Week 2 Discussion

2

Government Revenues

Where the Money Comes From

Income Taxes

Payroll Taxes

Sales Taxes

Property Taxes

Excise Taxes

Estate Taxes

Evaluating Taxes

Tax Expenditures

The State Level

The Local Level

Concluding Thoughts

A billion here, a billion there and pretty soon you’re talking about real money.

—Lane Kirland

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The need for tax revenue has always been a source of tension between governments and their citizens. From the beginnings of the American political system, leaders have recognized the importance of public revenues. The American Revolution began as a rebellion against British taxes and one of the rallying cries throughout the American Revolution was “no taxation with- out representation” (Ross 2004). Determining the level of tax- ation is a crucial link between citizens and their governments and as a consequence, many of the provisions of the U.S. Con- stitution deal with government revenues in some fashion (Herb 2005). However, government revenues in the United States have changed considerably over the years. Changes have included the amounts of money raised, the formats of public budgets, and the processes used to make revenue decisions. This chapter will pro- vide an overview of government revenues in the United States and explore the implications of changes in government finances for public budgeting.

While people often think of public budgeting along the lines of traditional budgetary balance or deficits, budgeting is better recognized as consisting of two distinct and separate issues: gov-

ernment expenditures and revenue policy (Fisher 2009). The relationship between taxing and spending varies considerably across functions. Indeed, whether one focuses on expenditures or revenues can lead one to completely different interpretations about the politics of public budgeting (Wlezien and Soroka 2003).

In exploring information on government revenues, bear in mind that different information sources are not always fully com- parable. Seemingly minor differences in definitions or coverage can lead to large differences in apparent levels of government revenues. Some of the most common differences in measures of

revenues deserve mention. If we compare total revenues with own-source revenues (e.g., revenues that a government raises on its own rather than being given the funds by another level of government), state and especially local governments in the United States appear considerably larger and more expensive in terms of total revenues. General revenues are typically lower than total revenues, which include various dedicated funds (such as funds for public employee pensions) that can only be used for specific purposes. Any discussion of budgetary issues must be

Government Revenues 27

clear regarding what sorts of budgetary numbers are used, or considerable confusion may result (Schick 1995, 205–216).

Where the Money Comes From

Taxes have been the subject of political controversy since the United States was founded. The Constitution provides in Arti- cle I, Section 8 that “the Congress shall have power to lay and collect taxes, duties, imports and excises, to pay the debts and provide for the common defense and general welfare of the Unit- ed States.” This provision represents an extensive grant of fis- cal authority to Congress because it covers almost any common form of taxation imaginable. The constitutional framers, fearing potential abuses of executive branch control of the power of the purse, made sure that any tax proposals had to be passed by the people’s branch of government, the legislative branch, and originate in the House, the only branch originally elected by the public. Over time, however, Congress has delegated much of its taxing power to the presidency (Farrier 2004).

Taxes tend to be unpopular and many Americans believe that they pay too much in taxes. The political rhetoric concerning so- cial programs usually centers on the cost to the taxpayer, accom- panied by assertions that Americans are already overtaxed as it is. Compared to other developed countries, however, the United States collects among the lowest proportion of taxes (see Figure 2-1 on the next page). As a percentage of the Gross Domestic Product (GDP), taxes in Denmark are nearly twice what they are in the United States. The United States has by far the low- est tax rate for high income individuals, its corporate taxes are smaller than the mean, and its levies on goods and services are well below the mean.

Denmark’s willingness to tax considerably more than the United States is unquestionably a product of the countries’ polit- ical cultures. Political culture is a sound predictor of tax regime design (Lockhart 2003). In political as well as economic terms, taxes are the cost of providing the benefits of government. Com- paratively speaking, the people of the United States appear to be less willing to pay the costs of these benefits than are people in other countries (Fisher 2009, chap 2).

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Figure 2.1—Comparative Tax Rates

Denmark France

Italy Sweden Norway

Hungary Netherlands

Germany United Kingdom

Spain Canada

Japan Switzerland

Australia United States

Source: Organization for Economic Cooperation and Development, figures for 2012

For the most part, growth in federal revenues has historically been closely tied to the annual increase in the GDP. Before 2000, the major exceptions were when revenues dropped dramatically from the previous year when major tax cuts were enacted. In the twenty-first century, however, tax revenues have been more vol- atility than had been the case over the previous three decades. Tax revenues have become much more unpredictable and more buffeted by swings in the stock market than they were a decade ago. Tax revenues are increasingly dependent on the fortunes of the very wealthy, and the rich are different from other taxpayers in that much more of their income is tied not to wages but to the stock market and executive bonuses, which can swing widely from year to year (Andrews 2006).

