes on themselves in order to finance public services on which they place value but which are not adequately funded by market processes. However, determining which individuals or households or businesses actually reduce their private consumption or wealth as a consequence of a tax is not always a straightforward matter. After all, although taxes affect numerous aspects of every-one's lives, their impact is not uncontrollable.
Tax planning is simply the process of arranging one's actions in light of their potential tax consequences. After all, a character in Gone with the Wind improves on the earlier adage by observing, "Death and taxes and childbirth! There's never any convenient time for any of them!" Despite the inconvenience that taxes impose, the average individual will feel the impact of quite a number of taxes during his or her lifetime. As a result, almost any attempt to accumulate or preserve wealth requires diligent tax planning.
The process of minimizing the tax liability of an individual or of a transaction is usually referred to as tax avoidance. Not to be confused with tax evasion, tax avoidance is the perfectly legal effort by taxpayers, and by paid tax advisers on behalf of their clients, to take those steps necessary to reduce one's taxes. As a result, anyone interested in minimizing their tax liabilities in the United States should take their cue from a 1947 opinion by Justice Learned Hand: "Over and over again courts have said that there is nothing sinister in so arranging one's affairs so as to keep taxes as low as possible. Everybody does so, rich or poor, and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is pure cant."
see also Income Tax: Historical Perspectives
Brownlee, W. Elliot (2004). Federal Taxation in America: A Short History (2nd ed.). Washington, DC: Woodrow Wilson Center Press.
Graetz, Michael J. (1997). The Decline (and Fall?) of the Income Tax. New York: Norton.
Jones, Sally M. (1998). Principles of Taxation for Business and Investment Planning. Boston: Irwin/McGraw-Hill.
Richmond, Gail Levin. (2002). Federal Tax Research: Guide to Materials and Techniques (2nd ed.). New York: Foundation Press.
Jeffrey L. Jacobs
"Taxation." Encyclopedia of Business and Finance, 2nd ed.. . Encyclopedia.com. (February 20, 2018). http://www.encyclopedia.com/finance/finance-and-accounting-magazines/taxation
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Taxation of the population is the basic way governments raise the revenue necessary to carry out their functions, including administration of justice, defense, and construction of infrastructure, such as canals, roads, and public buildings. When taxes are inadequate, as they often were in Russia, they were supplemented by domestic and foreign borrowing (possible after the 1770s), confiscations, or disposal of state property. The various modes and objects of taxation also clearly demonstrate the level of economic development of Russia through the centuries, as well as the shifting class basis of state power.
Prior to the establishment of the Russian Empire, most taxation came from the revenues of the tsar's estates. As a major serf owner, he collected rent from them. Following the reduction of the independent boyar class, the Russian state demanded service from pomeschiki, nobles and gentry, in exchange for their property in land and serfs. The state also monopolized the export of certain commodities, such as grain, farmed out the sale of alcohol, and minted silver and copper coins. Where deficits persisted, the Muscovite princes simply defaulted on state obligation. Quantitative estimates are, however, nearly unavailable until the eighteenth century, when some quantitative studies of the state budgets were written, most notably those by Paul N. Milyukov and S. M. Troitsky.
The main taxes in the 1700s were the fixed poll (soul) tax, excise taxes on alcohol and salt, revenues from the export monopoly of certain commodities, tax on iron and copper, customs tariffs, and mint revenues. During emergencies these were supplemented by special taxes (such as on beards of religious dissenters), debasement of the coinage, or printing paper money (assignats ). The last two, which caused an inflation tax on holders of cash, occurred mostly during the frequent wars of those times. All peasants paid the poll tax according to population estimates, except during periods of natural hardship or on the accession of a new ruler, when rates were temporarily reduced. Throughout the century the government increased the rate of indirect taxes on alcohol, as well as demanding customs duties in hard currency. On the other hand, burdens on miners and iron-masters appeared to slacken in the post-Petrine period.
