The overall system of taxation in the United States is progressive. By a progressive tax system, we mean that the percentage of income an individual (or household) pays in taxes tends to increase with increasing income. Not only do those with higher incomes pay more in total taxes, but they also pay a higher rate of taxes.
The overall system of taxation in the United States is progressive. By a progressive tax system, we mean that the percentage of income an individual (or household) pays in taxes tends to increase with increasing income. Not only do those with higher incomes pay more in total taxes, but they also pay a higher rate of taxes. This is the essence of a progressive tax system.
For example, a person making $100,000 in a year might pay 25% of their income in taxes ($25,000 in taxes), while someone with an income of $30,000 might only pay a 10% tax rate ($3,000 in taxes).
A tax system may also be regressive or proportional. A regressive tax system is one where the proportion of income paid in taxes tends to decrease as one’s income increases.
A proportional tax system simply means that everyone pays the same tax rate regardless of income. A particular tax system may display elements of more than one approach. Consider a hypothetical tax system where one pays a proportional, or flat1, rate on income below a certain dollar amount and then progressively increasing rates above that dollar amount. Also, within an overall tax system, some particular taxes might be progressive while other taxes are regressive. We’ll see later on that this is the case in the United States.
What American Tax System?
The United States of America has separate federal, state, and local governments with taxes imposed at each of these levels. Taxes are levied on income, payroll, property, sales, capital gains, dividends, imports, estates, and gifts, as well as various fees.
In 2020, taxes collected by federal, state, and local governments amounted to 25.5% of GDP, below the OECD average of 33.5% of GDP. The United States had the seventh-lowest tax revenue-to-GDP ratio among OECD countries in 2020, with a higher ratio than Mexico, Colombia, Chile, Ireland, Costa Rica, and Turkey.
Taxes fall much more heavily on labor income than on capital income. Divergent taxes and subsidies for different forms of income and spending can also constitute a form of indirect taxation of some activities over others. For example, individual spending on higher education can be said to be “taxed” at a high rate, compared to other forms of personal expenditure which are formally recognized as investments.
Taxes are imposed
Taxes are impose on the net income of individuals and corporations by the federal, most state, and some local governments. Citizens and residents are tax on worldwide income and allow a credit for foreign taxes. Income subject to tax is determine under tax accounting rules, not financial accounting principles, and includes almost all income from whatever source.
Most business expenses reduce taxable income, though limits apply to a few expenses. Individuals are permit to reduce taxable income by personal allowances and certain non-business expenses, including home mortgage interest, state and local taxes, charitable contributions, and medical and certain other expenses incurred above certain percentages of income.
State rules for determining taxable income often differ from federal rules. Federal marginal tax rates vary from 10% to 37% of taxable income. State and local tax rates vary widely by jurisdiction, from 0% to 13.30% of income, and many are graduated. State taxes are generally treated as a deductible expense for federal tax computation, although the 2017 tax law imposed a $10,000 limit on the state and local tax (“SALT”) deduction, which raised the effective tax rate on medium and high earners in high tax states.
Prior to the SALT deduction limit, the average deduction exceeded $10,000 in most of the Midwest and exceeded $11,000 in most of the Northeastern United States, as well as California and Oregon. The states impacted the most by the limit were the tri-state area (NY, NJ, and CT) and California; the average SALT deduction in those states was greater than $17,000 in 2014.
What’s Wrong With the American Tax System
What’s wrong with the American tax system? Depending on their perspectives, taxpayers complain about a wide range of features. However, a 2019 study by the Pew Research Center reveals that a majority express a concern that the system is unfair. They believe that it often requires low- and middle-income individuals to pay taxes on a greater share of their income than is required from individuals with higher incomes.
Despite those concerns, an Internal Revenue Service (IRS) survey published in November 2020 reports that 94% of Americans believe it’s “every American’s civic duty to pay their fair share of taxes.”
All the same, Americans’ opinion of the fairness and effectiveness of the U.S. tax system has declined markedly over recent years. Some of the change corresponds to political party affiliations. Republicans’ and Democrats’ views have diverged, with Democrats increasingly skeptical and Republicans more positive, especially since the 2017 individual and corporate tax cuts.
Although most taxpayers recognize that some form and level of taxation is necessary to fund the government, differing views about the appropriate size of government and its funding level, the optimal structure of a tax system, the system’s effective rates, and its impact on different groups and interests contribute to an expansive debate that would require a tome to appraise.
Accordingly, this article focuses primarily on the current U.S. income tax regime and emphasizes features and effects that raise issues for taxpayers and policymakers alike. (It does not discuss excise taxes, which apply more narrowly to specific products and activities.)