Political debates on tax policy tend to revolve around the question of how much to tax. An equally important question is what to tax. Federal revenues are derived from various sources, the most important of which are individual income taxes, corpo- rate income taxes, and payroll taxes. In 2014, individual income taxes made up 46 percent of federal revenues, social insurance taxes 32 percent and corporate income taxes 13 percent (see Fig- ure 2.2). We will now analyze the most prominent sources of rev- enue for governments in the United States.

Government Revenues 29

Figure 2.2—Sources of Federal Revenue

Source: Congressional Budget Office. Figures are for the 2014 fiscal year.

Income Taxes

From our nation’s founding until World War I, tariffs and excise taxes were the primary sources of revenue for the tiny nation- al government. The income tax was unknown until it was used briefly during the Civil War. It then remained unused until 1894, when President Grover Cleveland convinced Congress to lower tariffs and substitute a modest tax on incomes to recoup reve- nues. The Supreme Court, however, ruled the income tax uncon- stitutional in the case Pollock v. Farmers’ Loan and Trust Co. (1895). In Pollock, the Supreme Court ruled that a tax on income from property should be required to be apportioned. The source of income was therefore relevant in determining whether a tax imposed on income was direct or indirect. This meant that while income taxes on wages were not required to be apportioned by the population, taxes on interest, dividends and rent income were required to be apportioned by population. As a result of the Pollock ruling, the federal government ran deficits 11 of the 21 years from 1894 to 1914. Reacting to the federal government’s inability to balance the budget, the Sixteenth Amendment al- lowing the income tax was ratified in 1913. Although the modern federal income tax was enabled by the Sixteenth Amendment, it was not until World War II that anyone other than the very wealthy paid it. In 1939, less than four million individuals paid the federal income tax; by 1945 that figure was greater than 42 million (Brownlee 2004, 115).

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A common criticism of the income tax is that it is difficult to administer. The income tax is only politically practical with withholding, where employers deduct specific amounts from each employee’s paycheck for yearly taxes. Withholding is a key administrative feature of this tax because it makes tax payment less painful to the average taxpayer and provides an indepen- dent source of information on people’s incomes. Despite the ad- ministrative difficulties of administering the tax, however, the considerable revenue potential of the income tax is seen to be a key attribute of the tax. This is why a majority of states utilize the tax. Even though it is often thought of as a federal tax, it is also an important source for state governments–the second largest source of revenue after the sales tax. At the federal level, the income tax is collected from both corporations and individ- uals and is collected on all types of income. State income taxes are often closely related to the federal tax, with specific changes mandated by the state legislatures.

Another critical feature of the income tax is that it can be a progressive tax because higher-income persons can be taxed at a higher rate. Since the election of Franklin Roosevelt as president in 1932, Democrats have generally favored a more progressive income tax than Republicans (Fisher 2009, chap 2). As a conse- quence, income tax rates have fluctuated considerably since the

Sixteenth Amendment was ratified. In 1913, the top marginal rate was only seven percent. This figure went up dramatically during World War I before being reduced to 25 percent in the 1920s. In order to pay for New Deal programs and later to help

finance World War II, however, Franklin Roosevelt raised the individual and corporate income taxes to unprecedented levels and the top marginal rate remained over 70 percent until 1982.

Figure 2.3 shows the top marginal individual income rate since the Sixteenth Amendment was ratified. The table contains a number of simplifications and ignores some factors—the defi- nition of taxable income, for example, has varied substantially through the years and taxable income can be considerably less than actual income. Also, the income level at which the top rate goes into effect has varied considerably through the years, with the top rate taking effect at the high end on taxable income over $2,000,000 in 1916–1917 and 1936–1941 and on the low end at $84,300 in 1991–1992. It is clear, however, that the rate of taxa-

Government Revenues 31

tion for the top income tax bracket has decreased dramatically during the past half-century, falling from 91% in 1963 to 35% in 2003. Since the end of World War II, therefore, the federal tax system has gradually become less progressive.

