Taxation is a system of raising money to finance government services and activities. Governments at various levels—local, state or provincial, and national—require people and businesses to pay taxes. Governments use the tax revenue to pay the cost of police and fire protection, health programs, schools, roads, national defense, and many other public services.
Taxes are as old as government. The types and degrees of taxation have varied through the years, depending on the role of the government. In modern times, many governments—especially in advanced industrial countries—have rapidly expanded their roles and taken on new responsibilities. As a result, their need for tax revenue has increased.
Throughout the world, people have frequently resisted tax increases. In these situations, taxpayers have favored keeping government services at current levels or reducing them. Voters have defeated many proposals for tax increases by state, provincial, and local governments.
Kinds of taxes
Governments levy many kinds of taxes. The most important kinds include property taxes, income taxes, and taxes on transactions.
Property taxes are levied on the value of such property as farms, houses, stores, factories, and business equipment. The property tax first became important in ancient times. Today, it ranks as the chief source of income for many local governments. Most states of the United States and provinces of Canada also levy property taxes. Property taxes are called direct taxes because they are levied directly on the people who are expected to pay them.
Income taxes are levied on income from such sources as wages and salaries, dividends, interest, rent, and earnings of corporations. There are two main types of income taxes—individual income taxes and corporate income taxes. Individual income taxes, also called personal income taxes, are applied to the income of individuals and families. Corporate income taxes are levied on corporate earnings. Income taxes may also be levied on the earnings of estates and trusts.
Capital gains taxes are taxes on income from the sale of capital assets, which include stocks, bonds, real estate, and partnerships. Most governments treat capital gains differently from ordinary income. Capital gains tax rates are usually lower than income tax rates.
Most nations in the world levy income taxes. Many nations have income taxes at more than one level. In the United States, for instance, income taxes are levied by the federal government, most state governments, and some local governments. Many nations have special income taxes that help fund social security programs. These taxes are known as social security contributions or payroll taxes. Income taxes generally are considered to be direct taxes.
Taxes on transactions are levied on sales of goods and services and on privileges. There are three main types of taxes on transactions—general sales taxes, excise taxes, and tariffs.
General sales taxes apply one rate to the sales of many different items. The United States and Canada use general sales taxes. The value-added tax, or VAT, is a sales tax levied in many countries in Europe, Latin America, and elsewhere throughout the world. It is applied to the increase in value of a product at each stage in its manufacture and distribution.
Excise taxes are levied on the sales of specific products and on privileges. They include taxes on the sale of such items as gasoline, tobacco, and alcoholic beverages. Other excise taxes include the license tax, the franchise tax, and the severance tax. The license tax is levied on the right to participate in an activity, such as selling liquor, getting married, or going hunting or fishing. The franchise tax is a payment for the right to carry on a certain kind of business, such as operating a bus line or a public utility. The severance tax is levied on the processing of natural resources, such as timber, natural gas, or petroleum.
Tariffs are taxes on imported goods. Countries sometimes use tariffs to protect their own industries from foreign competition. Tariffs provide protection by raising the price of imported goods, thus making the imported goods more expensive than domestic products.
General sales taxes and taxes on gasoline and other products are called indirect taxes because they tax a service or privilege instead of a person. Manufacturers and business owners pay these taxes, then add the cost to the prices they charge. These taxes may be called shifted taxes because manufacturers and business owners shift the cost of the tax to their customers.
Other taxes include estate taxes, inheritance taxes, gift taxes, and taxes on wealth or net worth. An estate tax is applied to the value of property before it is given to heirs. An inheritance tax is levied on the value of property after it has been given to heirs. A gift tax is applied to the value of property that is given away during a donor’s lifetime. The donor pays the tax. A tax on wealth or net worth is based on the value of a person’s or company’s assets.
In the United States, the federal government and some state governments levy estate and gift taxes. Only state governments levy inheritance taxes. Canada has no estate or inheritance taxes.
Principles of taxation
A good tax system must satisfy several general principles of taxation. The main principles include productivity, equity, and elasticity.
Productivity. The chief goal of a tax system is to generate the revenue a government needs to pay its expenses. When a tax system produces such revenue, it satisfies the principle of productivity. If a tax system fails to produce the needed revenue, the government may need to add to its debt by borrowing money.
