Income and Payroll Taxes

As noted above, income and payroll taxes are by far the largest source of federal tax revenues. Income taxes are also a large portion of state tax revenues. Individual income taxes will be discussed first, then corporate income taxes, followed by payroll taxes.

The federal government primarily relied on tariffs on imported goods and excise taxes in the nineteenth century. During the Civil War, an income tax was imposed that lasted until 1872. A second attempt at income taxation was made in 1894 but was declared unconstitutional before collection began. The Sixteenth Amendment was ratified in 1913, beginning the modern income tax. At the start, though, only the most wealthy individuals paid the tax, and the rates were graduated from 1 to 6% of income. It was not until World War II that the individual income tax became broad based, through the reduction in personal exemptions; the number of taxpayers increased from 4 million in 1939 to 43 million in 1945 (Ventry, 2002).

The federal individual income tax base includes salaries and wages, commissions/tips, earned interest and dividends, alimony, rent, and unemployment compensation. Some forms of income are not taxed, however, such as food stamps, disability retirement, and Workers' Compensation. The individual income tax at the federal level is progressive in design; the tax is graduated, with six marginal rates (see Table 7.3). A single individual pays 10% in tax on the first $7,000 of taxable income, then 15% on the amount of taxable income between $7,001 and $28,400, etc. Therefore, individuals with greater incomes pay a higher percentage of their income in tax.

The complexity of the federal income tax stems from the large number of items that may be deducted from income taxes and the way in which some of the deductions are defined.

Table 7.3 Revised Federal Individual Income Tax Rate Schedules, 2003

Tax Rate

Single Income

Married Filing Jointly

(%)

Range (Dollars)

Income Range (Dollars)

10

$0-$7000

$0-$14,000

15

$7001-$28,400

$14,001-$56,800

25

$28,401-$68,000

$56,801-$114,650

28

$68,801-$143,500

$114,651-$174,700

33

$143,501-$311,950

$174,701-$311,950

35

Over $311,950

Over $311,950

Source: Internal Revenue Service, Revised 2003 Tax Rate Schedules.

Source: Internal Revenue Service, Revised 2003 Tax Rate Schedules.

These "tax expenditures" reduce the income tax base. A few of the larger items and estimated amounts of revenue loss for 2002 include deductibility of mortgage interest on owner-occupied homes ($63.6 billion), deductibility of state and local property tax on owner-occupied homes ($21.8 billion), child credit ($22.2 billion), deductibility of charitable contributions ($30.9 billion), and exclusion of pension contributions and earnings ($129.0 billion) (U.S. Office of Management and Budget, 2003). Some of the deductions are for equity purposes, for expenses beyond an individual's control, such as medical expenses. Others allow deductions for expenses that are related to earning income, such as reimbursement for job-related activities. There are also a number of deductions that are the result of public policies to encourage specific behaviors, such as charitable contributions (Mikesell, 2003).

Tax expenditures can have a number of negative consequences. According to one expert, "The deductions largely subsidize activity that would have occurred anyway. They complicate tax filing and enforcement. They erode the tax base and thus require higher tax rates than would otherwise be necessary. They are regressive: only about 28% of all taxpayers itemize but 90% of households with income above $75,000 use the deductions, compared with less than 10% with income below $30,000. And of course high-income households claim larger deductions than low-income households Why should homeowners, merely because they have a large mortgage, be able to deduct charitable contributions or use a tax-deductible home equity loan to buy a car, when renters with similar income cannot?" (Gale, 1997, p. 4).

The mortgage interest exemption is just one example of income tax provisions that can change individual behavior. "Income taxation may affect the length of time an individual stays in school by affecting the after-tax return to education, the choice of jobs (because for some jobs a larger fraction of the return comes in untaxed 'benefits'), whether an individual enters the labor force or stays at home to take care of children, the number of hours a taxpayer works (when he or she has discretion over that), whether he or she takes a second job and the effort put into the job, the amount that the individual saves and the form savings take (the choice between bank accounts and the stock market), the age at which an individual retires, and whether he or she works part-time beyond the age of 65" (Stiglitz, 2000, p. 459). These decisions result in reduced economic efficiency. For example, a 10% increase in income tax has been estimated to result in a labor supply decrease of 1.5 to 3.0%, as individuals trade leisure for work at higher tax rates (Schiller, 2003). In addition, taxation of interest earnings can encourage current consumption rather than savings, which can reduce long-term economic growth that is dependent on savings and investment for increased capital (Mikesell, 2003).