To collect net fiscal revenue the Russian state employed either tax farmers, agents who paid for the privilege of collecting levies, or direct distribution of salt and alcohol. For these monopolized commodities the tax was simply the difference between the retail price and the cost of production. In 1754 the state granted gentry and members of the aristocracy its former monopoly in the sale of alcohol, from which incomes increased steadily, unlike those on salt, a prime necessity. The salt tax was actually abolished in 1881. Despite these measures, tax payments were frequently in arrears (nedoimki ), particularly during wars or famine. Peasants would try to avoid taxes by emigrating to the frontier areas of Siberia and the southern steppes, but the system of joint responsibility meant that fellow villagers would try to prevent their leaving. Little seemed to change in the tsarist regime during the more than half a century from Catherine's rule to the Crimean War and the subsequent Emancipation. Exemptions from taxation and a stagnant industrial economy meant that tax revenues did not increase much. Transcaucasia began to supply customs revenues from the 1830s, but the new areas of the southern fringe were expensive to conquer and hold. Fiscal inadequacy became painfully clear when Russia's poorly supplied troops were defeated at Sevastopol by English, French, and Turkish forces. That the Russian roads and river routes were so obviously inadequate for mobilization led to great interest in expensive and extensive railroad projects, requiring both more money and new industries.
The late nineteenth century was a period of rapidly rising governmental outlays, doubling between 1861 and 1890, and again between 1901 and 1905. Railroad building in this vast country accelerated, primarily for military purposes; debt service, health, and education also increased their share in state expenses, though the latter two were still small by international standards. To meet these expenditures, the government was able to increase indirect tax revenues, chiefly on vodka, but also by its monopoly on the sale of sugar, tobacco, kerosene, and matches. As was understood, reduced peasant net incomes meant more grain for export. Royalties and transportation tariffs on coal and iron also increased. Customs duties rose significantly, both as a result of higher rates and larger import volumes. Tax policy protected industry at the expense of agriculture, as direct taxes on company profits and capital plus redemption payments hardly increased at all between 1890 and 1910.
Despite some discussion of this possibility before World War I, most individual incomes were not taxed, but apartment rents and salaries of civil servants and joint-stock company employees were. This pattern points to the strongly regressive nature of tsarist taxation. According to estimates by Albert L. Vainstein, the tax burden on peasants averaged 11 percent of their total income in 1913, but probably more than one-quarter of their cash receipts.
Following the October Revolution, the Bolshevik government depended on confiscations and fiat money, but this chaotic strategy of covering expenditures soon led to peasant uprisings, and the government had to switch to a tax in kind (prodnalog )—replaced by cash in 1924—on the peasantry. After meeting their obligations, rural agriculturists could sell their surpluses on the local market. However,
|source: Narodnoe Khoziaistvo (National Economy), 1973, 1978, and 1984. Courtesy of the author.|
|Total Revenue (billion rubles)||18.0||102.3||376.7|
|Payments from profits||12||30||31|
|Mass bond sales||5||< 1||< 1|
|Social insurance contributions||5||5||7|
government efforts to keep the procurement price for grain low increased the actual surplus taken. Moreover, the nepmen had to pay a temporary tax on super-profits starting in 1926.
During the Stalinist period the government greatly increased the burden of taxation to an estimated 50 percent of household income. As shown, the principal mode of taxation was on the nationalized manufacturing and mining sectors, plus heavy exactions in kind from the collective and state farms. The Finance Ministry also conducted compulsory bond sales, but these were phased out during the 1950s.
In more recent Soviet times the regime imposed a mild income tax on employees, with a top rate of 13 percent above a certain exempt amount. But authors, physicians in private practice, tutors, landlords, craftsmen and like independents would pay at treble these rates or up to a marginal rate of 81 percent. Bachelors (and small families until 1958) paid a 6 percent surtax, but military personnel, students, and dwarfs were exempt. There was also a fairly stiff tax (from 12 to 48% by 1951) on money and imputed incomes from private plots in addition to a small tax on kolkhoz net income. This was in addition to forced deliveries at lower than market prices.
Soviet authorities strongly preferred indirect taxes over those imposed directly on persons. Apparently they believed workers would be more sensitive to their wages and wage differentials than to the prices they paid—money illusion. However, after 1947 they also endeavored to reduce official prices on goods of mass consumption.
While the turnover tax remained the single largest source of revenue until the 1960s, the type
of tax which increased the most during later Soviet times was that on profits. In 1950 the turnover tax accounted for 56 percent of the total, while deductions from profits provided only about 10 percent. By 1970, however, turnover tax declined to 32 percent, while deductions from profits rose to 35 percent of the consolidated USSR budget. However, the distinction between these two taxes is not sharp: both are enterprise taxes unrelated to the ability of citizens to pay.
