How the Current Tax System Works
Foundations for Tax Reform
by Gary Robbins, Aldona Robbins on 09/19/2001
24 Pages
If meaningful tax reform is ever to be successful, there has to be a better understanding of how taxes interact with our economy. It is crucial to recognize that without the workers, investors and entrepreneurs who produce the economy’s goods and services, there would be nothing to tax.
Some taxes, like “employer” payroll or corporate income taxes, are collected at the business level. Others, like the employee portion of social security or the personal income tax, are collected from individuals. But the reality is that, whether called an income tax, a payroll tax, a sales tax, a business tax or a property tax, all taxes are paid out of the income people earn with their labor and capital.
Proceeding from this fact, we have developed a set of National Tax Accounts that links output, taxes and the income earned by labor and capital. Some key findings are:
• Output, or gross domestic product, is equal to the sum of income earned by the factors of production, capital and labor. In 1999, GDP totaled almost $9.3 ;trillion.
• Taxes, which amounted to $2.7 trillion in 1999, come out of the income earned by capital and labor. With almost two out of every three dollars of income in the economy arising from labor services, 61 percent of the taxes collected by all levels of government fall on labor income and 39 percent on capital income.
• Federal taxes account for two-thirds of the total, mostly from income and payroll taxes. Almost 70 percent of revenues raised by states and localities come from sales, excise and property taxes.
• Almost $1.3 trillion, or about half, were taxes paid at the business level, like employer payroll taxes, corporate income taxes, sales taxes, and property taxes. These taxes shaved 9.9 percent off labor income before it got to workers and 19.1 percent off capital income before it got to investors, savers and entrepreneurs.
• Individuals paid the rest. These taxes, which include the individual income tax, employee payroll taxes and estate taxes, reduced personal income by 18.7 percent.
• Private businesses account for three-fourths of the economy and pay almost 90 percent of federal, state and local taxes. On average, a third of the labor income (33.2%) and almost half of the capital income (47.5%) arising in the private sector goes to taxes. Taxes on the next dollar of income are even higher – by a third for labor (44.4%) and a fourth for capital (60.6%). Marginal rates are especially important because production costs and prices depend on the last unit employed, not the first or the average.
• Labor in the rest of the economy – government, government enterprises, domiciles and institutions – faces somewhat lower tax rates. Capital is essentially untaxed because these sectors do not operate as for-profit entities and generate no capital income as measured by market transactions.
American workers and American capital pay a lot in taxes. Setting aside the issue of whether government is too big, is there a better way to raise revenue? While tax collections depend on average rates, economic expansion depends on marginal rates. The current tax system needlessly hamstrings growth because marginal rates exceed the averages. Taxing capital more heavily than labor only make matters worse through an inefficient resource mix.
These are the problems tax reform needs to address. The method of accounting presented here offers a starting point to assess how well proposals measure up to the current system and to each other.
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