Most people when asked how much they pay in taxes, will tell you what they pay is income taxes. Yet the income tax represents only 48 percent of federal taxes and about one-third of all taxes (including state and local taxes). The rest of federal taxes is made up of payroll (or Social Security) taxes (33 percent), the corporate tax (11 percent), and many other smaller taxes. Local and state taxes are evenly divided between property tax, income tax, sales (or excise) tax, and other taxes. Most taxes are direct taxeson persons or legal entities such as corporations (such as personal and corporate income taxes) but some are indirect taxeson goods and services (such as sales or excise taxes, and tariff duties on imports).
To understand the impact of taxes, you need to know what the marginal tax rateis. It is the percentage of taxes paid on added income. For example, if Joe's income goes up from $30,000 to $40,000 and he is in the 28-percent tax bracket (this is his marginal tax rate), he must pay $2,800 in extra taxes (or 28 percent of the added $10,000). The marginal tax rate,not the average rate, affects incentives to work and invest, since it determines the marginal benefit of working and investing. The average tax rateis the percentage of total income paid in taxes. For example, in 1998, a single person making $40,000 would have paid $~,852 in federal taxes, or an average tax rate of 19.6 percent. However, the marginal tax rate would have been 28 percent. Suppose a job requiring a move offers $2,000 more in pay. However, this is only worth $1,440 after 28 percent in taxes are deducted. If the annualized moving costs exceed $1.440, taking the job is not worth moving. Because of the complexity of the tax codes, I suggest using one of the tax software programs to find your marginal tax rate. .After calculating your current taxes, add $1,000 to your income and let the program calculate how much your taxes increase. For example, if they are $330 higher, your marginal tax rate is 33 percent ($330 / $1.000 x 100).
A progressive tax systemis one under which, as persons earn more, their average tax rate rises. Under a proportional tax system,everyone pays the same average tax rate. With a regressive tax system,as persons earn more, their average tax rate falls.
In a progressive tax system, the marginal tax rate is higher than the average tax rate (recall that when the marginal exceeds the average, the average rises). In a proportional system, the average and marginal tax rates are the same at all levels of income. In a regressive tax system, the marginal tax rate is below the average rate. Be careful! It is not necessarily true that the rich pay less taxes in a regressive tax system: They may pay more while still paying a smaller percent of income. Also, in a progressive tax system, it is possible for the marginal tax rate to go down over some ranges of income, but as long as the marginal tax rate exceeds the average rate, the average rate will go up with income.
YOU SHOULD REMEMBER
1. The marginal tax rate (the tax rate on added income) affects incentives.
2. In a progressive tax system, people with more income pay a higher percent of their income in taxes. The marginal tax rate exceeds the average tax rate, causing the average rate to rise as income goes up. In a regressive system, people with more income pay a smaller percent of their income in taxes. The marginal tax rate is below the average rate, causing the average rate to fall.
EQUITY IN TAXES
Since most people would like to pay less taxes, their basic notion of what is fair and equitable often coincides with what produces less taxes. Other less biased principles of equityinclude:
1. Horizontal Equity:Equals should pay equal taxes. If two persons are exactly alike, consistency requires that both should pay the same tax. For example, consider the double taxation of corporate income. It is commonly argued that it is "fair" to tax corporations at the same rate as individuals. However, the income from corporations that is paid out in dividends is first taxed at the corporate level and then taxed at the personal level. Thus, dividend income is taxed at a higher rate rather than at the same rate as other income. The principle of horizontal equity holds that dividend income should be taxed only once (say, by allowing corporations to deduct their dividends as expenses).
2. Vertical Equity:Unequals should pay different taxes. If Smith and Jones earn different incomes, then it seems right they should also pay different taxes.
3. Benefits Principle:People should pay taxes in proportion to the benefits they receive from the government. For example, taxes on gasoline are paid for by drivers, who benefit from good roads; these taxes support road construction and maintenance. The rationale for this principle is that, except for helping the poor, it is not right to benefit one group of people at the expense of others—those who get the benefit from a government program should pay for it. The same principle is used to condemn stealing and slavery.
4. Ability to Pay Principle:People who are able to pay more taxes should pay more. This implies that people who earn more should pay more. However, this result is consistent with some regressive tax systems, depending on what the vague term "ability to pay" means, so it is not a useful criterion. .Note that this principle is inconsistent with the benefits principle.