The federal government finances its operations with taxes, fees, and other receipts collected from many different sectors of the economy. In 2016, total federal receipts were $3.3 trillion, about 18% of GDP. The largest sources of tax revenue are individual income tax and payroll taxes, followed by the corporate income tax, the excise tax, and estate and gift taxes. Absent changes in tax laws, the total amount of revenue generally increases along with the economy. Regardless of the immediate source of revenues, individuals ultimately bear the burden of all taxes no matter how they are imposed.
One of the most hotly debated issues is whether people pay their fair share of taxes. To assess whether the tax system is fair or not, it is important to look at all of the taxes that people pay, not just one particular form of taxation.
Using this broader approach dispels two misconceptions that have emerged in recent debates about our tax system. The first misconception is that "nearly half of taxpayers pay no federal tax." While it is true that many people pay no individual income tax, those who are working pay payroll taxes even if they do not pay income taxes. In fact, taxpayers whose incomes are in the bottom 90% of all incomes pay, on average, more in payroll taxes than in income tax. The second misconception is that high-income Americans face low overall tax rates because they receive a significant amount of their income from capital gains and dividends, which are taxed at lower rates than wages and salaries. That conclusion, however, does not account for the fact that high-income taxpayers face high tax rates on their other income and indirectly bear a disproportionate share of the corporate income tax, which significantly raises their overall effective tax rates.
In the aggregate, our federal tax system is structured to be generally progressive, with higher-income taxpayers paying a larger share of their income in taxes. However, the composition of taxes paid is very different for taxpayers at different ends of the income distribution. For low-income Americans, payroll taxes and excise taxes are the major forms of taxation; for high-income Americans, individual and corporate income taxes comprise most of their tax burden.
The income tax code also contains provisions that allow individual and corporate taxpayers to reduce their tax bills. These special provisions — deductions, deferrals, exclusions, credits, and preferential rates — are often called tax expenditures. In 2016, tax expenditures totaled approximately $1.7 trillion. This represents an enormous amount, adding up to 90% of the revenue that the federal government actually collected in income taxes and exceeding what was spent by any single agency or spending program, including the Department of Defense and Social Security.
Tax expenditures work in various ways and take many forms, including:
For individuals, just six tax expenditures amount to $931 billion in 2016 — more than half the cost of all expenditures combined.
Tax expenditures are often referred to as "spending in disguise," because lawmakers use the tax code to direct subsidies to specific constituencies and activities. Policymakers also use tax expenditures to influence consumer and business behavior. The mortgage-interest deduction, for example, encourages taxpayers to buy homes instead of renting. Similarly, depreciation provisions for businesses encourage new purchases of equipment. In addition, because tax expenditures subsidize "favored" activities, they can distort economic decisions in ways that reduce the productivity of our economy.
Tax expenditures generally receive less scrutiny than spending programs. Most do not need annual review and approval, and therefore often remain in place for many years. With few opportunities for review and consideration, they are harder to control and less transparent than line-item spending programs. Many tax expenditures are also more valuable for people at higher marginal tax rates, so the benefits of tax expenditures often skew toward higher income earners.