Figure 2.3—Historical Highest Marginal Income Tax Rates

Source: Internal Revenue Service

The level of individual income tax receipts fluctuates signifi- cantly even when the marginal tax rates do not change. Histor- ically, individual income tax receipts have been the key deter- minant of movements in total revenues; between 1965 and the late 1990s, individual income taxes produced nearly half of all federal revenues. Another factor having an effect on the amount of revenue the income tax raises is inflation. For many years, inflation pushed income into higher tax brackets; the result was called “bracket creep” because tax rates rose without an increase in real purchasing power. Bracket creep was especially prob- lematic during periods of high inflation, such as the late 1970s, which led to adoption of indexing of income tax rates to adjust for inflation beginning in the 1980s.

There are many potential variations in the implementation of the income tax. One of the more politically controversial fea- tures of the federal income tax today is the Alternative Mini- mum Tax (AMT). The AMT was originally designed to limit the use of tax preferences (exclusions or deductions from a compre- hensive measure of income) by high-income taxpayers to ensure

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that they paid at least some income tax. Under the AMT, a paral- lel tax system with its own set of exemptions and tax-rate sched- ule was created with a more limited set of tax preferences than those that apply under the regular income tax. Taxpayers are required to pay whichever is greater–the tax they owe under the AMT or the tax they owe under the regular income tax. The AMT allows a single large exemption, which was originally designed to make sure that low- and middle-income taxpayers would not be forced to pay the AMT. Historically, the share of tax filers who are subject to the AMT has been small, reaching one percent of filers for the first time in 2000.

Along with personal incomes, the federal government taxes corporate incomes. The current corporate income tax rate ranges from 15 percent to 35 percent depending upon a corporation’s profits and the effective corporate income tax rate is close to 26 percent. Most businesses are classified by the IRS as “S” corpo- rations and not required to pay the corporate income tax. Fewer than 10 percent of all businesses, including farm businesses, are classified as “C” corporations and subject to the corporate income tax (Friedman 2003). The profits of businesses other than C cor- porations are subject to the individual rather than the corporate income tax.

Since World War II, the corporate income tax has been an important source of federal revenue and today corporate income taxes are the third-largest source of revenue for the federal gov- ernment. The relative share of corporate income taxes, however, has declined significantly since the 1950s, falling from 28 per- cent of federal revenues in the 1950s to 21 percent in the 1960s to 13 percent today. The fall in corporate income tax revenues is in part due to the decline in corporate tax rates, which exceeded 50 percent for most of the 1950s and 1960s. Another reason for the decline in corporate income tax revenues is the increasingly aggressive use of tax shelters by businesses to avoid paying tax- es. As a result, corporate income tax revenues as a share of the economy in the United States are less than that of most other developed countries (Friedman 2003).

Government Revenues 33

Payroll Taxes

The payroll tax is another major source of revenue for the feder- al government. Social Security is financed by a flat-rate payroll tax. Since only the first $117,000 in earned income is taxed, the effective payroll tax rate one pays drops as one’s income rises. As a result, the payroll tax is often criticized as regressive, where the wealthy pay relatively less, unlike the progressive income tax. Since 1990, employers and employees have each paid 6.2 percent of the employees’ earned income to finance Social Secu- rity and 1.45 percent to finance Medicare. Self-employed individ- uals pay both shares–15.3%. Workers do not pay the payroll tax on wages over $117,000 but they do continue to pay the health insurance tax.

The payroll tax rate for Social Security has gone up dramat- ically since Social Security’s founding (see Figure 2.4). The orig- inal Social Security payroll tax in 1937 was only 1 percent. This rate tripled by 1961, was increased to 4.2 percent in 1970, and gradually increased in the 1970s and 1980s before leveling off at 6.2 percent in 1990. The payroll tax thus now accounts for a greater proportion of federal revenues than has historically been the case and payroll taxes now represent the second largest source of revenue for the federal government.

Figure 2.4—Payroll Tax Rate for Social Security 7

6

5

4

3

2

1

0 1935 1945 1955 1965 1975 1985 1995 2005 2015

Source: Social Security Administration. Note: The payroll tax is the rate paid by both employees and employers

Pa yr

ol l T

ax R

at e (

% )

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Social Security is a pay-as-you go system with current work- ers paying for existing retirees. Despite the rhetoric of politi- cians, payroll taxes are used for the same purposes as income taxes–the government uses the money to meet whatever ex- penses are pending. It is therefore wrong to look at the payroll tax separate from the rest of the budget, despite the rhetoric of many a politician through the years.

