Steve Stanek Research Fellow

Welcome to the Budget and Taxes issue suite, a comprehensive resource for people who understand or want to learn more about the benefits of free markets and policies that promote them.

To the left of this essay are links to Budget & Tax News, The Heartland Institute’s national outreach publication of the free-market economics movement; Heartland Policy Studies, peer-reviewed original research on taxes, government spending, regulations, economic growth, and related topics; Research & Commentaries, collections of the best available research on hot topics in the free-market economics debate; Heartland books and booklets on government spending, regulations, taxation, and economic growth; bios and contact information for experts on budget, tax, and regulatory issues who work with The Heartland Institute; and comprehensive directories of individuals who support economic freedom in the U.S.

Below those links is a “What’s New” feature that presents titles, short reviews, and links to research and commentary on government budget and tax issues most recently posted on Heartland’s Web site. This list is continuously updated, so we hope you’ll check it regularly.

Under those links is a list of subtopics that appear under the “Budget” and “Taxes” topics in PolicyBot, the database and search engine that resides on The Heartland Institute’s Web site. You can click on any one of those subtopics and see the titles, authors, dates of publication, and short reviews of credible research and commentary from a wide range of sources. Then just click to open and read the entire article. PolicyBot is free, easy to use, and fast.

The essay below presents an overview of the debate over government spending and taxes and intervention in markets that is taking place today. It contains links to individual articles and subtopics in PolicyBot, so the reader can go into greater depth on the issues the author addresses.

Sound Tax Policy

Government tax policy should strive for fairness, simplicity, and clarity. The tax base should be broad, with low tax rates applied so that the tax does not distort the behavior of businesses or individuals. The fewer decisions that are made for tax reasons, the better, because the purpose of a tax system is to provide revenue for essential government operations, not to use the coercive power of government to manipulate behavior. The very nature of government means some things fall in and out of favor, depending on who wins elections or makes appointments to courts and government agencies. Using the tax code to reward the politically favored or punish the politically disfavored means no one can do long-term planning or make investment decisions with confidence, and it subjects citizens and businesses to the political whims of the moment.

Unfortunately, local, state, and federal tax systems rarely meet these sound tax policy criteria. [Ten Principles of State Fiscal Policy]

Destructive Income Tax

Probably the best example of poor tax policy, because it is so gargantuan, is the federal income tax system. The federal tax code covers more than 60,000 pages and costs Americans billions of hours of work and hundreds of billions of dollars annually to comply. [A Taxing Trend: The Rise in Complexity, Forms, and Paperwork Burdens] The mountain of paperwork includes rules that sometimes are contradictory, subject to wide interpretation, and included to reward favored constituencies or punish others. The result is a tax code that is virtually impossible to understand, unfair, discriminatory, and viewed with disdain by millions of people. This prompts people to try to game the system, which leads to more rules and stricter enforcement, which makes the system even more burdensome and disdained.

Many people defend income taxes by arguing they are “based on ability to pay” and therefore fair. Their argument ignores that “ability to pay” is in the eye of the beholder and has radically changed over time.

In fact, “The income tax is the champion of bad taxes, in terms of its destructive effect on people, prosperity, and their economic well-being,” according to Richard Vedder, distinguished professor of economics at Ohio University. Other economists who have studied the long-term impacts of income taxes agree.

One such study has taken a 40-year look at the personal incomes of citizens living in high- and low-tax states. The results show that the lower a state’s tax burden, the higher the rate of personal income growth for its citizens. Real personal income growth was more than twice as high in the states that did not raise their income taxes (or increased them only minimally), compared to states with the biggest increases in income taxes. [Taxes and Economic Growth: A Strategy for State Officials]

Tax Burden Shifts

Ever since the enactment of the federal income tax in 1913, “the wealthy” have been tax targets. Yet the “wealthy” as defined by the U.S. Tax Code includes many people who are really not wealthy, and tax-the-rich policies have repeatedly led to tax-nearly-everyone-more policies.

After the ratification of the 16th Amendment to the Constitution allowing a federal income tax, federal lawmakers enacted an income tax law with rates beginning at 1 percent and rising to 7 percent for taxpayers with income in excess of $500,000, who back then made up less than 1 percent of the population. [Fact Sheets: Taxes]

By 1916 Congress had doubled the bottom tax rate and more than doubled the top tax rate. The 1916 Act also imposed taxes on estates and excess business profits.

One year later, Congress enacted the War Revenue Act of 1917, which lowered exemptions and sent tax rates soaring to fund World War I. In 1916, a taxpayer needed $1.5 million in taxable income to face a 15 percent rate. One year later a taxpayer with only $40,000 faced a 16 percent rate and the individual with $1.5 million faced a tax rate of 67 percent.