To these taxes on profits, which after all belong to the state as owner, might be added retained profits devoted to state-mandated investments. After 1965 the regime added a small charge on net capital and broader rental payments in addition to remittances of the free remainder of profits. The miscellaneous category included large and rising profits from foreign trade—for example, on imported grain or exported oil—a stamp duty on legal documents, an inheritance tax, a local property tax, and a tax on automobiles, boats, and horses. All this added up to a considerable burden of taxation—approximately 45 percent of Soviet national income in the postwar period, about half again as much as in the United States and among the top tax-collection rates on the European continent. Nevertheless, except in oil boom years, the budget usually concealed a 2 to 8 percent deficit, financed by monetary emissions and resulting in inflation during the 1980s especially.
Some of the revenues mentioned above are retained by local or republican governments for their own expenditures. This was particularly high in the less developed regions of Central Asia, as part of the regional subsidy characteristic of Soviet welfare colonialism, as it has been called.
See also: alcohol monopoly; beard tax; tax, turnover
Gregory, Paul, and Stuart, Robert. (1998). Russian and Soviet Economic Performance and Structure, 6th ed. Reading, MA: Addison-Wesley.
Holzman, Franklyn D. (1955). Soviet Taxation. Cambridge, MA: Harvard University Press.
Kahan, Arcadius. (1985). The Plow, the Hammer, and the Knout. An Economic History of Eighteenth-Century Russia. Chicago: University of Chicago Press.
Martin C. Spechler
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The process whereby charges are imposed on individuals or property by the legislative branch of the federal government and by many state governments to raise funds for public purposes.
The theory that underlies taxation is that charges are imposed to support the government in exchange for the general advantages and protection afforded by the government to the taxpayer and his or her property. The existence of government is a necessity that cannot continue without financial means to pay its expenses; therefore, the government has the right to compel all citizens and property within its limits to share its costs. The state and federal governments both have the power to impose taxes upon their citizens.
Kinds of Taxes
The two basic kinds of taxes are excise taxes and property taxes.
Excise Tax An excise tax is directly imposed by the law-making body of a government on merchandise, products, or certain types of transactions, including carrying on a profession or business, obtaining a license, or transferring property. It is a fixed and absolute charge that does not depend upon the taxpayer's financial status or the value that the taxed property has to the taxpayer.
An estate tax is a tax that is placed on, and paid by, the estate of a decedent prior to the distribution of the property among the heirs in exchange for the privilege of transferring the property. Individuals who inherit property may be required to pay an inheritance tax on the value of the particular property received. Gift taxes are incurred by an individual who gives another a valuable gift.
Another type of excise tax is a sales tax, which is placed on certain goods and services. Precisely what goods and services are taxed is determined by the individual state legislatures. In some instances, a sales tax placed upon expensive items that are considered luxuries is known as a luxury tax.
A corporate tax is an excise tax imposed upon the privilege of conducting business in the corporate capacity, which provides certain advantages to individuals, such as limited liability. It is measured by the income of the corporation involved.
Other common examples of excise taxes are those imposed upon the processing of meat, tobacco, cheese, and sugar.
Property Tax A property tax takes the taxpayer's wealth into account, as represented by the taxpayer's income or the property he or she owns. income tax, for example, is a property tax that is assessed and levied upon the taxpayer's income; property taxes are imposed mainly on real property.
Direct and Indirect Taxes Taxes are also classified as direct and indirect. A direct tax is one that is assessed upon the property, business, or income of the individual who is to pay the tax. Conversely indirect taxes are taxes that are levied upon commodities before they reach the consumer who ultimately pays the taxes as part of the market price of the commodity. A common example of an indirect tax is a value-added tax, which is paid on the value added to the product at each stage of production, distribution, and sales.
The Constitution and laws passed by Congress have given the U.S. government authorization to collect various taxes. For example, duties are taxes imposed upon imports and can be either advalorem (a percentage of the value of the property) or specific (a fixed amount). An impost is another name for an import tax. Congress may not, however, tax exports.
The sixteenth amendment to the Constitution gives Congress the power to impose a federal income tax. Congress has also enacted laws that allow the federal government to tax estates remaining after people die and gifts made while people are alive.
