What are federal taxes?
Taxes are money that people and companies are legally required to pay to a government. Americans pay taxes to many different levels of government — to states, to cities to counties, sometimes to school districts or other entities — but wherever we live we are touched by the taxes collected by the federal government. Those are federal taxes.
The corporate income tax is much less important than the other two. Excise taxes are targeted sales taxes on things like cigarettes and alcohol. Other taxes include the estate tax (called the death tax by its opponents) levied on the wealth of very rich deceased people, as well as some minor fees.
What is the point of taxes?
People sometimes think it's obvious that governments collect taxes to get money. And it's true that local governments could not run libraries without tax revenue.
But the federal government of the United States and most national governments don't strictly need taxes to finance government operations. These governments issue their own currencies and always could finance spending by printing more money. But doing so could send inflation skyrocketing. If you financed something as large as the US government by printing money, prices might rise uncontrollably. So the government prints money and then taxes it back from its citizens.
Taxation is also a way to accomplish social goals. The federal tax code, for example, redistributes money from high-income people to lower-income people. It also discourages smoking by taxing cigarette sales and subsidizes certain favored behaviors like going into debt to buy a house.
What's the income tax?
The income tax is a tax on income — which sounds simple enough. It is complicated considerably by the fact that different forms of income are taxed in different ways. Wage and salary income aren't treated the same way as capital gains (profits from buying and selling investments) or dividends (special payments that companies make to their shareholders).
Ordinary income tax rates also vary according to your family status in a way that is somewhat difficult to summarize but modern technology makes it extremely easy to calculate how much you owe once your know your taxable income and family status. Try it here.
There is also a corporate income tax — a tax on corporate profits — that has its own set of tax rates and deductions and credits.
What's the payroll tax?
A payroll tax is a special kind of income tax. For starters, it's levied only on labor income — like your paycheck — not on income earned from investments. Payroll taxes are often tied directly to specific government programs (Social Security and Medicare in the United States) and are sometimes legally structured so that the official taxpayer is the employer rather than the employee.
In America, the main payroll tax is also called FICA, after the Federal Insurance Contributions Act. Part of it is paid by employers and part of it is paid by employees. Employee-side FICA taxes for Social Security are 6.2 percent on the first $117,000 of income and 0 percent after that. Employee-side FICA taxes for Medicare are 1.45 percent on the first $200,000 of income and 2.35 percent on any additional income. Employer-side FICA for Social Security is another 6.2 percent on the first $117,000 and 0 percent after that. Employer-side FICA for Medicare is a straight 1.45 percent on the first $200,000 of income.
It's a confusingly structured tax, but economists generally agree that in the long-run both sides of the tax come out of workers' pockets because the part that employers pay comes out of raises workers would otherwise have gotten.
Does America have the highest corporate taxes in the world?
Corporations have many of the legal rights of actual people, and they also have the obligation to pay income taxes on the profits they earn. The corporate income tax in the United States has a couple of noteworthy features. One is that the statutory rate is unusually high by the standards of other developed countries:
The other is that despite that high rate, the corporate income tax raises relatively little revenue. Just around 2 percent of GDP, which is low compared to many of these lower-rate countries. That's because corporate income tax deductions and credits wipe out a lot of corporate taxes. Moreover, many firms have gotten quite adept at exploiting international tax loopholes to avoid taxation.
Effective tax rates are lower than the statutory rate and vary quite a bit by industry.
The idea of reforming this system to one with lower rates and fewer deductions is perennially popular on Capitol Hill but incredibly hard to do in practice because the corporations benefiting from those credits and deductions don't want to give them up.
How do marginal tax rates work?
The marginal tax rate is the rate that a person would pay on a single additional dollar of income or wealth or consumption or whatever it is that's being taxed.
In the United States, for example, a single person pays a 10 percent rate on her first $8,925 of taxable income and then a 15 percent rate on the next $27,324 of taxable income. So that person is paying a 10 percent tax rate on her 8,924th dollar but a 15 percent tax rate on her 9,000th dollar.
