A World Without Taxes — Tax Basics

From Taxes: Where Does the Money Go? by Scott Loveridge, Liz Templin, Carole  Yoho, and Nancy Lenhart

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This section explains why taxes are necessary. It explains why tax collection methods vary from one level of government to the next. Functions of the various levels of government in the United States are explained.

A World Without Taxes

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Depending on where you live, how much you earn, and how many deductions you claim when you file your taxes, 20 to 50 cents of every dollar you make goes to pay some kind of tax.¹ What would you buy if you didn't have to pay those taxes? Many people probably would spend the money on a new house or a new car. Now let's think about what a typical day would be like with this new house and new car.

1. Get up in the morning and try not to use much electricity. Without government regulation, this monopoly service would be much more expensive. Water also would be much more expensive in the cities for the same reason.
   
   
2. If you live in a rural area, take a chance on the safety of your well water. Without government agencies regulating agricultural chemicals and waste disposal sites, you might have more medical problems as a result of groundwater pollution.
   
   
3. Take about 20 minutes to unlock and relock all the doors on your house and car. With no police, courts, or prisons, you would have to be a lot more careful about crime.
   
   
4. Notice how many poor people there are. Without public schools, there would be more uneducated people and it is difficult for the uneducated to get good jobs.
   
   
5. If you live in an urban area, take a minute to adjust your oxygen mask before getting on the highways. Without pollution control regulation and enforcement, it could be difficult to breathe some days.
   
   
6. Decide what kind of road to take. Most roads would either be dirt lanes or require payment of tolls.
   
   
7. Be careful not to get into an accident on the way to work. There would be fewer good doctors because lack of public education would make getting good training very expensive. Also, there would be many quacks due to lack of regulation.

Doesn't sound good, does it? And you haven't even gotten to work yet! We need taxes to pay for government services. Society is better off if access to some services (such as education, police, and fire protection) doesn't depend on a person's ability to pay. A good example of this principle is in the field of public health—if we prevent disease in other people, we are less likely to get those diseases ourselves.

Clearly we need government services and most of these services are paid for by our taxes.

What to Tax and How to Tax

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Taxes are usually placed on things visible and easy to count such as income, purchases, and property. In some places, imports, exports, or persons (heads) are taxed. Americans have a history of believing in free trade that goes back to the Boston Tea Party so we don't see taxes on imports and exports as a good way to raise most of our government revenue, though we do tax some imports. Most people consider head taxes (where each person pays the same amount of tax) unfair to poor people. How do we decide which kind of tax to use? Consider the following criteria:

Fairness — A tax should be based on both ability to pay and use of government services.

Efficiency — A tax should not distort people's incentives to earn money. (Example: What would people do if Minnesota had an income tax that took 99 cents of every dollar above $20,000 per year? Answer: Hourly workers making close to $20,000 would quit working after they reached $20,000, and people making significantly more than $20,000 would leave the state.)

Administrative convenience — It should be easy for the government to know who owes, how much they owe, and how to find them. The cost of collecting the tax should be low.

Understandability — People should be able to figure out how the government calculates their tax bill.

Small Government

Because small governments (such as cities, counties, and townships) have relatively low populations and small geographic areas, there are fewer types of taxes that they can effectively administer. Which taxes work best for small government?

Not income — It is easy to hide income or to move away from small governments.

Not purchases — In small geographic areas, people will travel to lower tax areas to make their purchases.

Not imports or exports — It is not administratively convenient to monitor everything that enters or leaves a city or a county. In addition, such a tax is unconstitutional for state and local governments in the United States.

Not heads (per person) — This method isn't fair to poor people and it may not reflect services received. As an example of how wealthy people use more services than poor people, consider education. Children of wealthy people tend to stay in school longer than children of poor people, so wealthy people benefit more from subsidies to education than poor people. As another example, think of government costs to maintain airports and air safety standards. Wealthy people are more likely to travel by air than poor people.

Property taxes are the most effective tax for use by small governments. These revenues are also very stable in comparison to other potential sources of tax revenue, making this type of tax attractive for small units of government that can't run deficits. Real estate is easier to tax than other types of property because it is hard to hide and fairly easy to assess. Larger units of government (i.e., state and federal government) prefer to use sales and income taxes, because in large geographic areas it is harder for people to dodge these forms of taxation.

A disadvantage of property taxes is that they do not necessarily reflect the current earnings of the property owner. The value of a person's property can increase faster than that person's income, as happened to many retired people on fixed incomes during the inflation years of the 1970s and the suburban land boom of the 1980s. Alternatively, property values can remain relatively stable while income drops, as happened to farmers in recent years, and as often happens when there is a death, divorce, or job loss in the family. The Minnesota property tax system attempts to adjust property taxes to take some of these situations into account. This is done with the circuit breaker program. See the "Steps for Calculating Your Property Taxes" section of this publication.

What Government Services Are We Receiving?