States possess the inherent power to levy both property and excise taxes. The tenth amendment to the Constitution, which reserves to the states powers that have neither been granted to the United States nor proscribed to the states by the Constitution, implicitly
acknowledges this fundamental right. A state may raise funds by taxation in aid of its own welfare, provided the tax does not constitute unjust discrimination among those who are to share the tax burden. Property taxes, for example, may properly be imposed on landowners within the jurisdiction. In addition, the state may levy income, gift, estate, and inheritance taxes upon its residents.
The question of whether states should be able to tax sales conducted over the internet has generated increased interest as states scramble for additional funding in the wake of budget deficits. Technically, these transactions are taxable. A U.S. Supreme Court ruling in 1992, however, stated that states can only require sellers to collect taxes if they have a physical presence in the same state as the consumer. The reason, said the Court in Quill Corp. v. North Dakota, 504 U.S. 298 112 S. Ct. 1904, 119 L. Ed. 2d 91, is that the current system of 7,500 taxing jurisdictions across the country makes it too complicated for online retailers to collect sales taxes fairly and efficiently. In 1998 Congress imposed a three-year moratorium against any Internet taxes; the moratorium was renewed for two years in 2001. Online businesses and consumers have supported these moratoria for the obvious reason that taxes would cost money and affect sales, as well as the less obvious reason that tracking Internet sales would violate individual privacy by generating records of who is purchasing what.
The National Governors Association (NGA) initiated the Streamlined Sales Tax Project (SSTP) in 2000 with the goal of adopting uniform tax rates among the states and thus making it easier for online retailers to collect taxes. NGA hopes to complete SSTP by the end of 2005.
Equality is a fundamental principle of taxation. The taxing power of the legislature must always be exercised in such a way that the burdens imposed by taxation are laid as equally as possible on all classes. The progressive tax, which imposes a higher rate of taxation upon individuals with large incomes than on those with small incomes, is an attempt to achieve this objective.
Equality in taxation is achieved when no higher rate in proportion to value is imposed on one individual or his or her property than on other people or property in similar circumstances. Equality does not mandate that the benefits that arise from taxation should be enjoyed by all the people in equal degree or that each individual should share in each particular benefit. For example, the fact that a husband and wife have no children or choose to send their children to private school does not signify that they are permitted to stop paying their share of school tax.
The principle of uniformity of taxation bears a close relation to the concept of equality because similar items are taxed equally only if the mode of assessment is the same or uniform.
A tax that is levied upon property must be in proportion or according to its value, ordinarily determined as its fair cash or fair market value. This requirement protects equality and uniformity of taxation by preventing arbitrary or inconsistent methods of determining how much tax is due. This requirement applies only to property taxes, not to excise taxes.
Reid, John Phillip, 2003. Constitutional History of the American Revolution: The Authority to Tax. Madison: Univ. of Wisconsin Press.
"Taxation." West's Encyclopedia of American Law. . Encyclopedia.com. (February 20, 2018). http://www.encyclopedia.com/law/encyclopedias-almanacs-transcripts-and-maps/taxation
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Costs. As today, there were various costs that prompted colonial authorities to levy taxes on inhabitants. Local and provincial costs such as officials’ salaries, schools (especially in New England), church expenses (New England and New York town taxes), benevolence efforts, road construction and maintenance, and the militia were paid through taxes. Unlike today, there were no income or sales taxes. In addition to trade duties indirect revenue was acquired largely through internal excise taxes. These allowed for lower individual taxation. The principle of individual (direct) taxation, in whatever form, was generally based on the concept of production. Both direct and indirect taxes were levied on the local and provincial levels. It should be remembered that taxation varied from region to region. The following, therefore, is an overall generalization.
Land Taxes. Both on the local and provincial level a primary measurement of taxation was land. Since land was most colonist’s chief form of production, its value was taxed. The only way to avoid such a tax was to demonstrate that the property was at the time dormant. But for most a considerable amount of their property did produce income and was therefore taxable. On the provincial level a similar system was used with an additional system called quitrents. Quitrents were employed as a means of land taxation. The quitrent had its origin in feudal England. The prefix quit referred to one’s payment obligation to the manor lord as quit or free once the annual rent was met. Royal and proprietary colonies often charged quitrents, which “emphasized the feudal dependence of the American colonies, and was the visible token of such a relation.” Quitrents served as a necessary fixed rate of taxation (as opposed to labor rates which were variable and hard to enforce) for the transition of feudal England’s inhabitants from tenancy to freeholdership. This system found its way first into Virginia and the Carolinas and later Pennsylvania. Some northern colonies adopted it, but it never reached widespread use as in the southern provinces. Quitrents are considered here as a form of taxation since colonial authorities looked to them as a primary means of income for governmental operations (and hopefully personal profit).
