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The federal government finances its operations with taxes, fees, and other receipts collected from various sectors of the economy. In 2022, after the effects of the pandemic have wound down, total federal receipts are projected to total about $4.4 trillion — or 18.1 percent of gross domestic product (GDP). The largest sources of revenues are individual income taxes and payroll taxes followed by corporate income taxes. Absent changes in tax laws, the total amount of revenues generally follows the path of the economy. Individuals ultimately bear the burden of all taxes regardless of which type of entity is responsible for remitting the tax payment.
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.
For example, while it is true that many people owe little or no individual federal income tax, there are many other kinds of taxes that apply to individuals. In fact, taxpayers whose incomes are in the bottom 90 percent of all incomes pay, on average, more in payroll taxes than in income taxes. At the other end of the spectrum, high-income Americans receive a significant amount of their income from capital gains and dividends, which are taxed at lower rates than wages and salaries. However, wealthier taxpayers also face higher tax rates on their other income and indirectly bear a greater share of the corporate income tax, which significantly raises their overall effective tax rates.
On 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. Such special provisions — deductions, exemptions, deferrals, exclusions, credits, and preferential rates — are known as tax expenditures. In 2020, tax expenditures totaled approximately $1.8 trillion. That amount nearly equals the revenues that the federal government actually collected in income taxes and exceeds 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:
Just eight tax expenditures amounted to $1.2 trillion in 2020 — more than half the cost of all such expenditures combined.
|Major Tax Expenditures||Budgetary Costs
|Exclusion of pension contributions and earnings*||$292 billion|
|CARES Act recovery rebate tax credit||269 billion|
|Exclusion of employer contributions for medical insurance and care**||170 billion|
|Reduced rates of tax on dividends and long-term capital gains||149 billion|
|Child Tax Credit||118 billion|
|Earned Income Tax Credit (EITC)||68 billion|
|Tax credits for health insurance purchased through marketplaces||53 billion|
|Reduced tax rate on active income of controlled foreign corporations||45 billion|
SOURCE: The Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2020–2024, November 2020.
NOTES: *Estimate includes defined benefit plans, defined contribution plans, plans covering partners and sole proprietors, and IRAs. **Estimate includes employer-provided health insurance purchased through cafeteria plans and TRICARE medical insurance. Entries do not sum due to rounding.
© 2021 Peter G. Peterson Foundation
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 those with higher incomes.