Taxes: Where the Federal Government gets its money is not where you think

It is almost April 15th; the time many people in the U.S. file their income taxes.  Shocking as it may seem, personal income taxes don’t provide most of the federal government’s revenue.  Since World War II personal income taxes have consistently provided less than half of all the money taken in by Washington.

Just as shocking has been the change in the source of federal revenues over time. The official statistics show in the 1940s and 1950s corporations picked up a major share of supporting the federal government. Today, it is taxes on workers. Social security and Medicare taxes are now four times more important in providing revenue for the government than they were in the mid-1940s.

These shifts are quite surprising since most people focus their ire on the burden of income taxes each year. Social Security and Medicare taxes are buried in paycheck stubs and rarely talked about. One reason few talk about these are hidden taxes is that the amount taken by the federal government is not found on any line of the 1040 personal tax form. Only the amount paid each year for income tax amount is highlighted. This leads many people to overlook these stealth deductions to their pay.

Where does the money come from?

Since World War II the federal government’s revenue has come from four main sources.
The first place is individual income taxes. The U.S. has continuously had a personal income tax since 1913 when the 16th amendment was ratified. The income tax takes not only a portion of wages but also money earned from interest, dividends, capital gains and other sources. In 1945 the personal income tax provided a bit over forty percent of all federal government revenue. In 2015, the latest available figures, personal income taxes provided 47%. This is a relatively small rise compared to the dramatic changes in the other three categories.

The second category is corporate income taxes. These taxes take a portion of business’ profits. Many corporate leaders complain bitterly about the taxes they pay. Nevertheless, many corporations have become quite skilled at avoiding taxes. Overall business’ funding of the federal government has fallen dramatically over time. In 1945 corporations provided over one-third of all federal revenue. In 2015 the figure was a bit over ten percent, a three-fold reduction.

The third category is social insurance taxes. These are the taxes that pay for Social Security and Medicare. They are what some people see listed on paystubs as FICA, which stands for Federal Insurance Contributions Act taxes. Taxes on Social Security and Medicare are called payroll taxes because they only impact people who are working, or on payrolls.

In 1945 the government got less than ten percent of its revenue from these sources. The amount and the underlying tax rates have risen dramatically over time. Today one-third of the U.S. government’s revenue comes from FICA, a four-fold growth. During the Great Recession of 2007-08, social insurance taxes reached a peak of 42% of all federal revenues!

The last category is excise and other taxes. Excise revenues are money from taxing things like gasoline, alcohol, tobacco and telephone calls. Other taxes are revenue from sources like customs duties and inheritance taxes. In the mid-1940s the government got about 16% of all revenue from this last group. Since then the figure has fallen and is now below ten percent.

Why is the change important?

Understanding the shifts in the source of government revenue is important. In general most government revenue comes from taxes. Taxes discourage an activity by either raising the cost of doing it, or lowering the rewards.

Over time the U.S. government’s tax policy has been shifting the burden of who pays to run the country from corporations to workers. This shift benefits businesses and people who own shares in companies since they receive a larger share of profits. However, this shift discourages working. The rising importance of payroll taxes reduces the incentive for people to work more hours since the rewards are less.
This shift from funding the government based on corporate taxes, towards taxing wages is troubling.

To quote the 2013 budget message “America was built on the idea that anyone who is willing to work hard and play by the rules can make it if they try—no matter where they started out.”

It is a shame the rhetoric from Washington, that hard work matters, does not match the federal government actions over time. Instead the steady shift toward payroll taxes means politicians are increasingly penalizing the very foundation on which the US was built.