Once the rules are in place, individuals and corporations will, not surprisingly, do their best to use them to their advantage. What’s important is to look at the disparate impact of those rules, as well as who benefits and who doesn’t.
Unfair Distribution of the Tax Burden
Most U.S. taxpayers consider an income tax system that applies graduated, higher rates on higher levels of income—commonly characterized as “progressive”—to be fair. But, currently, critics are concerned that the national tax burden is not sufficiently graduated according to income level among individuals and between individuals and businesses, particularly large corporate businesses.
News reports about major corporations paying no income taxes—and alleging that former President Trump paid no more than minimal income taxes for decades—have undercut taxpayers’ confidence in the system.
The tax code provision that imposes no income tax on individuals with meager incomes (for 2021, income below $9,950 for singles and $19,900, and for 2022, below $10,275 for single individuals and $20,550 for married couples) is considered realistic and fair. In addition, it saves administrative expense by eliminating the cost of processing many tax returns that are unlikely to produce revenue.
The Internal Revenue Code (IRC) includes individual and corporate income taxes, payroll taxes, excise taxes, estate, and gift tax, and generation-skipping transfer tax. However, criticism generally has focused on the broad-based individual and corporate income taxes. Understandably, there is little enthusiasm for paying taxes. Still, it is about the fairness and not the actual dollar amount of tax liabilities that currently generates most complaints—perhaps a tacit acknowledgment of the tax law’s current rates, which are relatively moderate compared to far higher rates in the past.
Deductions vs. Credits
Deductions that produce lower taxable incomes benefit taxpayers in a regressive, rather than progressive manner. The tax benefit for such items generally equals the amount of the reduction multiplied by the taxpayer’s marginal tax rate.
Thus, if an individual taxpayer’s income falls into the top 37% tax bracket, each reduction of $100 from income that otherwise would be taxed at this rate will save the taxpayer $37. If the applicable rate is 24%, the savings for a $100 reduction in income would be only $24.
This allowance of greater tax savings for higher incomes contrasts with the savings from a tax credit. A 20% tax credit generally will save all taxpayers $20 in tax liability for each $100 expended, regardless of income level and tax bracket. However, if the amount of the credit exceeds the taxpayer’s tax liability, the taxpayer will not enjoy the full $20 savings unless the credit is refundable. Many tax credits are non-refundable.
Corporate Tax Avoidance
Currently, the tax law generally applies a corporate income tax of 21%. However, many U.S. corporations pay far lower effective rates or no tax at all because of substantial business write-offs, carrybacks and carryforwards of losses, aggressive tax planning, and if audited, tenacious and lengthy negotiating.
Even as some challenge the existence of any corporate tax regime, others debate the appropriateness and level of corporate tax benefits, particularly those enjoyed by politically influential industries.
Alternative Minimum Tax Limitations
Corporate and individual alternative minimum tax (AMT) rules were enacted to ensure that taxpayers with high income but substantial possible deductions and other tax breaks pay at least some taxes.
To date, these rules have never fully accomplished that purpose, in large part because they have relied on tax law concepts and definitions rather than on economic or financial standards.
Then, the 2017 Tax Cuts and Jobs Act repealed the AMT for all C corporations. It also increased the exemption amount and exemption phaseout under the individual AMT, with the result that under present law, fewer individual taxpayers are subject to the AMT today than they were before 2018.
Preferential Rules for Investment Returns and Business Losses
Lower rates for investment returns and certain tax write-offs for businesses are also subjects of controversy.
Capital Gains and Dividends
Special low rates applicable to capital gains and dividends can enable taxpayers with significant investment returns to pay effective rates far below those applicable to ordinary income, such as salaries, wages, or interest.
Investor Warren Buffett, whose income is comprise mainly of investment returns, famously acknowledge that the tax law should not allow him to pay a lower tax rate than his receptionist.
Because these lower rates make the system less progressive and undercut perceptions of fairness, they provoke debate. Critics question the need for the rules and the size of the benefits. Proponents of these benefits, on the other hand, believe that they encourage desirable economic investment.
Certain Business Losses
Individuals who materially participate in a trade or business operated directly or in a pass-through entity—or who participate in a real estate business as a real estate professional—can use losses from such activities to offset earnings or investment income from other activities.
The rules permitting current, carryback, and carryforward deductions for such losses by an active participant (or real estate professional, as applicable) permit eligible taxpayers to claim substantial write-offs that reduce or even eliminate their overall net taxable income.
In addition to income tax, the tax code imposes payroll and estate and gift taxes. Although generally less discussed than income taxes, some of these taxes present issues similar to those arising under the income tax.
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