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Understanding the Budget Debate Part 2: Individual Taxes

Editor's Note: This is the second in a five-part series of articles on the federal budget. In the first one, we examined deficits and the mounting federal debt. This article is aimed at sorting fact from fiction and illuminating some of the underlying issues.

Congressional policymakers who hope to keep the federal debt in check have just two options: spend less money or collect more money in the form of taxes. Neither is easy, which is why the debt has continued to climb.

Federal tax receipts have been surprisingly stable in relation to the size of our economy over the past 67 years – about 18% of gross domestic product (GDP), on average – despite wide variations in tax rates (Exhibit 1).

exhibit
      1Tax receipts lagged that average in the years during and following the Great Recession, as high unemployment and declining corporate earnings reduced the tax base. But receipts recovered 17.5% of GDP in 2014, 18.2% in 2015 and 17.8% in 2016.

Since tax rates seem to have had a fairly small impact on tax revenues, some policymakers question the effectiveness of raising taxes to reduce the deficit. After all, economists generally agree that higher taxes weigh on the economy, and a booming economy is by far the biggest booster of tax revenues.

Still, it makes sense to try to find the most fair and efficient mix of taxes – individual versus corporate, income versus payroll. Let's look at who actually pays taxes, and how much.

Who pays taxes?

Individual income taxes and payroll taxes generate the vast majority of federal tax receipts – typically about 80% to 85%. Corporate taxes, by contrast, account for a relatively small share at just 9%. Excise and other taxes make up the other 9% to 10% (Exhibit 2).

exhibit
      2Payroll taxes are used to fund specific programs, such as Social Security, health care, unemployment compensation and workers compensation, and they are distinct from income taxes, which go directly into the government's general fund. While there is a single payroll tax rate, income taxes are progressive, and rates vary based on earnings.

While corporations pay their taxes directly, the cost of those taxes are borne by consumers who must pay more for the goods and services, workers who may earn less and shareholders who see their shareholder value reduced.

The Congressional Budget Office, when analyzing who pays what, allocates the corporation's share of payroll taxes to individuals, and corporate income taxes to the shareholders. This is a reasonable way to think about how the tax burden is distributed among the population.

Exhibit 3 divides taxpayers into five groups based on their income levels, and shows the average tax rate for each group for each of the four main types of taxes.

exhibit
      3As you can see, the two lowest income groups have negative income tax rates, meaning they collect tax refunds even after paying no income taxes. This is what's behind the argument that 50% of U.S. households do not pay any taxes.

But that charge is true only as it relates to income taxes. As you can see, those lowest income groups do pay other types of taxes, most notably payroll taxes.

Another common issue, quite opposite to the first, is that payroll taxes are regressive, meaning they cost low-income taxpayers a larger share of income than high-income taxpayers.

This is true, because the payroll taxes supporting social security apply only to the first $127,200 of income as of 2017, according to the Social Security Administration. As income rises above that level, payroll taxes diminish as a percentage of a taxpayer’s total income.

Individual taxes are progressive

Still, taken as a whole, individual taxes in this country are progressive, as you can see in Exhibit 4. It shows that when you account for all types of federal taxes, taxpayers in higher income groups have higher effective tax rates, on average, than those in lower income groups. In fact, taxpayers in the top 20% by income bore 69% of the country's total tax burden in 2013.

exhibit
      4One can debate whether the tax scale should be more or less progressive, but the fact that it is so clearly progressive may come as something of a surprise, given the current political rhetoric about high-income taxpayers with very low tax rates. That does happen in some instances. But how? 

The answer lies in how their income is generated, and other nuances of the tax code. A retiree who has no wages or salary, for example, and whose income is made up primarily of dividends on stocks and interest on municipal bonds, will typically have a much lower tax rate than someone who generates all their income by working.

That's because dividends are currently taxed at a lower rate than earned income, and interest on municipal bonds is generally tax free.* Tax deductions and exemptions, such as the deductions for mortgage interest and charitable contributions, can also lower an individual’s effective tax rate.

What about the idea of taxing the wealthy? You may remember the debate over the "Buffet Rule," which would have implemented a minimum 30% tax rate on taxpayers earning at least $1 million. An analysis by Congress' Joint Committee on Taxation concluded that this rule would raise only $46.7 billion over 10 years, or barely more than 1% of the projected $4 trillion of deficits.

The amount is small because most high-income taxpayers already pay tax rates near or above 30%. The exceptions, like billionaire Warren Buffet, are few.

There are opportunities for change here. Tax deductions and exemptions – often referred to as "tax expenditures" – amount to a significant sum; they roughly equal the total income tax actually collected.

Those who want to simplify the tax code are primarily focused on reducing or eliminating tax expenditures. (More on tax expenditures in a future article.)

Yet another possible adjustment to the tax code would involve introducing a value-added tax (VAT), which is common in Europe. Perhaps as a result of VATs, taxes as a percent of GDP are higher in Europe than in the U.S.

VATs are similar to sales taxes, but are collected from businesses along the production cycle. Within the eurozone, they generally range from 18% to 25%. Historically, there has been strong resistance to introducing a VAT system in the U.S. 

Nevertheless, if the goal is to capture a higher percentage of GDP in tax revenue, something like this may be necessary.

Caution: tax effects on economic growth

Policymakers must exercise caution when devising tax policy. Most economists agree that if you tax something you get less of it, and that higher tax burdens are a drag on economic activity.

While there are differing views on this issue, Harvard economist Alberto Alesina contends that when governments seek to cut budget deficits, tax increases have hurt their economy more than spending cuts.

Summary

  1. Tax revenues as a percent of GDP have averaged about 18% for more than 60 years, regardless of the level of tax rates.
  2. The vast majority of tax revenues come from individuals through payroll taxes and income taxes.
  3. The total tax burden in the U.S. is progressive, with the highest-earning taxpayers paying the highest tax rates, on average.
  4. Tax deductions and exemptions, called tax expenditures, complicate the tax code and can dramatically impact tax rates from one person to the next.
  5. The total amount of tax expenditures is roughly equal to the amount of income tax collected.
  6. Economic growth can be sensitive to changes in tax policy.

 

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