The United States: Undertaxed Nation

Andrea Louise Campbell has written the most concise and most relevant article on the US tax system that I have ever encountered. It appears in Foreign Affairs under the title: America the Undertaxed: U.S. Fiscal policy in Perspective. Most discussions one finds in the media concentrate on the federal income tax and the federal budget and focus on assessing the fairness or unfairness of the system. Campbell forces us to consider that the federal income tax is only one part of the tax collection apparatus of the nation. One must also consider payroll taxes, state and local taxes, excise, and corporate taxes if one is to obtain a clear view of who is paying what and who is receiving what. She also provides clear comparisons of what other wealthy countries are paying in taxes, and what they receive in benefits.

Campbell gets things rolling with this crisp statement:

"Compared with other developed countries, the United States has very low taxes, little redistribution of income, and an extraordinarily complex tax code. These three aspects of American exceptionalism deserve more attention than they typically receive."

To prove the first point she presents this OECD chart:

The United States exceeds only Chile and Mexico among OECD nations in the amount of tax it collects relative to its GDP. Campbell suggests that a more relevant picture would be obtained if one looked at data from 2006, before the Great Recession, rather than the 2009 data in the chart.

"But it is important to look at pre-recession data, which better reflect long-term trends. In 2006, before the financial crisis struck, OECD tax statistics showed that total taxes in the United States -- at all levels of government: federal, state, and local -- were 27.9 percent of GDP, three-quarters the percentages in Germany and the United Kingdom and about half of those in Denmark and Sweden. Among the rich democracies in 2006, only South Korea had lower taxes."

So—long term, we were actually the second lowest in taxation rather than the third lowest.

Campbell’s greatest service is to provide a breakdown of the various types of taxes and illustrate how the US diverges from the policies of it counterparts.

"The reason for this discrepancy is not that the United States has lower personal income tax revenues than its OECD counterparts. In fact, in 2006, personal income taxes at the federal, state, and local levels in the United States came to 10.1 percent of GDP, just above the OECD average of 9.2 percent. Instead, the disparity results from the low effective rates -- or nonexistence -- of other forms of taxation."

Corporate taxes collected are similar: 3.4% of GDP for the US versus an OECD average of 3.8%. Social insurance taxes in the US brought in 6.6% of GDP, somewhat lower than the OECD value of 9.2%.

The biggest difference lies in the utilization of consumption taxes. The US collects sales taxes at the state and local levels, and the federal government and states tax certain products like tobacco and alcohol, and there are customs duties. These taxes are not nearly as efficient at generating revenue as the value-added taxes (VATs) collected by most OECD countries. A VAT appears to the end consumer as the equivalent of a sales tax, but it is a more complex beast in that a manufactured object, for example, is taxed for the value added in each step of the process as it proceeds from raw materials to finished product.

"OECD statistics show that VATs bring in an average of 6.7 percent of GDP among the OECD nations, accounting for the majority of the difference in total tax revenues between the United States, which does not have a VAT, and the rest of the OECD."

Sales taxes and VATs are highly regressive taxes that are a greater burden on those with lower incomes. The other OECD countries can get away with a regressive tax system by redistributing that revenue in the form of social support services. This is a major mechanism for reducing the income inequality that is common in wealthy countries.

"The economists Smeeding and Katherin Ross Phillips have shown that rates of market-income poverty -- the proportion of people living in households with incomes that are below 40 percent of the median disposable income -- are quite high across the advanced democracies. In fact, according to Smeeding and Ross Phillips, the United States' market-income poverty rate of 17.2 percent for working-age adults is only slightly higher than Germany's (14.9 percent) and Sweden's (15.8 percent) and even lower than Canada's (18.4 percent) and the United Kingdom's (25 percent)."

"Smeeding and Ross Phillips found that after the implementation of universal transfer and social assistance programs, poverty among those aged 25 to 64 fell: to 6.9 percent in Canada, 5.9 percent in the United Kingdom, 3.5 percent in Germany, and 1.8 percent in Sweden. Meanwhile, in the United States, it remains at 10.9 percent."