Sales Taxes

A sales tax is a levy that is made whenever someone buys a good or service. The tax is set as a percent of the sales price. A sales tax applies to goods and services normally levied at retail stores and expressed in percent terms. They can be general or selective. Importantly, the revenue base of the federal government does not rely on a sales tax. Though some local governments use it, in the United States the sales tax is primarily a state tax and it is the largest source of revenue for state governments. Only five states (Alaska, Delaware, Montana, New Hampshire, and Ore- gon) do not levy a general tax on the sale of goods and services.

Though it is relatively easy to collect, the sales tax is criti- cized as being regressive because it disproportionately hurts the poor. Sales taxes are also seen as increasing inequality since poor areas cannot generate the sales taxes that wealthiest areas can.

The United States is the only industrialized nation without a national sales tax or value-added tax, so named because it is imposed on the “value added” at every stage of production or service. A business that spends $10,000 on raw materials and other costs to turn out a product that sell for $15,000 would pay tax on only the $5,000 difference. This is the single most im- portant difference between the American and the tax systems of other industrialized nations. If, for example, the United States collected the same average amount of consumption taxes as the European Union, it would collect in taxes an amount equal to around 38 percent of the GDP, which is close to the overall tax rates of most European nations (Steinmo 1993, 196). If the feder- al government was to ever look for significant revenue increases, creating a value-added tax may offer the best means to do so.

Government Revenues 35

Property Taxes

A property tax is a levy on property that the owner is required to pay. In the United States, property taxes are largely utilized as a local government tax and are a major source of local government revenue. There are two stages to the implementation of the prop- erty tax. First, property is assessed locally so that property value is determined. Second, a tax rate is determined and applied on the basis of the property value.

Property taxes can be placed on personal and real property. Tangible personal property includes machinery, equipment, and motor vehicles. Intangible personal property includes stocks, bonds, mortgages, and money. Real property includes land as well as improvements to the land such as buildings.

The property tax has many critics and to many Americans it is the worst or least-fair tax. Criticisms of the property tax include: 1) it hurts low-income households; 2) it is an anti-house levy; 3) administration of the tax is difficult and often poorly done; 4) it contributes to urban blight and 5) administering the tax can be extremely complicated.

The unpopularity of the property tax, in fact, is said to be the catalyst for the modern tax cut movement in the United States. In 1978 California voters passed Proposition 13 which dramati- cally lowered property taxes in the state. Immediately after the passage of Proposition 13, tax reduction referenda succeeded in a number of other states, including Illinois, Massachusetts, and Michigan. Proposition 13 was successful due in part to the fact that there were dramatic increases in the property tax just prior to that issue coming on the ballot. The California government did not increase tax rates, but the huge increases in property values in California had suddenly pushed property assessments much higher than they had previously been, creating the percep- tion that the property tax in California was unfair. After it was implemented, Proposition 13 was indeed effective at reducing per capita property taxes and per capita state and local taxes. To circumvent the limits imposed by Proposition 13, however, the state has drastically increased nonguaranteed debt and has dra- matically devolved fiscal authority (McCubbins and McCubbins 2010).

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Excise Taxes

Excise taxes are taxes paid when purchases are made on a spe- cific good or when one engages in a particular activity. Before the twentieth century the major source of revenue for the United States was the tariff, an excise tax placed on goods upon impor- tation. The precedence for the federal government’s reliance on the tariff goes back to the first days of the nation when the First Congress passed the Tariff Act of 1789. Though high tariffs were often politically contentious, with free trade advocates arguing that high tariffs were economically counterproductive, high tar- iff rates provided a relatively stable revenue base for the small federal government throughout the nineteenth century. It was not until it became clear that tariff alone would no longer pro- vide enough revenue for the federal government to sustain itself that Congress reluctantly took the steps to ratify the Sixteenth Amendment allowing for the income tax.

Today, revenues from excise taxes amount to only a small fraction of all federal revenues. Contemporary excise taxes gen- erally fall into five major categories: highway, airport, telephone, alcohol, and tobacco taxes. It is very much like a sales tax, but it refers to a special tax on selected items like alcohol, tobacco, or gambling profits. Where applicable, one pays both an excise and general sales tax on the same item. A particular category of excise tax that is being utilized more often today than in the past are so-called sin taxes. Sin taxes on alcohol, tobacco and gam- bling profits are regularly levied by federal and state govern- ments. A problematic aspect of sin taxes is that they are largely seen to be regressive, because the poor are more likely to be pay- ing them, but compared to other taxes sin taxes are relatively politically acceptable.

