You Decide: What’s The Best Tax?

By Mike Walden

If you meet someone new and the conversation lags, one way to keep things going is to bring up the topic of taxes. Virtually everyone has an opinion about taxes.

Are taxes too high? Are they too low? Do some deserve tax breaks? Should others pay more taxes? Should some taxes be eliminated? Should others be expanded? These are some of the common questions about taxes.

Here I will focus on one key question about taxes — specifically, is there a “best tax.” Are some taxes better than others, and if so, should we shift to those and away from others? Indeed, at all levels of government, these questions are being asked today.

First, let’s look at how the three levels of government — federal, state and local — use different taxes to collect revenues. At the federal level, by far the dominant source of tax revenue comes from taxing income. Over 90% of federal revenues come from the individual income tax, the corporate income tax and taxes on income that support Medicare and Social Security. Revenues from taxes on imports (tariffs) and taxes on tobacco and fuel sales make up most of the rest. Interestingly, prior to 1913, when the income tax was authorized, federal revenues mostly came from tariffs, taxes on tobacco and liquor, and taxes on land sales.

Most states use three sources for tax revenues, which — ranked in order of amount — include income taxes on households and corporations, sales taxes, and taxes on motor fuel, tobacco and alcohol. Just like at the federal level, there’s been a trend toward greater reliance on income taxes among states and less reliance on sales taxes. However, there are nine states — Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Wahington and Wyoming — that have no income tax and therefore rely on other taxes, often the sales tax. For example, North Carolina has a statewide sales tax rate of 4.75%, while Tennessee’s is 7%.

With the federal and state governments using so many taxes, what is left for counties and cities? This is where taxes on property, mainly land and buildings, come in. Property taxes are the largest generator of revenue for local governments, followed by local sales taxes and “user fees” for water and trash pickup provided by local governments.

There are many ways to judge a tax, such as simplicity, ease of administration, progressivity, capacity, and keeping up with economic growth. Simplicity means the tax is easy to understand, and ease of administration indicates the tax is easy to collect. Capacity is the ability of the tax to raise significant revenues. Progressivity means the size of the tax relative to the taxpayer’s income rises with the taxpayer’s income, meaning the tax burden is relatively low for lower-income taxpayers. Lastly, a tax is preferred if the revenues it generates keep pace with an expanding economy, where public needs are likely greater.

How do the major taxes, including income, sales, fees and property, stack up on these measures? Experts view income taxes positively on all the factors, but especially on progressivity. With an income tax, it’s easy to divide the taxpayer’s income into segments and tax each segment with a different rate. Typically, the rates are higher for higher-income segments, meaning taxpayers with lower incomes pay less as a percentage of their income in taxes, while payees with higher incomes pay more.

Sales taxes also get high marks on simplicity, ease of administration, capacity and their ability to increase with economic growth. One issue is progressivity. It’s impractical to charge people with different incomes a different sales tax rate. Many states, including North Carolina, have addressed this issue by not taxing some essential purchases, like raw food items and prescription drugs. Fees receive similar evaluations as sales taxes.

Some of the biggest complaints over taxes are about property taxes, the main revenue source for local governments. Property owners, particularly homeowners, complain that their taxes rise as their property values increase. While the owners like that their property is worth more, some say they can’t afford the taxes until they sell the property. Retired owners, in particular, point to this issue. Many states, including North Carolina, are considering limiting increases in estimated property values to help owners deal with “tax shock” from higher property assessments.

There’s another tax that some states, such as California, are considering: a wealth tax. While gains in investment values are taxed, the full value of a person’s wealth is not taxed. Taxing wealth would provide a tremendous amount of new tax revenue. However, opponents argue such a tax is unfair, and is actually “double-taxation” because usually the wealth was accumulated from income that had already been taxed.

Taxes will always be a topic of discussion and debate. In recent years, there’s been discussion at both the national and state levels of moving away from the income tax. Supporters say the income tax discourages working more and earning more, and hence impedes economic growth. At the federal level, there’s been talk of eliminating the income tax and replacing it with revenues from tariffs and from a broader federal sales tax. In North Carolina, there’s been a gradual reduction in the state income tax rate, thereby shifting more dependence for revenues to the state sales tax.

There’s plenty to debate. Taxes are probably one of the most important and lasting decisions made by governments. But what kind of tax is best? You decide.

Mike Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University.