One tends, in the US, to think of Europe as the place where high incomes are taxed to the point of depressing individual initiative in order to redistribute money to the poor. Campbell tells us that the greater difference between the US and Europe is in the use of regressive taxes to alleviate income inequality.

It is not that the US does not have a mechanism for supporting socially desirable outcomes; it is just that it is a particularly dumb and inefficient mechanism: tax expenditures. Lawmakers avoid creating dedicated programs that would show up as spending in a budget, and instead they try to encourage prosocial behavior by creating a maze of rebates, subsidies and deductions that take tax revenue and give it back. This process is slightly less efficient than throwing dollar bills in the air and hoping the wind will blow them where they need to be. Because the federal income tax code is used to generate the revenue, it also serves as the mechanism for redistributing the revenue. Since the wealthy pay a higher income tax rate, they also receive the majority of the redistribution—for which they are quite grateful, and are rather satisfied with the efficacy of the system.

"The Urban-Brookings Tax Policy Center estimates that in 2011, households with incomes in the top fifth of the income distribution received two-thirds of the benefits from tax expenditures, with the top one percent receiving a quarter of them."

Campbell does not make the direct comparison, but she points out that these tax expenditures used to redistribute revenue add up to about $1.1 trillion. That is about 7% of US GDP, and, interestingly, is almost equal to the average VAT collections that she says make up the major difference in tax collections between the US and other OECD countries. The US is a higher tax nation than it would appear from the OECD data, however, it chooses to waste a lot of the money it collects.

Campbell performs a great service by explaining the US tax system to US citizens. This is a service that our normal media outlets never quite get around to delivering—leaving the general public woefully misinformed about tax issues.

The focus on federal income taxes and tax rates injects a bias in favor of the conservative assumption that the wealthy pay at much higher rates and thus contribute a much higher fraction of tax revenue than anyone else. When one considers total taxes, including the regressive payroll taxes and the state and local taxes, the tax distribution is not very progressive at all, and each income class more nearly contributes an amount proportional to its income.

"According to the Institute on Taxation and Economic Policy, a fiscal think tank, in 2011, the lowest fifth of earners received 3.4 percent of total income and paid 2.1 percent of total taxes, the middle fifth received 11.4 percent of income and paid 10.3 percent of taxes, and the top one percent received 21 percent of income and paid 21.6 percent of taxes."

Campbell also provides numerous other insights into the particulars of the taxing process.

The US claims that it has about the highest corporate income tax rate in the world, but what is important is not the stated rate, but what is actually collected.

"As Republicans are quick to point out, the United States does have one of the highest statutory corporate tax rates in the developed world. Combining the federal and state levels, the top rate of these taxes is 39 percent, compared with an average of 36 percent across the G-7 and 31 percent across the OECD. Yet as with the individual income tax, the United States applies these statutory rates to a narrower base of taxpayers than other advanced countries do, due to various corporate tax credits and breaks, such as the accelerated depreciation of machinery and equipment and the deferral of taxes on income earned abroad. As a result, according to a report issued by the U.S. Treasury Department, between 2000 and 2005, on average, U.S. businesses paid an effective tax rate of only 13 percent, nearly three percent below the OECD average and the lowest rate among the G-7 countries."

Federal tax revenue is usually considered in the context of income tax. Campbell tells us that in 2010, payroll taxes provided 40% of revenue, compared to 42% from personal income tax. She also points out that the federal government gives back more in tax expenditures than it actually collects as income tax revenue—a truly strange way to run a country.

Campbell’s article is required reading for anyone who wishes to understand the US tax system and the issues associated with budgets and deficits. And there is more of interest in the article than was appropriate to discuss here. Many thanks to her!

ANDREA LOUISE CAMPBELL is Professor of Political Science at the Massachusetts Institute of Technology.