II.

Types of Taxes

Governments impose many types of taxes. In most developed countries, individuals pay income taxes when they earn money, consumption taxes when they spend it, property taxes when they own a home or land, and in some cases estate taxes when they die. In the United States, federal, state, and local governments all collect taxes.

Taxes on people’s incomes play critical roles in the revenue systems of all developed countries. In the United States, personal income taxation is the single largest source of revenue for the federal government. In 2002 it accounted for about 48.8 percent of all federal revenues. Payroll taxes, which are used to finance social insurance programs such as Social Security and Medicare, account for 36.4 percent of federal revenues. The United States also taxes the incomes of corporations. In 2002 corporate income taxation accounted for 10.4 percent of federal revenues.

State and local governments depend on sales taxes and property taxes as their main sources of funding. Most U.S. states also tax the incomes of individuals and corporations, although less heavily than the federal government. All Canadian provinces collect income taxes from individuals and corporations.

A.

Individual Income Tax

An individual income tax, also called a personal income tax, is a tax on a person’s income. Income includes wages, salaries, and other earnings from one’s occupation; interest earned by savings accounts and certain types of bonds; rents (earnings from rented properties); royalties earned on sales of patented or copyrighted items, such as inventions and books; and dividends from stock. Income also includes capital gains, which are profits from the sale of stock, real estate, or other investments whose value has increased over time.

The national governments of the United States, Canada, and many other countries require citizens to file an individual income tax return each year. Each taxpayer must compute his or her tax liability—the amount of money he or she owes the government. This computation involves four major steps. (1) The taxpayer computes adjusted gross income—one’s income from all taxable sources minus certain expenses incurred in earning that income. (2) The taxpayer converts adjusted gross income to taxable income—the amount of income subject to tax—by subtracting various amounts called exemptions and deductions. Some deductions exist to enhance the fairness of the tax system. For example, the U.S. government permits a deduction for extraordinarily high medical expenses. Other deductions are allowed to encourage certain kinds of behavior. For example, some governments permit deductions of charitable contributions as an incentive for individuals to give money to worthy causes. (3) The taxpayer calculates the amount of tax due by consulting a tax table, which shows the exact amount of tax due for most levels of taxable income. People with very high incomes consult a rate schedule, a list of tax rates for different ranges of taxable income, to compute the amount of tax due. (4) The taxpayer subtracts taxes paid during the year and any allowable tax credits to arrive at final tax liability.

After computing the amount of tax due, the taxpayer must send this information to the government and enclose the amount due. In 2001 the average taxpayer in the United States paid about 15 percent of his or her income in income taxes. Many taxpayers, rather than owing money, receive a refund from the government after filing a tax return, typically because they had too much tax withheld from their wages and salaries during the year. Low-income workers in the United States may also receive a refund because of the earned income tax credit, a federal government subsidy for the working poor.

Income taxation enjoys widespread support because income is considered a good indicator of an individual’s ability to pay. However, income taxes are hard to administer because measuring income is often difficult. For example, some people receive part of their income “in-kind”—in the form of goods and services rather than in cash. Farmers provide field hands with food, and corporations may give employees access to company cars and free parking spaces. If governments tax cash income but not in-kind compensation, then people can avoid taxation by taking a higher proportion of their income as in-kind compensation.

The Internal Revenue Service (IRS), an agency of the Department of the Treasury, administers the federal income tax in the United States. Canada Customs and Revenue Agency, which operates under the Minister of National Revenue, administers the tax in Canada.

B.

Corporate Income Tax

All corporations in the United States and Canada must pay tax on their net income (profits) to the federal government and also to most state or provincial governments. U.S. corporate tax rates generally increase with income. For example, in 2001 corporations with profits of up to $50,000 paid 15 percent in taxes, whereas corporations with profits greater than about $18.3 million were taxed at a flat rate of 35 percent. In Canada the basic rate for corporations was 28 percent in 2000.

The corporate income tax is one of the most controversial types of taxes. Although the law treats corporations as if they have an independent ability to pay a tax, many economists note that only real people—such as the shareholders who own corporations—can bear a tax burden. In addition, the corporate income tax leads to double taxation of corporate income. Income is taxed once when it is earned by the corporation, and a second time when it is paid out to shareholders in the form of dividends. Thus, corporate income faces a higher tax burden than income earned by individuals or by other types of businesses. Tax legislation passed in 2003 in the United States attempted to address this issue by lowering the tax rate on dividends.

Some economists have proposed abolishing the corporate income tax and instead taxing the owners of corporations (shareholders) through the personal income tax. Other students of the tax system see the corporate income tax as the price corporations pay in return for special privileges from society. The most important of these privileges is limited liability for shareholders. This means that creditors cannot claim the personal assets of shareholders, because the liability of shareholders for the corporation’s debts is limited to the amount they have invested in the corporation.

C.