Income tax rates have climbed as high as 94 percent. From 1964 to 1986 the top individual tax rate fell from 91 to 28 percent. It’s gone back to 35 percent and is likely to go higher if tax cuts enacted in 2001 and 2003 expire in 2010 and 2011, as President Barack Obama supports.

Furthermore, “the wealthy” today pay a higher percentage of the federal income tax than ever, despite the current top tax rate being far below the record tax rate. In 2006, the top 1 percent of tax returns paid 39.9 percent of all federal individual income taxes and earned 22.1 percent of adjusted gross income. The bottom 50 percent of tax filers paid just 3 percent of the nation’s federal income tax, demonstrating how highly progressive the income tax system is. [Summary of Latest Federal Individual Income Tax Data]

In states that impose income taxes, those with the heaviest tax burdens, notably California and New York, have seen wealthy citizens leave for states with lower or no income taxes, taking the tax revenue and jobs they often generate with them. [Taxes Fuel Historic American Migration]

Property Tax Complaints

The local tax that arguably draws the most complaints is the property tax. Unlike the income tax, property taxes are not deducted from a person’s paycheck. Instead, property owners directly pay property taxes when the bill comes due. Or they pay it in installments when they write their monthly mortgage check, which may include escrow for property taxes.

Either way, property owners must write checks to cover property taxes, making the payments more noticeable than when they are deducted from paychecks, as income taxes usually are. This is probably a big reason polls consistently show the property tax is the most disliked local tax. [Tax Foundation Annual Survey of U.S. Attitudes on Tax and Wealth]

Another reason the property tax is so disliked is that property tax burdens have soared along with skyrocketing property values. Now that property values are falling, millions of property owners are frustrated and angry that their property tax bills are continuing to climb or falling more slowly than the value of their property. [Homeowners See Taxes Rise as Property Values Sink Amid Deficits]

This may have the salutary effect of showing people that they have often been deceived by local officials who have long implied and sometimes said straight out that property taxes must go up if property values increase.

The truth is, spending--and only spending--causes tax bills to rise. But for years, even decades in many places, local officials have escaped accountability by blaming rapidly rising tax bills on property values. Yet nothing--absolutely nothing--requires local governments to spend more money just because property values rise. A property tax assessment is nothing more than a way to determine a parcel’s share of a total property tax bill in a given area.

In most areas there are many local taxing bodies--school districts, library districts, fire districts, park districts, county governments, municipalities, etc. Each submits its tax bill--called a levy--to the county, and those levies get totaled up. The taxable value of all the properties within each taxing body’s jurisdiction also gets totaled up, and a tax rate to generate the necessary amount of money to cover each levy is set. The ultimate factor in the size of a property tax bill is the amount of spending local governments impose on their citizens.

Tax and Expenditure Limitations

High property taxes have spawned numerous tax revolts over the years, with California’s Proposition 13 more than 30 years ago being perhaps the most notable example. This measure, which received strong support in a statewide referendum, set limits on property taxes and is estimated to have saved California property owners nearly $530 billion since 1978.

Though many local and state officials through the years have tried to blame the measure for budget problems, Proposition 13's limits continue to enjoy strong voter support. [To Voters, Proposition 13 Is Still a Winner]

Since the success of Proposition 13, Taxpayers Bills of Rights (TABORs) and other measures to limit property taxes in one way or another have been introduced in states and localities across the country, most notably in 1992 in Colorado, where voters passed a TABOR to limit taxes and spending.

For the most part, though, these measures -- including caps on property tax assessments -- have had only limited success in holding down property taxes, as local and state government officials look for ways around the caps. [Local Property Taxes and Economic Growth in Texas]

Problems with Tax Incentives

Another factor driving up property taxes and sales taxes is the willingness of states and localities to use tax credits, rebates, and “incentives” to lure or retain businesses. Rather than broadening the tax base, which usually results in more stable tax revenues, use of targeted tax breaks and incentives narrows the tax base. The result is higher taxes for everyone except the lucky few businesses that receive the favored tax treatment. The fewer tax preferences that are handed out, the lower tax rates can be. The tax system also becomes more fair, transparent, and easy to understand. [Back to Basics: State Tax Policy and Economic Development]

The temptations to political corruption when states and local governments use their tax systems to pick winners and losers should be obvious.

What’s more, the justification for such incentives -- that they pay off by expanding economic growth -- have repeatedly been shown to be wrong.

Many states, for instance, use tax incentives to lure film companies, but these incentives often fall short of generating the promised benefits. [N.M. Film Subsidies Bring Poor Return]

Another favorite subsidy is for sports facilities and convention centers, yet economists who have studied such subsidies overwhelmingly conclude the taxpaying public loses. [Sports, Jobs, & Taxes: Are New Stadiums Worth the Cost?; Stadiums and Subsidies: Home Run for Wealthy Team Owners, Strike-out for Taxpayers]

TIF: Corporate Welfare Gone Wild

Tax increment financing was conceived in the 1970s as a tool to redevelop blighted areas of inner-cities or chronically economically depressed small towns. But it soon became a tool of wealthy landowners and real estate developers. Today cities and villages large and small use TIF, often in affluent areas. The winners are the politically connected property owners and real estate developers and business people whose buildings or municipal infrastructure is subsidized. The losers are taxpayers outside the TIF districts who must shoulder a heavier tax burden.

