The Public Sector: Government Revenue

 

To finance the services rendered to the public the government collects taxes. Unfortunately, the study of taxation requires many numbers. But it will be made here as simple as possible. The federal government relies mainly on the personal income tax, which is a tax levied on peoples’ income (we are all familiar with the April 15 deadline), and the corporate profit tax levied on the profit of corporations. State governments collect mainly sales tax, which is a tax levied on commodities people buy as a percent of price, and personal income tax. The mainstay of local governments’ revenue is property taxes, which are levied on peoples’ property, such as houses, and calculated as a percent of the assessed value of the property. This is summarized in the following table.

Revenue Sources of Each Level of Government

Federal Government

Personal Income Tax

Payroll Taxes

Corporate Profit Tax

STATE GOVERNMENT

Sales Taxes

Personal Income Taxes

License and Permit Fees

LOCAL GOVERNMENT

Property Tax

Sales Tax

Fees

Several distinctions are made between types of taxes.

Direct and Indirect Taxes: Direct taxes are taxes imposed on a factor of production and are paid by the entity upon which they are levied. The personal income tax paid by “labor” and the corporate profit tax are examples. An indirect tax is a tax levied on commodities. A general sales tax is an example, where a uniform levy (e.g. five percent of price) is imposed on all goods sold. It appears as if the buyer pays the entire tax as it is added to the price by the store clerk, but in fact, part or all of it is shifted to the seller. Certain essential commodities, such as food and medicine, are often exempt from the sales tax. Another example of an indirect tax is an excise tax which is imposed only on a few specific commodities such as alcohol or cigarettes.

Progressive, Proportional and Regressive Tax: A tax is progressive if the percentage or proportion of income paid in tax rises with income. It is proportional if the percentage of income paid in taxes remains constant as income rises. Sometimes this is also called “a flat tax”. And, it is regressive if the proportion of income paid in tax declines as income rises. Note that the distinction between the three types lies not in the absolute dollar amount paid in tax but in the proportion of income paid. The absolute amount may rise, even under proportional or regressive tax, although in the latter case it may decline. This is illustrated in the following table:

 

Taxable Annual

Progressive
Tax

Proportional
Tax

Income

Tax Rate

Tax Paid

Tax Rate

Tax Paid

$20,000

20%

$4,000

20%

$4,000

$50,000

30%

$15,000

20%

$10,000

Taxable Annual

Regressive
Tax I

Repressive
Tax II

Income

Tax Rate

Tax Paid

Tax Rate

Tax Paid

$20,000

20%

$4,000

20%

$4,000

$50,000

10%

$5,000

5%

$2,500

 

In the progressive example, the tax rate rises from 20 to 30 percent as annual income rises from $20,000 to $50,000 and the tax paid rises from $4,000 to $15,000. In the proportional case, the tax rate remains at 20 percent of income, but the absolute amount paid in tax still rises (but not as steeply) from $4,000 to $10,000. In the case of regressive tax, the tax rate declines from 20 to 10 percent of incomes, but the absolute dollar amount still increases from $4,000 to $5,000. Only the last case is regressive enough to allow the absolute dollar amount to decline from $4,000 to $2,500.

Progressivity of the Federal Income Tax: Some states impose a proportional income tax but the federal government levies a progressive income tax. The mechanics by which the federal income tax is made progressive is by subjecting successively higher income brackets to higher marginal tax rates. This is the rate that applies to the income above a certain cutoff point. Observe for example the following three annual income brackets.

Hypothetical Taxpayer

Annual Taxable Income

Marginal Tax Rate

Income

Tax Paid

% of Income

(I) Under $20,000

0%

0

0

0%

(II) $20,000 – $50,000

10%

$30,000

$1,000

3.3%

(III) $50,000 – $100,000

20%

$90,000

$11,000

12%

Suppose a person made an annual taxable income of $30,000. She would pay zero percent on her first $20,000 (bracket I). On the next $10,000 she falls in bracket II, and would pay 10 percent or $1,000, that amounts to 3.3 percent of the income. Suppose next she made $90,000 per year. On the first $20,000 she would pay $0. On the next $30,000 (which are in bracket II) she would pay 10 percent or $3,000, and on the last $40,000 that falls in bracket III she would pay 20 percent, or $8,000 for a total of (0+3,000+8,000) $11,000, or 12 percent of income. The numbers on the right-hand side of the table show a progressive income tax where the percent of income paid in tax rises with income. However, a variety of deductions and exemptions available to upper income groups make the income tax tend more towards proportionality.

Regressivity of the Sales Tax: A general sales tax of say five percent of the price of all purchases is regressive, despite the appearance of proportionality. The reason is that it is the percent of income (and not of price) that determines the nature of the tax. Higher income people are better able to save than lower income ones and, since savings are not subject to the sales tax, they pay a lower percentage of income in sales taxes. One reason for the popularity of the sales tax is that it is paid a little at a time in “nickels and dimes”. So, people do not feel the burden as when a tax is paid in one big lump. To make the tax less regressive, essential commodities such as food and medicine, which are consumed heavily by lower income people, are often excluded from it.

Share
Mordechai E. Kreinin

Mordechai E. Kreinin

Mordechai Kreinin is a University Distinguished Professor of Economics, emeritus at Michigan State University and past President of the International Trade and Finance Association. He is the author of about 200 articles and books about economics, including the widely used text, International Economics. He can be reached at kreinin@msu.edu or by cell phone at (517) 488-4837

Advicoach Business Spotlight

Follow Us