Payroll Tax

Whereas an income tax is levied on all sources of income, a payroll tax applies only to wages and salaries. Employers automatically withhold payroll taxes from employees’ wages and forward them to the government. Payroll taxes are the main sources of funding for various social insurance programs, such as those that provide benefits to the poor, elderly, unemployed, and disabled. In 2002 payroll taxes accounted for about 36.4 percent of all federal tax revenues in the United States; in Canada, the figure was 21 percent. For most people, payroll taxes are the second-largest tax they must pay each year, after individual income taxes.

The U.S. federal government levies the Social Security and Medicare payroll taxes at a flat rate. In 2003 the rate was 7.65 percent for employees and 15.3 percent for the self-employed. Of the 7.65 percent, 6.2 percent goes for Social Security and 1.45 percent for Medicare. The rate is based on annual gross income up to a certain limit. The limit was $87,000 in 2003. The limit rises each year at the same rate as the growth in average wages. The government imposes no payroll tax on earnings above the limit. Employers pay half the tax and employees pay the other half. The Medicare payroll tax is 2.9 percent of all earnings, with no cap. Again, employers and employees split the cost of the tax. Self-employed individuals must pay the entire payroll tax.

Although the legislators who set up payroll taxes intended to divide the tax burden equally between employers and employees, this may not occur in practice. Some economists believe that the tax causes employers to offer lower pretax wages to employees than they would otherwise, in effect shifting the tax burden entirely to employees.

D.

Consumption Taxes

A consumption tax is a tax levied on sales of goods or services. The most important kinds of consumption taxes are general sales taxes, excise taxes, value-added taxes, and tariffs.

In the United States, consumption taxes account for only 3.3 percent of all federal tax revenues. This is considerably lower than in most other countries. In Canada, the figure is 24 percent. General sales taxes and excise taxes are the largest sources of revenue for state and local governments in the United States, accounting for about 36 percent of their total tax revenues.

D.1.

General Sales Taxes

A general sales tax imposes the same tax rate on a wide variety of goods and, in some cases, services. In the United States, most states and many local governments have a general sales tax. The country has no national general sales tax. State sales taxes range from 3 to 7 percent, and local sales taxes range from a fraction of 1 percent to 7 percent. In Canada, all provinces except Alberta impose a general sales tax on goods. In some provinces, the provincial sales tax and the federal goods and services tax (GST) are combined into a single tax known as the harmonized sales tax (HST). Local governments in Canada do not have the authority to impose general sales taxes.

Although sellers are legally responsible for paying sales taxes, and sellers collect sales taxes from consumers, the burden of any given sales tax is often divided between sellers and consumers (for more information, see the Effects of Taxes section of this article). Most states exempt certain necessities from sales tax, such as basic groceries and prescription drugs. Both individuals and businesses pay sales tax. See Sales Tax.

D.2.

Excise Taxes

Federal, state, and local governments levy excise taxes, which are sales taxes on specific goods or services. Excise taxes are also called selective sales taxes. Goods subject to excise taxes in the United States and Canada include tobacco products, alcoholic beverages, gasoline, and some luxury items. Excise taxes are applied either on a per unit basis, such as per package of cigarettes or per liter or gallon of gasoline, or as a fixed percentage of the sales price.

Governments sometimes levy excise taxes to pay for specific projects. For example, voters in a city might approve a tax on hotel rooms to help pay for a new convention center. Some national governments impose an excise tax on airline tickets to help pay for airport improvements or airline security. Revenues from gasoline taxes typically pay for highway construction and improvements. Excise taxes designed to limit consumption of a commodity, such as taxes on cigarettes and alcoholic beverages, are commonly known as “sin taxes.”

Another type of excise tax is the license tax. Most states require people to buy licenses to engage in certain activities, such as hunting and fishing, operating a motor vehicle, owning a business, and selling alcoholic beverages. See Excise Tax.

D.3.

Value-Added Tax

In Canada and Europe the favored form of consumption taxation is a value-added tax (VAT). In this system, the seller pays the government a percentage of the value added to goods or services at each stage of production. The value added at each stage of production is the difference between the seller’s costs for materials and the selling price. In essence, a VAT is just a general sales tax that is collected at multiple stages.

In the production of apple pies, for example, the farmer grows apples and sells them to a baker, who turns them into a pie. The baker sells the pie to a restaurant owner, who sells it to a consumer. At each stage, the producer adds value to the commodity by processing it with capital (machines) and labor. The farmer, the baker, and the restaurant owner each charge their customer a VAT. However, they can each claim a credit to recover the tax they paid on purchases related to their commercial activities. See Value-Added Tax.

Canada’s VAT, adopted in 1991, is known as the goods and services tax (GST). In 2003 the GST was 7 percent on most goods and services in Canada. The government exempts certain goods and services from the tax, including most food, most medical and dental services, child-care services, and previously owned residential housing.