Poll Tax. The poll tax was an across-the-board flat labor tax imposed primarily on white adult males. This tax centered around the concept of income-earning labor. Anyone, most commonly white males, who earned an income was subject to this tax. For fathers who put their sons to work on the farm, their labor was also taxed; it was paid by the father as long as he drew the profit of their labor. Fourteenth-century England saw the earliest poll tax. Laborers above the age of fourteen were subject to the tax. Near the end of the seventeenth century the poll tax was abolished in England due to its perceived unfairness. Pennsylvania enacted its first poll tax in 1693 around the same time of its demise in the mother country. The Pennsylvania tax required sixteen-year-old white males who had been free from indentured servitude for at least six months and whose net worth did not exceed a certain amount to pay the tax. For many of the colonies the poll tax covered at least half of the government expenditures on the provincial (as opposed to local) level.
Excise Taxes. Another form of taxation that produced considerable income on the provincial level was the excise (internal) tax, especially on liquor and slaves. Since slaves existed for the owners’ profit, they were a form of production subject to taxation. The most common excise tax in all the colonies was that paid by tavern owners on liquor, a cost passed on to the consumer. Provincial leaders eventually imitated the English Parliament, which established an excise tax on intoxicating drinks in 1643. This, of course, was the period of growing Puritan influence in Parliament, and the tax bore certain social implications. The records show Parliament increasing the excise of liquor in reaction to calls to limit excesses in alcoholic consumption. Although it cannot be shown that such, in England or the colonies, was the only or even the primary reason for the excise tax, the desire for moderation certainly was a motivating factor. One may be surprised to learn that the average alcohol consumption per person was much higher in the American colonial period than today. In 1733 Pennsylvania’s lieutenant governor Patrick Gordon argued for an increase in the excise tax stating that the “debauchery introduced by the vast Consumption of it (liquor) is the crying Sin and disease of the Country; not only Numbers of Single Persons but Families are ruined by it.” Gordon also asserted that the tax was “of much greater importance to the welfare of the Country, than the raising of Money from It.”
Burden. Some assume that the burden of taxation in the colonial era was great due to the more stringent measures (Sugar Act, Stamp Act, Tea Act, and so forth) enacted in the Revolutionary period. The fact is, however, the average colonist’s tax burden was moderate at best. After all, government operations were, compared to today’s standards, low-budget affairs. There were very few full-time office holders. During this period Massachusetts, for instance, employed around six full-time government officials. The highest salary in the colonies usually went to the governor, whose income might exceed, again by today’s standards, $100,000. The absence of a standing army also meant minimal defense costs, costs that of course went up in time of war. On balance, military costs did not become a large concern until the Seven Years War. In short, taxation, though a sporadic concern in the early and middle colonial eras, never became a colonywide source of discontentment.
Beverley W. Bond, The Quit-Rent System in the American Colonies (New Haven, Conn.: Yale University Press, 1919);
Patricia U. Bonomi, A Factious People: Politics and Society in Colonial New York (New York: Columbia University Press, 1971);
Jack P. Greene, “The Growth of Political Stability: An Interpretation of Political Development in the Anglo-American Colonies, 1660–1760,” in Greene, Negotiated Authorities: Essays in Colonial Political and Constitutional History (Charlottesville: University Press of Virginia, 1994), pp.131–162;
Lemuel Molovinsky, “Continuity of the English Tax Experience in Early Pennsylvania History,” Pennsylvania History,46 (July 1979): 233–244.
