The W2s are in the mail and tax providers’ commercials on TV. Yes, it’s tax season and time for a reminder about what and why taxes are. Here’s a brief excerpt from Taxes in America: What Everyone Needs to Know by Leonard E. Burman and Joel Slemrod.
Most people know what the individual income tax is. It’s the tax that has made April 15 as iconic as the Super Bowl, without the parties or the popcorn. It’s probably the most salient tax for most people, even though these days most people owe more in payroll taxes than income taxes. The federal payroll tax is earmarked to fund Social Security retirement, survivors, and disability insurance and Medicare. Sometimes it’s called the FICA tax after the legislation that enacted it (the Federal Insurance Contributions Act). For self-employed people, it’s called the SECA tax (the Self-Employment Contributions Act). We have no idea why there are two names for basically the same tax, but it’s a fun fact that will impress your friends at cocktail parties.
What is the personal income tax?
Pretty simple: It’s a tax on individual income collected by the federal government and most states.
The federal tax is progressive, which means the tax rate rises with income. Defining income, however, is not as straightforward as you might think. The standard economist’s definition of income is the sum of what you spend and what you save. Spending is pretty straightforward.
But measuring saving is a little more complicated. It includes what we put in the bank, mutual funds, retirement accounts, and other kinds of investments. But increases in wealth that we don’t spend also add to savings (and hence to income). In many cases this unfamiliar definition lines up with the more familiar meaning—what you are paid if you are employed plus what you make from owning a business and from investments—but, in some cases that we’ll expand on later, it differs in important ways.
The income tax is much more than a tax on income. While some deductions account for the cost of earning income—for example, you can deduct the cost of uniforms that you have to wear to work—many deductions, exemptions, and tax credits are intended to provide subsidies of some sort or another. They often have little to do with the measurement of income.
The income tax is the most common point of contact between people and the government. The filing deadline of April 15 is as well-known a date as April Fools’ Day, and not many events bring on more stress than a tax audit. It’s really no surprise that, according to public opinion polls, the Internal Revenue Service (IRS) ranks near the bottom of American government institutions in popularity, while the Social Security Administration (SSA) tops the list: for most
Americans the IRS cashes your checks, while the SSA sends checks out. This image persists even though in recent years the IRS has dispersed hundreds of millions of payments related to, for example, the Earned Income Tax Credit and stimulus programs. Not only that, but the process of calculating what is owed is for many a complex, time-consuming, intrusive, expensive, and ultimately mysterious process, where the right answer is elusive. As the noted humorist Will Rogers said decades ago, “The income tax has made more liars out of the American people than golf has. Even when you make a tax form out on the level, you don’t know when it’s through if you are a crook or a martyr.” Many taxpayers suspect that they are suckers—when others find loopholes to escape their tax liability, they’re left holding the bag.
What is a tax?
A tax is a compulsory transfer of resources from the private sector to government that generally does not entitle the taxed person or entity to a quid pro quo in return (that’s why it has to be compulsory). Tax liability—what is owed to the government—may be triggered by a wide variety of things, such as receiving income, purchasing certain goods or services, or owning property.
Taxes can impose a substantial cost on people over and above the purchasing power they redirect to public purposes because they can blunt the incentives to work, save, and invest and can also attract resources into tax-favored but socially wasteful activities such as tax-sheltered orange orchards or construction of “see-through” office buildings (which could be profitable in the early 1980s because of tax benefits despite a dearth of tenants).
Tax policy affects the rewards or costs of nearly everything you can think of. It increases the price of cigarettes and alcohol, lowers the cost of giving to charity, reduces the reward to working, increases the cost of owning property or transferring wealth to your children, lowers the cost of homeownership, and subsidizes research and development. For this reason, tax policy is really about everything, or at least everything with an economic or financial angle.
Can taxes be discussed without getting into government spending?
The appropriate level of taxes should reflect a comparison of the benefits of what government spending provides—be it national security, social insurance, fire departments, or national parks—with the cost of taxes. When comparing the benefits to the costs, we need to bear in mind that the cost of taxes should also incorporate the disincentives and misallocations that taxes inevitably cause. For this reason a bridge that costs $500 million to build should promise benefits quite a bit higher than that.
Many Americans care little about the abstract question of whether overall taxes are too high, too low, or just about right. They care much more about their taxes, and their own tax liability. That’s a whole different matter, because whether my tax burden is $25,000 a year or $50,000 a year has absolutely no effect on the strength of our national defense, the viability of the Medicare system, or whether the local park system is well manicured. At the macro level, determining the right allocation of tax burdens depends on resolving what is fair—always a contentious issue—and how alternative tax systems that assign tax burdens differently affect economic growth.
Leonard E. Burman and Joel Slemrod are the author of Taxes in America: What Everyone Needs to Know. Leonard E. Burman is Daniel Patrick Moynihan Professor of Public Affairs at Maxwell School of Syracuse University. Joel Slemrod is Professor of Economics in the Department of Economics and the Paul W. McCracken Collegiate Professor of Business Economics and Public Policy in the Stephen M. Ross School of Business, at the University of Michigan.