What’s more, numerous studies show communities that use TIF often grow more slowly than those that do not use it, defeating the argument that TIF subsidies are worth the price because they generate economic growth. [TIF Districts Hinder Growth] As the Developing Neighborhood Alternatives Project, a consortium of Chicago neighborhood groups and university economists, has pointed out: “TIF does not tend to produce a net increase in economic activity; favors large businesses over small businesses; often excludes local businesses and residents from the planning process; and operates in a manner that contradicts conventional notions of justice and fairness.” [Study: TIF Doesn’t Work, Hurts Neighborhoods, and Is Unfair]

In Chicago, where one-third of the city, including the showcase Loop business district, has been placed into TIF districts, property taxes are more than 10 percent higher than they otherwise would be to make up for the tax-shifting caused by TIF. [LaSalle Street TIF Proposal Has Chicago Politician Calling for Moratorium]

The Bad of ‘Sin’ Taxes

A favorite tactic of politicians at every level of government these days is to raise revenues by imposing excise or “sin” taxes on certain items: cigarettes, alcoholic beverages, gasoline, and sugared soft drinks, to name a few. For the most part, raising excise taxes amounts to attempts to impose heavy tax burdens on narrow segments of the population and to use taxes to influence behavior.

Growing reliance on excise taxes punishes a relative handful of citizens for the benefit of the many and gives people incentives to avoid the taxed products, thus reducing the amount of expected revenue. It also gives people an incentive to engage in smuggling or other illegal activities to evade the tax. [Cigarette Trafficking Grows as Taxes Climb]

Sin taxes also disproportionately burden lower- and middle-income people. [Excise Taxes Impose Growing Burden on the Poor] Robert Sirico, president of the Acton Institute, notes sin taxes set “up a moral hazard for policy makers, who vacillate between wanting to discourage undesirable behavior and wanting to encourage it for revenue purposes.” He adds, “this moral hazard is especially dangerous for the poor, who spend a disproportionate amount of their income on products deemed sinful under a consumption tax.”

Benefits of Investment

Taxes on investment earnings slow economic growth by discouraging the business investments that make job creation and economic growth possible. Taxes on investment also discourage saving for future consumption, and they shift current consumption from nondurable to durable goods, such as houses, cars, and boats. Reducing taxes on capital by one percentage point increases private-sector GDP by about 1.5 percent, with about two-thirds going to labor income and about one-third going to capital income. [Extending the Fifteen Percent Tax Rate on Dividends and Capital Gains]

To invest money necessarily means to defer gratification, because money that could be spent now is instead tied up with the hope -- not the guarantee -- that the deferred gratification will pay off in the future. High taxes on investment are one reason the United States went much of the 1990s and this decade saving little or nothing. Lower taxes on investment would provide the capital needed to boost productivity and build national wealth. [U.S. Capital Formation: How the U.S. Tax Code Discourages Investment]

Other Resources

These are only a few of the many tax and budget issues confronting Americans today. For more information, go to PolicyBot on this Web site or to these other good resources, all of which provide research, blog postings, and other information related to government taxes and spending and public policy:

Americans for Tax Reform -- ATR was founded in 1985 by Grover Norquist at the request of President Ronald Reagan. The organization is perhaps best known for the Taxpayer Protection Pledge, a written promise by legislators and candidates for office that commits them to oppose any effort to increase income taxes on individuals and businesses. ATR works with state taxpayer coalitions in all 50 states.

Cato Institute -- The Cato Institute’s Centers and Projects tackle a wide range of topics, including health care, education, environment and energy, foreign policy, and international human rights. Scholars in these Centers and Projects vigorously apply America’s founding principles to key issues of the day and are committed to countering the continued expansion of government beyond its constitutional constraints, and to confronting escalating attacks on individual rights.

National Taxpayers Union -- NTU pursues institutional change in government. The organization believes paramount among these reforms is scrapping the U.S. Tax Code for a better alternative, adding a Balanced Budget Amendment to the U.S. Constitution, and a Tax Limitation Amendment to prevent lawmakers from raising taxes to raise spending.

Tax Foundation -- The mission of the Tax Foundation is to educate taxpayers about sound tax policy and the size of the tax burden borne by Americans at all levels of government. From its founding in 1937, the Tax Foundation has been grounded in the belief that the dissemination of basic information about government finance is the foundation of sound policy in a free society.