Taxes are obviously necessary in order for a society to provide public goods and services to its citizens. Unfortunately, taxes also impose costs on citizens both directly (because if an individual gives money to the government, she doesn’t have the money any longer) and indirectly (because taxes introduce inefficiency or deadweight loss) into markets.
Because the inefficiency that taxes introduce grows more than proportional to the amount of a tax, it makes sense for the government to structure taxes so that a lot of markets get taxed a little bit rather than so that a few markets get taxed a lot.
Therefore, a number of different taxes exist, and they can be categorized in a number of ways. Let’s take a look at some of the common tax breakdowns.
An income tax, not surprisingly, is a tax on the money that an individual or household makes.
This income can either come from labor income such as wages, salaries, and bonuses or from investment income such as interest, dividends, and capital gains. Income taxes are generally stated as a percentage of income, and this percentage can vary as the amount of a household’s income varies.
Consumption taxes, on the other hand, are levied when an individual or household buys stuff.
In the U.S., the most common consumption tax is a sales tax, which is levied as a percentage of the price of most items that are sold to consumers.
In China, the sales tax is replaced by the quite similar value-added tax. (The main difference between a sales tax and a value-added tax is that the latter is levied at each stage of production and is thus levied on both businesses and households.)
Consumption taxes can also take the form of excise or luxury taxes, which are taxes on specific items (cars, alcohol, etc.) at rates that may differ from the overall sales tax rate. Many e conomists feel that consumption taxes are more efficient than income taxes in fostering economic growth.
Regressive, Proportional, and Progressive Taxes
Taxes can also be categorized as either regressive, proportional, or progressive, and the distinction has to do with the behavior of the tax as the taxable base (such as a household’s income or a business’ profit) changes:
A regressive tax is a tax where lower-income entities pay a higher fraction of their income in taxes than do higher-income entities.
A proportional tax (sometimes called a flat tax) is a tax where everyone, regardless of income, pays the same fraction of income in taxes.
A progressive tax is a tax where lower-income entities pay a lower fraction of their income in taxes than do higher-income entities.
Revenue Taxes versus Sin Taxes
The main function of most taxes is to raise revenue that the government can use to provide goods and services to the public.
Taxes that have this goal are referred to as “revenue taxes.” Other taxes, however, are put in place not specifically to raise revenue but instead to correct for negative externalities, or “bad” behaviors, where production and consumption have negative side effects for society.
Such taxes are often referred to as “sin taxes,” but in more precise economic terms are known as “Pigovian taxes,” named after e conomist Arthur Pigou.
Because of their differing objectives, revenue taxes and sin taxes differ in their desired behavioral responses from producers and consumers.
Revenue taxes, on one hand, are viewed as best or most efficient when people don’t change their work or consumption behavior very much and instead let the tax just act as a transfer to the government. (A revenue tax is said to have low dead-weight loss in this case.)
A sin tax, on the other hand, is viewed as best when it has a large effect on the behavior of producers and consumers, even if it doesn’t raise very much money for the government.