Equity. Most people agree that a tax system should be equitable (fair) to the taxpayers. Economists refer to two kinds of equity—horizontal and vertical. Horizontal equity means that taxpayers who have the same amounts of income should be taxed at the same rate. Vertical equity implies that wealthier people should pay proportionately more taxes than poorer people. This is sometimes called the principle of ability to pay.
Governments often try to achieve tax equity by making their taxes progressive. A progressive tax has a rate that varies depending on the sum to which it is applied. The rate increases as that sum increases. For example, in most countries, individual income tax is a progressive tax because it applies a higher rate to larger taxable incomes than it does to smaller ones.
Elasticity. A tax system should be elastic (flexible) enough to satisfy the changing financial needs of a government. Under an elastic system, taxes should help stabilize the economy. For example, tax increases during periods of economic growth can help limit inflation (rapid price increases) by making less money available for consumers. Similarly, tax cuts during periods of economic decline can encourage consumer spending and help prevent a recession.
Other principles of taxation. Taxes should be convenient and easy to pay, and they should be inexpensive for governments to collect. In addition, taxpayers should know in advance when a tax has to be paid, so that they can save enough money to cover the payment.
Some economists believe a tax system should also satisfy the principle of neutrality. According to this principle, tax laws should not affect taxpayers’ economic decisions, such as how to spend, save, or invest their money. However, other economists believe a tax system must defy the principle of neutrality to achieve tax equity and to stabilize the economy. Still other economists believe a tax system should play an active role in redistributing wealth. They support taxing the wealthy at highly progressive rates and using the collected revenue to finance services for the poor.
Taxation in the United States
The Constitution of the United States gives Congress the right to levy federal taxes. Congress first used its tax powers in 1789, when it introduced a tariff. Tariffs were the chief sources of federal revenue until the outbreak of the American Civil War in 1861. At that point, the cost of the war prompted the government to levy a series of excise taxes and other new taxes.
In 1894, the federal government levied a tax on individual incomes. But the tax was abolished in 1895 because it violated a section of the Constitution that required any direct tax to be apportioned (divided) among the states according to population. In 1913, the 16th Amendment removed this restriction. Later that year, the first modern income tax took effect.
During the early 1900’s, the income tax became the main source of federal revenue. Local governments relied chiefly on property taxes. State governments also depended heavily on property taxes during the early 1900’s. But by the 1930’s, state governments received a large percentage of their tax revenue from income taxes and sales taxes.
During the Great Depression of the 1930’s, the role of the federal government grew tremendously. The New Deal program of President Franklin D. Roosevelt greatly increased federal services and activities in order to help bring economic relief to the country (see New Deal).
The federal government continued to expand its activities during and after World War II (1939-1945). As a result, the nation’s tax system also grew to pay for the new federal programs.
Today, the main federal taxes are individual and corporate income taxes and Social Security contributions. Some revenue from these taxes goes to state and local governments to finance such projects as roadbuilding and public housing.
Taxation in other countries
Most modern tax systems contain a mix of individual and corporate income taxes, payroll taxes, and general sales taxes. Some systems also have value-added taxes, property taxes, and taxes on net worth. Most industrialized countries rely heavily on income taxes and sales taxes. Less developed countries rely more heavily on taxes on international trade. In many countries, federal governments collect most of the tax revenue and then share a portion of the money with lower levels of government.
In Canada, the individual income tax is the chief source of revenue for the federal and provincial governments. Other sources of revenue include sales taxes (including the Goods and Services Tax), corporate income taxes, capital gains taxes, payroll taxes, and excise taxes. Property taxes are the main source of revenue for local governments.
In the United Kingdom, taxes collected by the central government include individual and corporate income taxes, capital gains taxes, payroll taxes, and value-added taxes. Other sources of revenue include inheritance taxes, excise taxes, and stamp duties. Stamp duties are taxes levied on the transfer of certain assets, such as land and securities (stocks and bonds). Local governments receive funds through a council tax, a local tax based on property values. The tax systems of Australia and New Zealand are largely similar to the British system.
Taxation in India includes individual and corporate income taxes, capital gains taxes, payroll taxes, and value-added taxes. India imposes a business tax on certain services, such as advertising, banking, and consulting. It also has a wealth tax that may be applied to such assets as houses, yachts, automobiles, and land. Japan relies heavily on individual and corporate income taxes, payroll taxes, and sales taxes. China relies on individual and corporate income taxes, property taxes, excise taxes, and value-added taxes.