By far the most important excise tax in the United States to- day is the gasoline tax, which accounts for about half of all excise receipts. The federal gas tax is currently 18.4 cents to the gallon. At the state level, gas tax rates vary considerably, with Wiscon- sin having the highest state gas tax at 31 cents per gallon and Georgia having the lowest gas tax at 14.5 cents per gallon. The entire federal gasoline tax is deposited in the Highway Trust Fund. With the passage of the Transportation Equity Act for the 21st Century (TEA-21) in 1998, Congress established a direct link between the Highway Trust Fund and the funding trans-

Government Revenues 37

ferred to states and cities for highways and transit. As a result, spending on all highway and transit programs is decreased pro- portionately if tax revenue in the trust fund falls short (Fisher and Nice 2002).

Estate Taxes

The estate tax is a tax levied on the transfer of property after one dies. It tends to be a relatively controversial tax, despite the fact that it brings in relatively little federal revenue. Despite its political contentiousness, the estate tax affects few households: fewer than 1 percent of estates paid federal estate taxes in 2014 and only a little more than more 1 percent of all federal revenues are derived from the estate tax. A justification for this tax is that an inheritance constitutes an income for the recipient that is not earned in the same sense that money is earned through work or even through returns on investment decisions. Proponents of the estate tax argue that is necessary to a system of progressive taxation because it only affects estates of considerable size and provides numerous credits that allow a significant portion of es- tates to escape taxation. Supporters of the tax also argue that the high effective transfer tax rate encourages billions of dollars in charitable donations each year.

Since the estate tax is only imposed on an estate after some- one has deceased, critics of the estate tax refer to the tax as a “death tax.” Those opposing inheritance taxes argue that taxes presumably were paid by the person leaving the estate while he or she was earning a living. The federal estate tax was phased out for a year in 2010 but reinstated in 2011. Though it was rein- stated, estate tax rates have gone down considerably since 2002. In 2002 estates worth more than $1 million paid the tax; when it was reinstated in 2011 the exclusion rate was $5 million. At the same time the top estate tax rate was reduced from 50% in 2002 to 35% in 2011.

Evaluating Taxes

The most obvious goal of taxation is to raise revenue for the gov- ernment. Buoyancy refers to the ability of a tax to collect the same “real” revenue in the face of changing economic circum-

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stances. Policymakers should not have to reset tax rates when the economy changes if the tax is buoyant. A tax that is high- ly dependent on the condition of the economy or on a particu- lar activity can put government revenues on a veritable roller coaster. A lack of predictability causes management and political problems for policymakers who may need to establish new or increase taxes to cover projected revenue shortfalls.

Another goal of tax policy, less obvious but more politically contentious, is to redistribute wealth. All taxes discriminate. The public policy question is how to raise revenue with a tax that provides the desired discrimination. Taxes can be progressive, regressive, or proportional. In a progressive tax structure, the rate of taxation increases as one’s income and wealth increase. For example, in a progressive tax system a person with $200,000 in income might pay 40 percent of their income in taxes while a person with $50,000 in income might pay 20 percent of their in- come in taxes. As we discussed earlier in this chapter, the federal income tax is currently (and has always been) progressive in its implementation. A regressive tax system is the opposite of a pro- gressive tax, with the rate of taxation decreasing as one’s wealth increases. The federal payroll tax is currently construed as a re- gressive tax. A proportional tax is a tax imposed so that effective rate is fixed as the amount to which the rate applied increases. Proportional taxes maintain an equal tax rate regardless of in- come level and do not shift the rate disproportionately to those with higher or lower incomes. A sales tax where all goods are taxed at one fixed rate is a common example of a proportional tax (though some argue that proportional taxes on consumption are regressive because low income people spend a greater per- centage of their income in taxable sales).

The most important choice the federal government ever made about taxation was the decision to raise revenue by tax- ing personal and corporate incomes. The second most important choice made was that the federal income tax be progressive, with the heaviest burden carried by those most able to pay. Advocates of the income tax as a major source of revenue tend to stress the tax’s progressivity as a primary advantage of the tax.