If you're actually in the process of forking money over to the government, you're probably less interested in your marginal tax rate than in your average or effective tax rate — the total amount of taxes paid divided by your income. Because the United States has a progressive income tax, most people will find their effective tax rate is lower than their marginal tax rate.
Is it true that 47 percent of Americans don't pay taxes?
No. What is true is that a large number of Americans pay no federal income taxes, either because they are retired or because their income is low enough that after all deductions and credits are accounted for they have no income tax liability.
But that doesn't mean they pay no taxes. Essentially everyone pays state and local sales taxes. Everyone directly or indirectly pays property taxes and gasoline taxes. What's more, everyone with a job pays payroll taxes on their income.
According to the Tax Policy Center, only 14.4 percent of people pay neither income nor payroll taxes — of which the vast majority are senior citizens who presumably paid labor taxes before they retired.
Can cutting taxes increase revenue?
The idea that income tax cuts could or would spur so much new economic activity that they would actually increase government revenue has been enormously influential in American politics over the past couple of generations.
The basic idea is associated with conservative economist Arthur Laffer who supposed outlined it to members of the Ford administration on a napkin. Laffer's notion is that the relationship between revenue and tax rates is a curve like this:
In the abstract, this is clearly correct. Imagine a state that tried to impose a 1,000 percent tax on beer. Rather than seeing an increase in beer tax revenue, the state would see a collapse in legitimate beer sales. People would either buy something else or buy beer on the black market. And at some point the same dynamic should apply to income taxes.
Both Ronald Reagan and George W. Bush relied heavily on this kind of reasoning to justify their respective tax cutting agenda. In practice it turned out not to work, and the budget deficit soared early in both Republican administrations while it fell after Bill Clinton raised taxes:
During the Obama era, conservatives have largely dropped Laffer-style arguments. They still favor lower taxes, but have placed much more emphasis than Reagan or (especially) Bush on the need to cut spending.
If a raise puts me into a higher tax bracket, do I lose money?
This is a common misunderstanding, but Congress is smarter than that. When a raise pushes you into a higher tax bracket, that means your marginal tax rate increases. The money you were earning previously, though, is taxed at the same old rate.
Suppose you're making $100 and paying a 10 percent tax rate, and get a raise to $150, and you're worried because a new 15 percent tax bracket starts at $110. The way the tax code works is that you pay the 10 percent rate on your first $110 (i.e., you pay $11) and then you pay the 15 percent rate on your next $40 (i.e., you pay $6) for a total of $17 in taxes. Which is to say that your extra $50 in income cost you an extra $7 in taxes, still leaving you $43 richer than you were before the raise.
Why is investment income taxed at a lower rate than regular income?
The tax rates charged on long-term capital gains (the profits you make from selling stocks or other assets at a profit) or qualified dividends (when a profitable company pays out money to its shareholders) are lower than the rates charged on ordinary income. What's more, most labor income is also subject to payroll taxes while investment income generally isn't. This strikes many people as unfair, especially since capital gains income is so highly concentrated in the highest-income households.
There are two main arguments given for lower taxes on investment income.
One relates to fairness and is based on the the idea that investment income has already been taxed. You work, you earn a salary, and you pay taxes on that salary. Then you take some money that you've saved and invest it. The investment turns a profit and the government taxes you on the profits. That's seen by some as "double taxation" of money you already paid income taxes on the first time.
The other relates to economic growth. Lowering taxes on investment income should make people more likely to invest their money. In theory, if people saved and invested more there would be more capital available for business investment which could grow the economy and make everyone better off in the long run. Traditionally, most economists have accepted this view, but surveys of the profession show growing doubts that it’s correct.
Are America's taxes high?
By the standards of other rich countries, the United States is a low-tax country. The Organization for Economic Cooperation and Development's most recent data is from 2012, but the picture is clear enough that small changes won't make a difference:
On the other hand, in terms of top marginal tax rates, American taxes can be pretty high. Our 39.6 percent top federal income tax rate is low by European standards but if you live in California you could be paying as much as 13.3 percent in state income taxes and as much as 3 percent in local income taxes on top of that. Even so you'd be below Sweden's top tax rate of 57 percent, but well above the top rates in Germany or Denmark.