Different levels of government provide different services. Table 1 identifies the largest expenditure category by level of government. The past two decades have seen little change in the biggest expenditure category of each level of government. This has changed recently for the federal government, however, with defense spending beginning to drop, while Social Security, Medicare, and interest costs are increasing.

State and local governments in Minnesota provide the services identified in figure 1. (Local government includes counties, cities, townships, school districts, and special districts.)

Table 1. Where Do Tax Dollars Go?

Largest Expenditure Category
Federal State Counties Cities Townships	Social Security/Medicare Education Human services Public safety and streets Roads/bridges
Source: U.S. Bureau of the Census, Government Finances 1990-91, Series GF-91-5, USGPO, Washington, D.C. Forthcoming.

Figure 1. Percentage of State and Local Government
General Expenditure by Function, Minnesota FY 1990-91 Source: U.S. Bureau of the Census, Government Finances 1990-91, Series GF-91-5, USGPO, Washington, D.C. Forthcoming.
*"Other" includes sewerage, natural resources, parks, housing, and miscellaneous.

Education is by far the largest single item on which state and local dollars are spent. It accounted for roughly one-third of total spending in 1990-91. The proportion of expenditures allocated to education and the various other expenditure categories has remained almost constant over the last decade.

In contrast, total expenditures have changed since 1981. The top line in figure 2 shows how much expenditures have increased when adjusted for inflation (constant 1991 dollars), while the bottom line is not adjusted for inflation. The top line is the more accurate way to look at changes in spending. The unadjusted figures are often used by people who want to reinforce a point they are making about excessive government spending.

Figure 2. Minnesota State and Local Government
Expenditure per Person Adjusted for Inflation and Unadjusted Sources: State and local government general expenditure from U.S. Bureau of the Census, Government Finances, USGPO, Washington, D.C., various years; Population and inflation rates from U.S. Bureau of Census, Statistical Abstract of the United States, USGPO, Washington, D.C., various years.

A good way of looking at spending trends is to compare state and local government general expenditures with personal income. We demand more services from government as our incomes grow. Think of roads. When families had only one car, there was less congestion and less wear and tear on roads. Now that more people can afford to own cars, road construction and maintenance costs have gone up. From 1981 to 1991 state and local government general expenditures increased from about 19 percent to about 22 percent of personal income. So state and local government is taking a bigger bite than it did in the past.

U.S. Tax Bill Compared with Other Nations

How does the American tax bill compare to taxes paid by other nations? We pay a smaller proportion of our national income in taxes than do citizens in 20 of the 21 other developed nations belonging to the Organization for Economic Cooperation and Development (OECD). The only country in that organization with a smaller tax burden than the United States is Turkey. Our tax bill is roughly 30 percent of national income, or more than 4 percent less than the average for OECD countries. Many of the differences between the tax bill in the United States and these countries have to do with the kinds of services provided by government (e.g., health care, college education, and child care). Table 2 provides details of tax revenues as a proportion of national income (measured here as Gross Domestic Product — see Definitions for an explanation of GDP).

While the United States as a whole is a low tax nation, the state and local governments of Minnesota have higher taxes than many other states. Table 3 shows that Minnesota tax revenue as a percentage of income is higher than neighboring states and the nation as a whole. (The taxpayers of the District of Columbia, New York, Wyoming, Alaska, and Hawaii pay a higher proportion of income in taxes than do Minnesotans.)

Summary

• Our tax dollars go to pay for government services. While we may argue about the level of services to be provided, it is clear that we need government to provide some services. Crime, pollution, and the cost of many things we purchase from for-profit organizations would be higher without the services government provides.
  
• The size and functions of local, state, and federal governments have a lot to do with what services they provide and what type of taxes they collect. Each level of government tends to focus on different services and local services are usually the most visible.
  
• Education is the largest combined expenditure at the state and local level.
  
• Our tax bill (as a percentage of income) compares favorably to that of the other wealthy nations of the world, while our Minnesota state and local tax bill takes a higher proportion of our personal income than is taken by the state and local tax bills of most other states.
  

Definitions

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general expenditure. All government expenditures except those associated with employee retirement or other insurance trust expenditures, government-run liquor stores, and public utilities.

general revenue. All receipts except those associated with insurance trust funds, government-run liquor stores, and public utilities.

gross domestic product (GDP). The market value of all goods and services produced during the year and sold through the market but not resold within the national borders. This figure does not account for earnings on foreign investments.

human services. State auditor's term for the following social welfare programs and functions: Minnesota Supplemental Assistance, General Assistance, Aid to Families with Dependent Children, Medical Assistance, Social Services, and other welfare programs.

public welfare. U.S. Census Bureau term for a variety of public assistance programs and their administration. Includes Aid to Families with Dependent Children, Old Age Assistance, the Supplemental Security Income program, and general cash assistance. Other spending in this category includes payments to service providers under the various programs, including medical care providers in the Medicaid program and institutional care for the needy.

¹ Government Finances, 1989-90, GF-89-5, p. 3. Back

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