Taxation

B

Saving

Saving is the portion of income that is not spent. Might taxes levied on returns to saving (such as interest and dividends) influence the amount people save? When a tax is levied on interest or dividends, it reduces the reward for saving. For example, if an individual earns 10 percent interest on a savings account and faces a 20 percent income tax rate, then he or she makes only an 8 percent return—the other 2 percent goes to the government. This effect tends to reduce the amount of saving that an individual does. On the other hand, when interest is taxed, an individual must save more to achieve any particular savings goal. For example, if parents regularly save money to accumulate enough for their child’s college tuition payments, and taxes on interest increase, they must save more in order to reach their saving target. This effect tends to increase the amount of saving. Because the two effects work in opposite directions, in theory an increase in the tax on interest can increase or decrease saving. Economists have devoted a great deal of effort to studying people’s saving behavior. Although no firm consensus has emerged on the impact that changes in interest and dividend tax rates have on saving, a reasonable estimate is that such changes have a negligible effect.

C

Physical Investment

Physical investment refers to the purchase by businesses of manufactured aids to production. Physical investment includes such items as machines, factories, computers, trucks, and office furniture. The return on a physical investment is the amount by which the investment increases the business’s revenues. How do taxes affect physical investment? In effect, a tax on business income is a tax on the physical investment’s return—the tax reduces the firm’s income and thus the benefit from making the investment. Most economists believe that business taxes decrease the amount of physical investment by businesses.

Taxes also influence the types of physical investments that businesses make. This is because the government taxes returns on some types of investments at higher rates than others. These differences cause businesses to make investment decisions based on tax consequences, rather than whether they are sound from a business point of view. By distorting physical investment decisions, the tax system leads to an inefficient pattern of investment.

D

Tax Evasion and Avoidance

Tax evasion is failing to pay legally due taxes. One important way that high tax rates affect behavior is by increasing evasion. For example, people may fail to report income to the government, thus reducing their tax bill and the government’s tax revenue. Tax cheating is extremely difficult to measure. The Internal Revenue Service estimates that taxpayers voluntarily pay only about 80 percent of the taxes they legally owe. The greater an individual’s tax rate, the greater the incentive to defraud the government.

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Tax avoidance occurs when people change their behavior to reduce the amount of taxes they legally owe. When individuals relocate their business to a state with lower taxes or take advantage of loopholes in tax laws, they are practicing tax avoidance. There is nothing illegal about tax avoidance.

VI

History of Taxation

For as long as governments have existed, they have had to come up with ways to finance their activities. Methods of public finance have changed enormously over time.

A

Ancient Times

In the ancient civilizations of Palestine, Egypt, Assyria, and Babylonia, individual property rights did not exist. The king was sole owner of everything in his domain, including the bodies of his subjects. Thus, instead of taxing individuals to support the government, the king could simply force them to work for him. Ancient kings earned income in the form of food from their lands and precious metals from their mines. If this income did not meet the king’s demands, he might lead his armies into neighboring countries to confiscate their property. The conquered peoples might also be required to make payment (known as tribute) to the conqueror in acknowledgment of their submission to his power. If kings were not very wealthy or not very good at stealing from other countries, they would resort to taxing their own people. In societies that operated without money, the ruler taxed farmers by requiring that they turn over some proportion of their crops to the state. Poll taxes were a major source of revenue in Egypt under the Ptolemaic dynasty (323 bc-30 bc).

The government of ancient Athens, Greece, relied on publicly owned silver mines, tribute from conquered countries, a few customs duties, and voluntary contributions from citizens for revenue. It levied poll taxes only on slaves and aliens (noncitizens) and made failure to pay a capital crime.

In the early years of the Roman republic all Roman citizens paid a poll tax. However, Roman military victories brought in so much foreign tribute that the government exempted citizens from this tax in the 2nd century bc, after the Punic Wars between Rome and Carthage. More than 100 years later, Emperor Augustus introduced land and inheritance taxes. Succeeding emperors raised rates and found an increasing number of things to tax, including wheat and salt.

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