The official corporate income tax rate of 35 percent in the United States is also relatively high by global standards, though the vast majority of companies pay a much lower rate than that in practice.
How progressive are federal taxes?
One of the goals of federal tax policy is to redistribute economic resources from the haves to the have-nots. And the federal tax code in the United States does quite a lot of redistribution. Research from University of Arizona sociologist Lane Kenworthy illustrates the reduction in equality achieved by the tax codes of various different countries. There isn't a great deal of international variation, but the United States actually leads the pack.
The reasons countries such as Finland, Sweden, and Germany achieve so much more redistribution than the United States isn't that they do more to tax the rich; it's that they spend more on programs that benefit the poor.
It's worth noting that state and local taxes are regressive, which is to say that poor households spend a larger share of their income on state and local taxes than do rich households:
This means that even though taxes in America are only mildly redistributive overall, the federal tax code redistributes a great deal.
Why are federal taxes progressive and state and local taxes regressive?
Rich households pay a larger share of their income to the federal government in taxes than do poor households. But, as this data from Citizens for Tax Justice shows, for state and local governments the pattern is flipped.
The reason is that the federal government and state and local governments tax different things.
The federal government derives the bulk of its revenue from the progressive income tax where the more you earn the higher the rate you pay.
State and local governments rely heavily on retail sales taxes for financing. Since poor people have very little savings, sales taxes chew up a large share of their income. Local governments also collect a lot of property tax revenue, which tends to fall heavily on middle-class households whose home is probably the most valuable thing they own.
Do high taxes crush economic growth?
This is really the trillion-dollar question as far as politics is concerned, and as with most controversial topics you can find experts on both sides. Conservative economists such as Harvard's Gregory Mankiw have models in which tax cuts generate tens of billions of extra economic growth per year. Liberal economists retort that in practice, American economic performance does not correlate with tax rates.
Why are income taxes so complicated?
The only thing politicians like more than complaining about the complexity of the tax code is taking steps to make the tax code more complicated. That's because politicians like to create programs to encourage certain forms of behavior or accomplish different social goals. And the easiest way to create a new subsidy in America is to structure it as a kind of tax cut. So instead of writing every homeowner in America a monthly check, we have the home mortgage interest tax deduction. We have tax credits for having a kid, tax credits for child care, special tax-preferred accounts for children's education, tax-advantaged ways to save for retirement, tax deductions for giving to charity, and dozens of other little exceptions.
What's the story with estate taxes?
When you die and try to leave something behind to your heirs, the IRS will insist on taking a cut — but only if you're very rich. In practice, upwards of 98 percent of estates owe $0 in taxes and, due to exemptions and exclusions, the effective tax rate paid by even very large estates is below 20 percent.
But if your estate is worth more than $5,340,000 then you could end up paying a marginal tax rate of up to 40 percent on assets above that threshold.
The estate tax brings in about $20 billion a year.
Precisely because so few people pay estate taxes, liberals tend to find the political resistance to them maddening. The substantive argument against estate taxes is essentially identical to the case against taxing investment income. As a political matter, many people also recoil from the idea of turning death into a taxable event, hence the effort by estate tax opponents to rebrand it as the death tax.
Where can I learn more about taxes?
Taxes are perhaps the most discussed economic policy issue around, so information is not scarce.
The Tax Policy Center, a joint project of the Brookings Institution and the Urban Institute, provides frequent, credible timely analysis of in-the-news tax issues. Tax Analysts is anther great source of commentary on a range of tax issues.
The Joint Committee on Taxation does official analysis of federal tax legislation.
The Organization for Economic Cooperation and Development collects comparative datathat helps put US tax policy in global context.
You didn't answer my question!
This is very much a work in progress. It will continue to be updated as events unfold, new research gets published, and fresh questions emerge.
So if you have additional questions or comments or quibbles or complaints, send a note to Matthew Yglesias: email@example.com.
How have these cards changed?
This is a running list of substantive updates, corrections, and additions to this card stack. These cards were last updated on April 11, 2014. Here is a summary of edits:
- Two corrections made to Card 4 on payroll taxes to correctly reflect the current tax rates. (April 11)