There has been a great deal of discussion about replacing the current individual income tax with a "flat tax" with one single tax rate. Flat tax proponents argue that it would be more transparent, less costly to administer, and fairer than the current system because everyone would pay the same percentage of his or her income in tax, without all the exemptions and deductions in the current system. In addition, it is argued that this would increase economic efficiency, as individuals and businesses would not make decisions based on the tax code (Hall and Rabushka, 1985).

On the surface, this would be a proportional tax, rather than the current progressive tax. However, under most proposals, the flat tax would apply to salaries and wages but not to other forms of income such as interest, dividends, and capital gains. Because these exempted forms of income are more likely to be earned by wealthier individuals, the flat tax would actually be regressive and regarded by many as inequitable (Winfrey, 1998). In addition, the flat tax would substantially reduce the tax rate paid by the wealthy, who currently pay the majority of income taxes, which would require other taxpayers to pick up the slack. Proposals include exemption of the first several thousand dollars of earnings; this would protect low-income taxpayers to some extent, which means that the incidence of the flat tax would be with middle-income taxpayers. "The major consequence of moving to a flat rate is a downward shift in the tax burden from the upper end to the mid-upper range. With nearly 50% of the current tax base, and 60% of revenue, accounted for by the top 10% of returns, the resulting shift to the middle of the income spectrum would be substantial" (Musgrave, 2002, p. 19).

States also rely heavily on the individual income tax. Only nine states do not use this tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming (Mikesell, 2003). Many states "piggyback" on the federal tax system in their individual income tax structure. For example, the state may use the federal tax base, with the state tax owed being a percentage of the federal tax paid. State income taxes are much less progressive than the federal tax, however. In most states, the highest tax rate is 4 to 5%. In addition, "nineteen states impose income taxes on taxpayers at or below the federal poverty level; six states require families of four with income at one-half of the federal poverty level to pay income tax" (Brunori, 2002, p. 207). Some local governments also use an income tax (approximately 3500); most of these are in the state of Pennsylvania (Mikesell, 2003).

The federal corporate income tax applies to net profits, with provisions for deductions of some things such as capital depreciation. This tax is graduated, from 15 to 35%. This tax is controversial. Some portion of corporate income would escape taxation without the tax, but some income is double-taxed because individuals pay income tax on corporate dividends. In addition, little is known about the incidence of this tax. "There is wide disagreement among economists as to who actually bears the burden. Some studies claim that most of the corporation income tax is passed on to consumers in the form of higher prices. This would indicate that the tax is regressive Other studies claim that corporations have not raised prices in response to tax increases, and therefore, the burden must reside with the owners" (Winfrey, 1998, pp. 60-61).

Other equity and efficiency issues with the corporate income tax exist. As with the individual income tax, certain tax breaks are included in the tax code. One study of 250 large corporations found a wide divergence in the portion of profits paid in taxes over the period 1996-1998. Forty-one of the companies, rather than paying taxes, actually received rebates from the federal government during this time. Petroleum companies in the group paid an overall effective tax rate of 12.3% in this period, while publishing companies paid a rate of over 30% (Institute on Taxation and Economic Policy, 2000). In addition to these differences, which can shift resources between segments of the economy, this tax discourages savings and investment, which results in lower economic growth. Most states have a corporate income tax similar to the federal tax. One difficulty with the state tax is that many corporations do business in more than one state, which requires the use of formulas to determine the amount of tax owed in each state (Mikesell, 2003).

The Social Security tax is a federal payroll tax that applies to wages and salaries and funds the insurance system. This tax is regressive: it does not apply to other forms of income, which are more likely to be received by the wealthy, and there is a cap on the amount of income to which it applies. In 2003, the Social Security portion of the payroll tax is 6.20% paid by the employee, with an equal amount paid by the employer, on maximum earnings of $87,000* (Social Security Administration, 2003). So, for example, an individual who earns a salary of $150,000 will pay $5,394, or 3.6% of earnings, compared to someone who earns $50,000, who will pay $3,100 or 6.2%. Although the payroll tax is paid equally by both employers and employees initially, most studies have found that employers shift their portion to employees with lower wages, so that the burden is actually on the employees (Winfrey, 1998).

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