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Taxation is as old as recorded history. The earliest forms of writing, pictographs from the ancient Near East, are records of taxpayer accounts, paid and owed, to the king. Taxation is the taking of economic resources by a political entity from an individual or collective who is subject to its authority. It is a taking in that taxation is not a freely voluntary exchange, because resources are given under threat of coercion. Economic resources can take the form of money, goods, or service. Political entity refers to an individual (chief, prince), group (tribe, caste), or institution (state, government) that makes claims on and decisions for those from whom economic resources are sought. Their authority to claim economic resources is derived by consent, law, or force. The subjects of taxation are usually territorial based, including social collectives (tribes, villages, colonies, castes), economic collectives (guilds, mercantile companies, incorporated businesses), and individuals and households.
There are two general forms of taxation, direct and indirect. Direct taxation refers to tax claims made on fixed entities, such as a person, a business, land, and property. Indirect taxation refers to tax claims made on economic transactions, such as the sale of goods and services, trade, and commerce. For much of preindustrial history, taxes were direct, such as the poll tax. They were imposed on collectives and paid in kind with service (labor) or goods (a percentage of agricultural harvests). With the rise of capitalist cash economies in the modern period, taxation increasingly was directed toward money and financial assets. The modern state has shown a preference and capacity for indirect taxes as well as direct taxes claimed from individual households and business collectives.
Taxation is a type of exchange relationship between a political entity and its claimed subjects. Exchange is what distinguishes taxation from plunder. The political entity is supposed to provide something in exchange for economic resources. In the earliest forms of taxation, political entities claimed tribute in exchange for protection from physical harm, both from the political entity itself and from others in warfare or robbery. As the relationship evolved historically, taxation became more varied in form and rou-tinized in collection; in exchange, political entities provided more public goods, such as dispensation of justice, enforcement of law and property rights, establishment of economic infrastructure and cultural institutions, and provision of social and economic welfare goods. Some taxes are imposed not just to raise revenue but also to promote or discourage social behavior. For example, a reduced tax burden is meant to encourage charitable donations, while higher tax rates are meant to discourage smoking and drinking.
Taxation serves as the arena where power and wealth collide and connive in society. Each society develops its own system of distribution of tax burdens, progressive or regressive, which inevitably penalizes some and benefits others. Quasi-voluntary compliance occurs when political authorities succeed in providing sufficient goods in exchange and maintain a perception of fairness in the tax burden and a threat of coercion against those who do not pay. If these three factors are not in place, the tendency for evasion and noncompliance increases. Also income tax compliance was enhanced when employers were made to share responsibility for payment with employees. Tax burdens are sometimes effectively hidden in the final costs of goods. Resistance to the revenue claims of political authorities in the form of tax revolts provides some of history’s most notable political conflicts, including the English civil war, the French Revolution, and the American War of Independence.
SEE ALSO Poll Tax; Tax Credits; Tax Relief; Tax Revolts; Taxes; Taxes, Progressive; Taxes, Regressive
Adams, Charles. 1993. For Good and Evil: The Impact of Taxes on the Course of Civilization. London and New York: Madison Books.
Burg, David. 2004. A World History of Tax Rebellions: An Encyclopedia of Tax Rebels, Revolts, and Riots from Antiquity to the Present. New York: Routledge.
Webber, Carolyn, and Aaron Wildavsky. 1986. A History of Taxation and Expenditure in the Western World. New York: Simon and Schuster.
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There is a range of criteria which governs a good tax system. Adam Smith's four canons in the Wealth of Nations, that taxes should be based on a person's ability to pay, and that they should be certain, convenient, and economical, remain valid today, although the emphasis on each has changed with time. The problem is that in many instances the most certain, convenient, and economical tax to collect involves taxing those least able to pay.
While modern taxation is conducted using monetary transfers, there is a long history of taxation involving transfers in kind; most notably labour services or agricultural output. The Roman period saw the taxation of consumption and trade (customs duties) and forms of poll (tributum) and land taxation were employed. Inheritances were also taxed. During the Middle Ages these taxes gave way to the authority of the sovereign to levy taxes in a more or less arbitrary manner. The results were direct service obligations and aids (essentially gifts and tributes), although transit duties and market fees were also used. Export duties were first introduced in England on hides and wool in 1275. Gradually, a number of, often short-lived, indirect taxes were introduced (e.g. the window tax) especially at times of national emergency. As overseas territories were acquired, new forms of taxation were developed relating to trade. These provided additional revenue but often bred resentment amongst colonists—as in North America, which felt unrepresented in the political decision-making processes.
