Measuring the Burden of High Taxes

Policy Reports | Taxes

No. 215
Wednesday, July 01, 1998
by Gerald W. Scully

Where Our Tax Dollars Go

Table I - Tax Revenue as a Percent of GDP%2C 1994

Taxes are collected for two basic purposes. First, they are used to provide public goods, such as national defense and a legal system. Second, they are used to redistribute income from the economically successful to the less successful.1

When government takes a dollar from taxpayers and spends it on a government program, there are three possible outcomes: the economy's total output of goods and services can go up, it can go down or it can remain unchanged.

Over some range of taxation, the provision of government goods and services makes private economic activity more productive. It is clear that the current level of productivity would not be possible without the infrastructure, protection of property and educational level of the workforce we have. These are activities largely funded by taxation. Thus, up to this level, reducing private goods by a dollar yields more than a dollar increase in total output. Beyond this level, where taxes are used mainly for transfer payments, the reduction in incentives produced by income redistribution lowers the rate of economic progress. Penalizing success with high marginal tax rates and subsidizing failure with generous public transfers damages economic efficiency. People work fewer hours and do not work as hard, there is more job shirking and absenteeism and workers take longer vacations. Moreover, to avoid the burden of taxes, people will engage in avoidance and evasion - diverting resources from the most productive uses to uses that lower their tax burden. Income redistribution schemes reduce incentives to innovate, save and invest, and they generally lower the rate of economic growth. Hence, reducing private goods by a dollar yields less than a dollar increase in total output.

"Government has increasingly engaged in the redistribution of income - more often than not from middleclass taxpayers to middleclass beneficiaries."

In the early days of our republic, a common view was that federal activities should be confined to actions that promote the general welfare. Presumably, these would be activities that, on balance, increased the national wealth. In the modern period, however, government has increasingly engaged in the redistribution of income - more often than not from middle-class taxpayers to middle-class beneficiaries rather than from rich to poor. Such transfer programs clearly have the potential to reduce the national wealth, for the reasons given above.

Taxes. Prior to the New Deal, taxes were low in the United States. In 1902 federal, state and local taxes were about 6.5 percent of gross national product (GNP).2 By 1929 taxes had climbed to 10.9 percent of GNP. This number rose steadily up to World War II and then sharply thereafter. In 1950 the total tax burden was about 24.1 percent of GNP; a decade later, it was 27.2 percent. Today taxes take about 31.3 percent of national economic output.

"The character of government spending has changed dramatically during the 20th century."

Spending. The character of government spending has changed dramatically during the 20th century. Before World War II most government spending was directed toward defense, education, highways, criminal justice and administration. In 1929 transfer payments to individuals were less than 1 percent of GNP. Today transfer payments to individuals (along with interest payments on a huge public debt) are the largest and most rapidly growing component of public spending, absorbing about 14 percent of GDP.3 The accelerated rise in the welfare state began with the Johnson administration's War on Poverty and other social programs in the 1960s. Like the federal government, state and local governments have reallocated public expenditures away from core functions to transfer payments to individuals.

The Welfare State. Despite massive transfer payments under various entitlement programs aimed at redistributing income, the United States has not gone nearly as far as other countries. When measured by the reduction of income inequality, we are less taxed than people elsewhere. [See Table I.]

  • Among nations in the Organization for Economic Cooperation and Development (OECD), only Turkey taxes less, although Japan is close to the U.S. level of taxation.
  • Clearly, the Scandinavian nations have made the most progress in using taxes and expenditures to homogenize incomes.
  • On the average, the European Economic Community collects 40 percent more taxes than does the United States.

Net Impact. Setting aside philosophical questions about income redistribution, the practice raises economic questions both in the United States and elsewhere. Has the United States reached the point at which the positive net benefits of taxing and spending to provide public goods, those of benefit to the economy as a whole, are more than offset by the negative impact of income transfer programs? If so, was there an earlier period in our history when the level of taxation was more beneficial to the economy as a whole? And what has been the cost to the country of taxation that reduced the nation's output of goods and services?

This study calculates the marginal cost of taxation in the United States - how much output is never produced for each extra dollar of taxes collected - and considers the marginal benefit of taxation. No methodology exists for calculating the aggregate marginal benefit of taxation, but we can examine progress across a range of social progress indicators and assess whether public spending has been responsible for this progress.

The experience of other nations is also relevant to judging the relationship between taxation and economic growth in the United States. This study calculates the marginal cost of taxation for selected countries and considers the impact of that taxation on economic growth.

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