Whether or not federal taxes are progressive depends on which taxes you are talking about. The federal income tax is progressive. Payroll taxes and excise taxes, however, tend to be

Government Revenues 39

30

25

20

15

10

5

0 -5

Personal Income Payroll All Federal

regressive. Figure 2.5 displays the markedly different impacts of personal income taxes and payroll taxes depending upon one’s income. For the lowest quintile (poorest 20 percent), the effective income tax rate is actually negative (meaning that they receive money from the federal government) because of the Earned In- come Tax Credit (EITC) program. For the highest quintile (the wealthiest 20 percent), the effective income tax rate is about 10 percent. With payroll taxes, on the other hand, the effective tax rate goes down the more money you make because the payroll tax is paid only on incomes up to $117,000. While the effective payroll tax rate for the lowest quintile is 6.6 percent, it is only 2.3 percent for the wealthiest one percent. To critics, the magni- tude of the Social Security-Medicare payroll tax makes the U.S. tax system less progressive than it should be. Due to its regres- sive nature it can be argued that the payroll tax is unfavorable to lower-middle-class Americans (Quirk 2003). The total amount one contributes in all federal taxes, however, is progressive; the effective tax rate for all federal taxes is 3 percent for the lowest quintile and 21 percent for the highest quintile.

Figure 2.5—Effective Federal Tax Rates by Income Level

35

Lowest Quintile

Second Quintile

Third Quintile

Fourth Quintile

Highest Quintile

Top 10% Top 5% Top 1%

Income Level

Source: Congressional Budget Office. Rates are for 2014 fiscal year.

Ef fe

ct iv

e Ta

x Ra

te (%

)

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An advantage of progressive taxes from a revenue perspec- tive is that it is easier to raise money by taxing the wealthy in a progressive manner. It is easier for the very wealthy to enhance their income levels than other segments of the population. There is also evidence that wealth is more concentrated than it used to be, suggesting that progressive taxes can be justified on “fair- ness” grounds. The fairness of progressive taxes of course is de- batable, but progressive tax rates have unquestionably impacted the concentration of wealth in the United States. Of the forty richest men in American history, for example, not one made his fortune during eras in which the tax code was at its most pro- gressive (Pizzigati 2005).

Tax Expenditures

An important though sometimes confusing aspect of federal bud- geting involves tax expenditures. Tax expenditures are revenue losses attributable to provisions of the federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of liability. A tax expenditure has the same eco- nomic effect as raising revenue through taxes and then spend- ing it to support some activity or facility. Politically, however, tax expenditures do not have to go through the budget process every year and are sometimes treated differently from spend- ing programs because, as some observers repeatedly say, a tax expenditure simply lets people keep their own money. Support for otherwise identical social programs is generally higher when such programs are portrayed as being delivered through tax ex- penditures than when they are portrayed as being delivered by direct spending (Faricy and Ellis 2014). Bear in mind that a tax expenditure, in effect, means less money in the federal treasury, just the same as spending money means less money in the fed- eral treasury. In fact, the federal government gives up almost as much money from tax expenditures as it collects in individual and corporate income taxes (Wessel 2012).

Tax expenditures take a number of forms (see Table 2.1). Two of the largest involve employer contributions for medical insurance and care, and provisions regarding pension contribu- tions and earnings. Two tax expenditures that are dear to the

Government Revenues 41

hearts of many home owners are the deductions for mortgage interest payments and property taxes on owner-occupied homes. Some federal tax expenditures have important effects on state and local financing: Deductions for property taxes on owner-oc- cupied homes and for nonbusiness state and local taxes and the exclusion of interest on state and local public debt (such as state government bonds) from taxable income all make state and local revenue raising a little less painful. If the property taxes on my home increase, some of the sting is relieved because I will receive a larger deduction on my federal income taxes. In a similar fash- ion, deductions for charitable contributions make fund-raising for charities somewhat easier; a $1,000 contribution to a quali- fied charity can produce a federal tax saving of $200 or $300 for the donor, depending on the donor’s income tax bracket.

