The Government Raises Money: Introduction to Some Basic Concepts of Taxes and Taxing Income

• Author: William Kratzke
• Pages: 1-37

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Chapter 1: The Government Raises Money: Introduction to Some

Basic Concepts of Taxes and Taxing Income

I. Introduction to Some Basic Concepts

The word is out: the United States Government needs money in order to operate.

The vast majority of us do want the government to operate and to continue to

provide benefits to us. There are many ways in which the Government may

endeavor to raise money, only one of which is to tax its own citizens on their

income. A few examples follow:

Tariffs: The Government might impose tariffs (i.e., taxes) on imports or exports.

In order to sell their wares in the United States, foreign merchants at one time had

to pay very high tariffs. Tariffs would of course protect domestic producers of the

same wares who did not have to pay such tariffs. However, this hardly helps

domestic consumers of products subject to a tariff because they must either pay an

artificially inflated price for an import or a higher price for a (lower-quality?)

domestic product. Export duties could also have a pernicious effect. They

encourage domestic producers to endeavor to sell their goods at home, rather than

in foreign markets where they might have made more profits. Export tariffs also

discourage imports of perhaps more efficiently produced (and therefore more

inexpensive) foreign imports. And notice: the use of tariffs as a means of raising

revenue creates a cost that mostly the buyers and sellers of those products alone

pay. The burden of paying for Government is not spread very evenly if tariffs are

the means of raising revenue to support the Government. Nevertheless, tariffs were

one very important source of revenue for our country in its early days. This is not

nearly so true any longer.

Government Monopoly: The Government might choose to enter a business and

perhaps make competition in that business unlawful. Lotteries were illegal in most

places until some wag discovered that the state could make a lot of money by

engaging in the business of running lotteries and giving itself a monopoly over the

business. Nowadays, most states have lotteries that they run with no competition

other than what they are willing to tolerate, e.g., low-stakes bingo games that

charities operate. One argument favoring this means of financing government is

that there is no compulsion to buy lottery tickets, i.e., willing buyers contribute to

the Government coffers. States may also become quite adept at making customers

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feel good about buying lottery tickets because the state is able to do so much good

with the money it raises. Again, the burden of paying for what lottery proceeds

purchase falls only on the consumers of lottery tickets. Many non-purchasers derive

benefits from lottery proceeds at the expense of those willing to give up some of

their wealth in the forlorn hope of hitting it big. Governments may engage in

businesses other than lotteries. For example, many states own the liquor stores that

operate within its borders. Governments may charge for services that they provide

with a view to making profits that are spent in pursuit of other government

objectives. There is always the risk that the Government might not be very good at

running a particular business. Government-operated airlines are notorious money-

losers. And again, why should consumers of certain products or services be saddled

with the burden of paying for a government that (should) benefit(s) all of us?

Taxing Citizens: Instead of trying to raise money from those willing to give it to

the Government, Government may tax its citizens or residents – and perhaps try to

tax non-citizens or non-residents. This raises the question of what it is government

should tax – or more formally, what should be the “tax base.” There are various

possibilities.

The Head Tax: A head tax is a tax imposed on everyone who is subject to it, e.g.,

every citizen or resident, every voter. The tax is equal in amount for all who must

pay it. A head tax has the advantage that it is only avoidable at a cost unacceptable

to most (but not all) of us: leave the country, renounce one’s U.S. citizenship,

surrender the right to vote. Its relative inescapability assures that all who derive

some benefit from the existence of a government bear its cost burden. A head tax

of course has many drawbacks. Obviously, its burden falls unequally on those

subject to it. Some persons might hardly notice a head tax of $1000 per year while

others might find it to be a nearly insurmountable hardship. Surely we as a society

have a better sense of fairness than that. With one notable exception, we hear very

little of involuntary head taxes in the United States.

The notable exception was the poll tax whereby some southern states in the post-

Civil War era imposed a uniform tax, payment of which was necessary in order to

vote. The very purpose of imposing such a tax was to discourage recently

emancipated and almost uniformly poor Black persons from asserting their

constitutional right to vote. The unfairness of the relative tax burdens associated

with this cost of voting led to adoption of the 24th Amendment to the Constitution,

which made poll taxes unconstitutional.

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Consumption Taxes: As the name implies, consumption taxes tax consumption.

There are different variants of consumption taxes. Three important consumption

taxes are the sales tax, the excise tax,

and the value added tax (VAT).

Sales Tax: A sales tax is a tax

on sales and are usually a flat

percentage of the amount of

the purchase. Sellers usually

collect sales taxes at the point

of sale from the ultimate

consumer. Many states and

localities rely on a sales tax

for a substantial portion of

their revenue needs. Sales

taxes are relatively easy to

collect. By their very nature,

sales taxes are not collected

on amounts that citizens or

residents save. Hence, their

effect is more burdensome to

those persons who must spend

more (even all) of their

income to purchase items subject to a sales tax. While such taxes are

nominally an equal percentage of all purchases, their effect is regressive

(infra) for those who accumulate no wealth and who spend all of their

income on items subject to them.

In states that have sales taxes applicable to all purchases, every citizen or

resident who buys anything pays some sales tax. In this sense,

citizen/beneficiaries may more equitably share the burden of paying for

state or local government than is the case of the financing schemes already

noted.1 The recent financial crisis has made clear that a state’s revenues are

1 Of course, state legislatures may carve out exceptions. Purchases of food might not be subject to a

sales tax, or be subject to a reduced sales tax. Purchases of services might not be subject to a sales tax.

Online purchasers from out-of-sta te sellers who have no physical presence within a state are not (yet)

subject to sales taxes. See Quill v. North Dakota, 504 U.S. 298 (1992).

The Ramsey Principle: Taxes on items for which

demand is inelastic raise the most revenue for

the state. See F.P. Ramsey, A Contribution to the

Theory of Taxation, 37 ECON. J. 47 (1927). For

our purposes, “inelastic demand” means that

the quantity that buyers buy does not change

(much) as prices increase or decrease. A life-

saving drug might be such an item. Taxes on

items for which demand is inelastic will not

divert consumers’ purchase to or from those

items, i.e., they do not distort markets as much

as other taxes might. Unfortunately, the things

for which demand is inelastic are often things

that poorer people must buy. Strict adherence

to the Ramsey principle would create an

excessive burden for those least well-

off.

Moreover, the burdens of such taxes would not

fall evenly across those who benefit from them.