Lawmakers have recently begun proposing different policy options that would change the U.S. taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. system—ranging from wealth taxes to higher marginal income tax rates to increasing the estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. . When discussing changes like these, it’s important to understand the composition of taxes under the current system.
Using data from the Office of Management and Budget, we can look at how the composition of federal revenue has changed over time. Several trends stand out: the increasing significance of both individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. es and payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. es as well as the decreasing significance of corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. es and excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. es.
But before pointing to these trends as proof for the need to raise taxes on a certain group of taxpayers, it’s crucial to know some of the underlying information.
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Before 1941, excise taxes, such as gas and tobacco taxes, were the largest source of revenue for the federal government, comprising nearly one-third of government revenue in 1940. Excise taxes were followed by payroll taxes and then corporate income taxes.
Today, payroll taxes remain the second largest source of revenue. However, other sources have shifted in relative importance. Specifically, individual income taxes have become a central pillar of the federal revenue system, now comprising nearly half of all revenue. Following an opposite trend, corporate income and excise taxes have decreased relative to other sources.
Several policy changes contributed to these trends. For example, the growth in payroll taxes as a source of revenue reflects the implementation and expansion of Social Security and Medicare. One factor explaining the changes in individual and corporate income taxes is that more business income is now taxed under the individual income tax rather than the corporate income tax. The majority of companies in the United States are pass-through businesses and are not subject to the corporate income tax; they therefore pay individual income taxes instead.
Past decisions to change the tax code, such as creating payroll taxes or new forms of organizations, have led to changes in the composition of federal revenue. Awareness of these trends are important context for contemporary discussions of who pays taxes and how much.
Note: This is part of our “Putting a Face on America’s Tax Returns” blog series