D.4.

Tariffs

Tariffs, also called duties or customs duties, are taxes levied on imported or exported goods. Import duties are considered consumption taxes because they are levied on goods to be consumed. Import duties also protect domestic industries from foreign competition by making imported goods more expensive than their domestic counterparts. In the United States, import duties were the largest source of federal revenues until the introduction of the income tax in 1913. Today they account for only a small portion of federal revenues.

For general information on tariffs, see Tariff. For a history of tariffs in the United States, see Tariffs, United States.

E.

Property Taxes

In principle, a property tax is a tax on an individual’s wealth—the value of all of the person’s assets, both financial (such as stocks and bonds) and real (such as houses, cars, and artwork). In practice, property taxes are usually more limited. In the United States, state and local governments generally levy property taxes on buildings—such as homes, office buildings, and factories—and on land. There is no federal property tax. In 2000 property taxes accounted for 2.0 percent of state tax revenues and 72 percent of local tax revenues. The Canadian constitution allows the federal government to levy property taxes. However, currently only local and provincial governments collect property taxes. The property tax is by far the largest source of revenue for local governments.

The property tax is often unpopular with homeowners. One reason is that, because homes are not sold very often, governments must levy the tax on the estimated value of the dwelling. Some citizens believe that the government overvalues their homes, leading to unfairly high property tax burdens.

F.

Estate, Inheritance, and Gift Taxes

When a person dies, the property that he or she leaves for others may be subject to tax. An estate tax is a tax on the deceased person’s estate, which includes everything the person owned at the time of death—money, real estate, stock, bonds, proceeds from insurance policies, and material possessions. Most governments levy estate taxes before the deceased person’s property passes to heirs, although many governments do not impose an estate tax on property inherited by a spouse. An inheritance tax also taxes the value of the deceased person’s estate, but after the estate passes to heirs. The inheritors pay the tax. Estate and inheritance taxes are sometimes collectively called death taxes. A gift tax is a tax on the transfer of property between living people.

In the United States, the federal government imposes gift and estate taxes, and some states impose inheritance or estate taxes. However, they are usually minor sources of revenue because the taxes apply only to very large estates and gifts. Property transferred to a deceased person’s spouse is not taxed. Under the Economic Growth and Tax Relief Reconciliation Act of 2001, estate taxes were to be gradually lowered and then phased out altogether in 2010. Under the new law, the exemption for estate taxes was to rise from $1 million in 2002 to $3.5 million in 2009. However, the new law itself was due to be repealed on the eve of 2011, reverting to the legislation that existed prior to the passage of the act unless Congress agreed to extend it. These so-called “sunset” provisions are often enacted as a result of legislative compromises. Opponents of the provision agree to support a tax bill only if the provision is due to expire. Proponents of the provision agree to the compromise because they anticipate that the provision will prove popular and will be extended.

In 2002 less than 2 percent of the people who died in the United States had estates that were subject to the estate tax. In 2002 federal gift-tax law allowed each individual to give any other person up to $11,000 per year tax-free. The Tax Relief Reconciliation Act amended other provisions of the gift tax as well. In Canada, there are currently no death taxes, although both the federal and provincial governments levied estate taxes in the past.

Estate and gift taxes are controversial. Proponents argue that they are useful tools for distributing wealth more equally in society and preventing the rise of powerful oligarchies. Opponents argue that it is a person’s right to pass on property to his or her heirs, and the government has no right to interfere. If an individual has paid tax on his or her income while in the process of accumulating wealth, critics ask, why should it be taxed again when the wealth is transferred? Others argue that estate and gift taxes discourage individuals from working and saving to accumulate wealth to leave to their children. On the other hand, the presence of an estate tax might encourage people to accumulate greater wealth in order to reach a given after-tax goal. See Estate Tax. See also Gift Tax.

G.

Other Taxes

A poll tax, also called a lump-sum tax or head tax, collects the same amount of money from each individual regardless of income or circumstances. Poll taxes are not widely used because their burden falls hardest on the poor. When the British government implemented a system of local poll taxes in 1990, citizens considered the tax so unfair that they held demonstrations—some violent—around the country. The extreme unpopularity of the tax contributed to the downfall of Prime Minister Margaret Thatcher. Her successor, John Major, repealed the tax in 1991. In the United States, the 24th Amendment, ratified in 1964, prohibited the payment of poll taxes as a requirement for voting in federal elections. Until that time, a number of Southern states had used poll taxes to deny poor blacks the right to vote. See Poll Tax.

A pollution tax is a tax levied on a company that produces air, water, or soil pollution over a certain level established by the government. The tax provides an incentive for companies to pollute less and thus reduce damage to the environment. The United States, France, Germany, and The Netherlands all levy taxes on some types of pollution. However, these taxes account for just a tiny amount of total tax revenue. In Canada, some provincial governments levy pollution taxes.