Levies on capital or income were not considered a normal means of financing government, except in exceptional circumstances, until the 19th cent. The taxation of incomes was initiated by Pitt the Younger in 1799 as a temporary measure to assist financing the wars with France and only became a permanent feature of the British fiscal system after its reintroduction in 1842 during a period of tariff reform. Its introduction required a more sophisticated institutional infrastructure and brought with it, as the appropriate sphere of government became more clearly defined, the development of tax law. The growth in importance of direct taxation for income redistribution policy has led to graduated rates and allowances which, combined with an explicit corporate income tax, has added to the institutional bureaucracy.
Indirect taxation has traditionally been on property, especially at the local level, either on the capital or rental value of land (rates), or levied at death (death duties). Excise duties, taxes levied on particular types of goods such as alcoholic drinks, petrol, and tobacco, increased in importance in the 20th cent. They are often depicted as taxes on luxury goods. A general sales tax, purchase tax, was only introduced in 1940, and then seen initially as a temporary measure. It was subsequently replaced by a multi-stage value added tax, where taxes are imposed at each stage of the production process.
"taxation." The Oxford Companion to British History. . Encyclopedia.com. (February 20, 2018). http://www.encyclopedia.com/history/encyclopedias-almanacs-transcripts-and-maps/taxation
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taxation, system used by governments to obtain money from people and organizations. The revenue collected is used by the government to support itself and to provide public services. Aside from being relatively permanent, taxation is compulsory and does not guarantee a direct relationship between the amount contributed by a citizen and the extent of governmental services provided to him. An enforced levy to meet an emergency (e.g., capital levy) is distinguished from taxation as not being part of a long-term system; fees for special services, such as postage, are not taxes. A government may secure its revenue without taxation, as from natural resources, manufactured products, or services. Taxes are sometimes resisted when those who must pay them consider them too onerous or unfair; such resistance was one of the causes of the American Revolution. Ease of collection is considered a merit in a tax, and ability to pay is one test of the amount that an individual should contribute. Such a progressive levy is the U.S. inheritance tax. A general property tax formerly met requirements in the United States satisfactorily (see land tax); but as property increasingly assumed forms that escaped taxation, the burden on farms, once the usual form of property, became more than they could carry. A tax on luxuries is free in part from such an objection, although a luxury to one person may be a necessity to another. A modern variation of the sales tax is the value-added tax. Tariff duties have occasioned great debates on protection and free trade. Increasing use has been made of the graduated income tax. Excise taxes, as on tobacco and alcoholic beverages, encounter little resistance; when too high, however, they may encourage bootlegging. A single tax on land is advocated by the followers of Henry George. Increases or decreases in taxes or changes in the types of taxes levied are often used to regulate a nation's economy. See tax exemption.
See Dick Netzer, Economics of the Property Tax (1966); J. F. Due, Government Finance (4th ed. 1968); C. S. Shoup, Public Finance (1969); H. M. Groves, Financing Government (7th ed. 1973); C. Webber and A. Wildavsky, A History of Taxation and Expenditure in the Western World (1987).
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"taxation." World Encyclopedia. . Encyclopedia.com. (February 20, 2018). http://www.encyclopedia.com/environment/encyclopedias-almanacs-transcripts-and-maps/taxation
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tax / taks/ • n. a compulsory contribution to state revenue, levied by the government on workers' income and business profits or added to the cost of some goods, services, and transactions. ∎ [in sing.] fig. a strain or heavy demand: a heavy tax on the reader's attention. • v. [tr.] 1. impose a tax on (someone or something): hardware and software is taxed at 7.5 percent. ∎ fig. make heavy demands on (someone's powers or resources): she knew that the ordeal to come would tax all her strength. 2. confront (someone) with a fault or wrongdoing: why are you taxing me with these preposterous allegations? 3. Law examine and assess (the costs of a case). DERIVATIVES: tax·a·ble adj. tax·er n.
"tax." The Oxford Pocket Dictionary of Current English. . Encyclopedia.com. (February 20, 2018). http://www.encyclopedia.com/humanities/dictionaries-thesauruses-pictures-and-press-releases/tax-1
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Hence sb. compulsory contribution. XIV. So taxation XIV. — (O)F. — L.
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tax·a·tion / takˈsāshən/ • n. the levying of tax. ∎ money paid as tax.
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