Tax Base

What is a Tax Base?

The tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.

How Does the Tax Base Figure into Total Tax Liability?

The tax base is what gets taxed, and the tax rate is the fraction of the base that is collected by taxation. Thus, the total tax liability is calculated by multiplying the tax rate by the tax base. A taxing authority can tax a narrower base at a higher rate or a broader base at a lower rate in order to achieve the same revenue target.

The federal income tax base includes all types of income such as wages, interest and dividends, and capital gains. However, the federal income tax base is made narrower by various deductions and credits. A more neutral tax base will levy a low rate across a broad tax base with few exceptions. The more exceptions that are carved out of the tax base, the greater the tax burden is shifted upon what remains of the tax base.

What Makes a Tax Base Narrower?

Exceptions to a broad tax base are made in various ways for various reasons. For example, tax expenditures are tax provisions that result in reduced tax revenue. These can take the form of credits, exemptions, and deductions. Credits reduce tax liability dollar-for-dollar. Deductions reduce taxable income when certain conditions are met. Exemptions, by definition, keep things from being subject to taxation in the first place based on category, class, or status. Politically popular tax expenditures include a generous standard deduction against taxable income, a child tax credit, and sales tax exemptions for groceries and prescription drugs. (See Base Broadening to see what makes a tax base broader.)

Services are largely exempt from state sales taxation for historical reasons—many state sales taxes were adopted when the U.S. had a largely goods-based economy, and taxing services would have been administratively challenging. Other exceptions make economic sense, such as exempting tangible and intangible personal property from the property tax base, thereby limiting the property tax base to land and its improvements (real property). Finally, some exceptions are made to avoid tax pyramiding, which occurs when a tax is applied at each stage of production and can result in high effective tax rates for some industries. One way tax pyramiding can be avoided is by exempting business purchases from the sales tax.

What Is an Example of a State Sales Tax Base?

State sales tax bases have gradually eroded over time as a portion of final consumption. When state sales taxes were first introduced in the 1930s, they were levied almost exclusively on goods at a time when goods made up more than 60 percent of consumption. Today, more than 60 percent of consumption is of services, yet services remain largely exempt from state sales taxation. The result is that state sales tax bases have grown narrower as a portion of total consumption as service consumption has become a proportionately larger share of total consumption. A state can collect the same amount of sales tax revenue at a lower tax rate if the state expands its sales tax base to include more services.

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