Table 2.1—Major Federal Tax Expenditures, 2014

Exclusion of employer contributions for medical insurance and medical care $212 billion Net exclusion of pension contributions and earnings (employer plans) $176 billion Deduction of mortgage interest on owner-occupied homes $101 billion Charitable deduction $54 billion Deductibility of state and local income taxes $52 billion Lower capital gains rates $47 billion Capital gains exclusion on home sales $46 billion Exclusion of interest on state and local bonds $34 billion Deductibility of state and local property taxes $25 billion

Source: Treasury Department

The State Level

Generalizing about state and local revenues is a somewhat risky enterprise, for revenue and spending patterns vary a great deal from one jurisdiction to another, especially at the local level. With that caution in mind, a substantial share of state govern- ment revenue comes in the form of aid from other governments, mostly the federal government (see Table 2.2). Another major state revenue source is sales and gross receipts taxes. This group includes relatively general sales taxes, which cover all or almost all sales of products (some states exempt groceries and/or oth-

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er products, such as some medicines), and selective sales tax- es on particular products, such as motor fuels. The typical state also raises significant revenue from income taxes, with most of the revenue being raised by individual income taxes. Another important revenue source is taxes and fees that finance vari- ous insurance trusts to support unemployment compensation programs, state employee pensions, and other programs. State revenue decisions are often shaped by the fear that taxes that are perceived as tough on businesses may cause businesses to relocate to other states and discourage other businesses from moving into the state.

Table 2.2—State and Local Revenue Sources

and Expenditures, 2012

State revenues Intergovernmental funds 28% Sales and gross receipts taxes 20% Charges and fees 16% Income taxes 17% Other sources 19%

State expenditures Welfare (including health care for the poor) 22% Education 14% Insurance trust spending 10% Health and hospitals 2% Transportation 5% Other 53%

Local revenues Intergovernmental funds 33% Property taxes 27% Charges, fees, and miscellaneous 20% Sales and gross receipts taxes 6% Other 12%

Government Revenues 43

Local expenditures

Education 36% Health and hospitals 3% Police, fire, and corrections 8% General debt interest 5% Welfare 3% Highways 4% Other 43%

SOURCE: State and Local Government Finances by Level of Government and State (American FactFinder; Bureau of the Census, Washington, DC).

A proportionally minor state revenue source that has at-

tracted considerable attention in recent years is state lotteries, which are now found in 36 states. Lotteries have become fairly popular, partly because they raise money voluntarily, in contrast to the relatively mandatory nature of taxes. However, a major shortcoming of lotteries is their very high overhead costs: For every dollar taken in by the typical state lottery, more than 60 cents is spent on prizes and administration, leaving less than 40 cents for the state treasury. Critics of lotteries also charge that they are relatively regressive revenue sources, primarily because people in the lower income brackets are likely to spend a larger share of their incomes for lotteries and most of the money spent by citizens on lottery participation is lost to the state govern- ment running the lottery.

The Local Level

Local revenue systems vary greatly from one local government to another, but overall the single largest source of local revenue is aid from other levels of government, particularly state gov- ernments. Property taxes are another important local revenue source, as are charges and fees for a wide range of things: wa- ter and sewer service, trash collection, building permits, library cards for nonresidents, parking—the list is practically endless. Charges and fees seem to have come into favor in recent years, in part because they are more acceptable politically than are prop- erty taxes in many localities. A modest amount of local revenue

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is provided by sales and gross receipts taxes; their contribution to the overall totals is limited because many localities are not permitted to use them and because local sales tax rates are gen- erally quite low.

Concluding Thoughts

As citizens make increasing demands on their governments to provide goods and services, governments have had to find ways to grow their revenue to satisfy these demands. The problem is, government revenues may not be stable—they tend to fluctuate quite a bit from year-to-year—but the laws that create revenues do tend to be stable. Once enacted, taxes are politically difficult to change. The great majority of revenue laws are thus old laws. By sustaining familiar taxes, inertia tends to make taxation po- litically acceptable, while new tax proposals can induce anxiety or anger by their unfamiliarity. When the taxation status quo fails to generate a sufficient amount of revenue to meet expected expenditure, policymakers can then resort to borrowing to fund deficits—what has been called the “non-decisionmaking model” (Rose 1986). This gets around the need to make a decision about matters that are both visible and likely to be politically unpopu- lar. Informal rules and behavioral patterns assure that a policy already in place will continue in effect without new explicit deci- sions being made. This is not just inertia, but a systematic bias against active consideration of raising taxes (Schick 1980).

Unfortunately, when public demand for benefits and services outruns their willingness to pay taxes or fees to support them, the result may be more and more borrowing to unsustainable levels eventually precipitating a financial crises. Consequently, public budgeting has become a much more complex and con- flict-ridden task.