What's the best Tax?

If you meet someone new and the conversation lags, one way to get the talking restarted is to bring up the topic of taxes.  Virtually everyone has an opinion about taxes.  Are taxes too high, are they too low, do some deserve tax breaks, should others pay more taxes, should some taxes be eliminated, should others be expanded?  These are some of the common questions about taxes.

Here I will focus on one key question about taxes – specifically, is there a “best tax.”  Are some taxes better than others, and if so, should we shift to those and away from others?  Indeed, at all levels of government, these questions are today being asked.

First, let’s look at how the three levels of government – federal, state, and local – use different taxes to collect revenues. At the federal level, by far the dominate source of tax revenues is from taxing income.  Over 90% of federal revenues come from the  individual income tax, the corporate income tax, and taxes on income that support Medicare and Social Security. Revenues from taxes on imports (tariffs) and taxes on tobacco and fuel sales make up most of the rest. Interestingly, prior to 1913 when the income tax was authorized, federal revenues mostly came from tariffs, taxes on tobacco and liquor, and taxes on land sales.

At  the state level, most states use three sources for tax revenues, which - ranked in order of amount – are income taxes on households and corporations, sales taxes, and taxes on motor fuel, tobacco, and alcohol. Just like at the federal level, there’s been a trend to more reliance on income taxes in states and less reliance on sales taxes.  However, there are nine states – Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Wahington, and Wyoming - that have no income tax and therefore rely on other taxes, often the sales tax. For example, North Carolina has a statewide sales tax rate of 4.75%, while Tennessee’s is 7%.

With the federal and state governments using so many taxes, what is left for localities like counties and cities?  This is where taxes on property, mainly land and buildings, comes in.  Property taxes are the largest generator of revenue for local governments, followed by local sales taxes and “user fees” for water use and trash pickup provided by local governments.

There are many ways to judge a tax, with simplicity, ease of administration, progressivity, capacity, and keeping up with economic growth some of the key considerations.  Simplicity means the tax is easy to understand, and ease of administration indicates the tax is easy to collect. Capacity is the ability of the tax to raise significant revenues. Progressivity means the size of the tax relative to the taxpayer’s income rises with the taxpayer’s income, meaning the tax burden is relatively lower for lower income taxpayers.  Lastly, a tax is preferred if the revenues it generates keep pace with an expanding economy, where public needs are likely greater.

How do the major taxes, including income, sales, fees, and property stack up on these measures?  Experts view income taxes positively on all the factors, but especially on progressivity.  With an income tax, it’s easy to divide the taxpayer’s income into segments and tax each segment with a different rate.  Typically, the rates are higher for the higher income segments, meaning taxpayers with lower incomes pay less as a percentage of their income in taxes, and payees with higher incomes pay more as a percentage of their income in taxes.

Sales taxes also get high marks on simplicity, ease of administration, capacity, and increasing with economic growth. One issue is progressivity. It’s impractical to charge people with different incomes a different sales tax rate.  Many states, including North Carolina, have addressed this issue by not taxing some essential purchases, like raw food items and prescription drugs. Fees receive similar evaluations as sales taxes.

Some of the biggest complaints over taxes are for the property tax, the main revenue source for local governments. Property owners, particularly of homes, complain of their taxes rising when the value of their property rises.  While the owners like that their property is worth more, some say they can’t afford the taxes until they sell the property.  Retired owners particularly point to this issue.  Many states, including North Carolina, are considering limitations on increases in estimated property value to help owners deal with the “tax shocks” resulting from a higher property value assessment.

Theres’s another tax that some states, such as California, are considering, and it is a wealth tax.  While gains in investment values are taxed, the full value of a person’s wealth is not taxed.  Taxing wealth would provide a tremendous amount of new tax revenue.  However, opponents argue such a tax is unfair, and is actually “double-taxation because usually the wealth was accumulated from income that had already been taxed.

Taxes will always be a topic of discussion and debate.  In recent years there’s been discussion at both the national and state levels of moving away from the income tax.  Supporters say the income tax discourages working more and earning more, and hence impedes economic growth.  At the federal level, there’s been talk of eliminating the income tax and replacing it with revenues from tariffs and from a broader federal sales tax.  In North Carolina, there’s been a gradual reduction in the State income tax rate, thereby shifting more dependence for revenues to the State sales tax.

There’s plenty to debate about taxes.  Taxes are probably one of the most important and most lasting

Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University.