Forms of Taxation

The Function of Taxation

Taxation is the collecting of money by governments from individuals and other entities which are used to fund the government’s activities. Not all government activities are funded by taxation though, and a significant portion is also borrowed, through the issuance of bonds and other debt instruments.

Government debt is in fact a huge issue and governments, without the normal constraints that individuals and businesses are under, tend to borrow a lot, and also pay a lot in interest payments to service this debt.

Like individuals though, governments have both an income and debt sheet, and aside from any business profits governments may have, taxation provides the income side of things, if we understand taxation broadly as government-imposed costs upon its people.

Taxation funds both government spending and debt servicing, and debt servicing is becoming more and more of a factor, taking up large portions of expenditures these days. The amount that is devoted to this differs by jurisdiction, and this alone can speak pretty loudly to its long term economic health, especially when we see projections that will not be sustainable.

If the government that is collecting these taxes also controls the money supply, as is the case with federal governments, this will serve to extend the limit that they may borrow, but increasing the money supply too much can bring down the entire economy, so this is not really ever a long term solution.

Therefore, there are limits to this, and there are also limits to how much taxation can be increased, where we can easily get to the point where this harms the economy as well. Higher levels of taxation rates tend to suppress the economy, and decreasing this often will stimulate growth, even though a lot of people may have the perception that they may not have been benefited directly.

Managing all of this requires a delicate balance, because government spending tends to drive the economy as well, as well as drive votes. This causes governments to take a shorter term perspective on things, far shorter than may be desirable, but the election is not 20 or 50 years from now, so concerns about what may happen then may stimulate some thought but little else.

Along the way, governments of every type, federal, state, county, and local governments will fund their coffers by collecting money from its constituents in the form of taxes of one variety or another. Since we are the ones that are paying these taxes, we need to be aware of the issues here and particularly how changes we make will affect this.

Income Tax

Governments lay claim to a portion of all of the income in their jurisdiction, and assess various rates of taxation on it and have a set of rules which dictate how much income tax someone owes them.

Many people ponder the fairness of such tax structures, but this really isn’t about fairness, it’s more about targeting those more with a greater ability to pay.

This is why we see those who make more money not only paying more in income tax, but also paying a higher percentage of their income in tax than lower earners. Whether this is fair or not is of no real consequence, as high income earners have more means to pay more, and therefore they are charged more to take advantage of this.

This is called progressive taxation, and while this is somewhat controversial, it is widely accepted, especially since the majority of the population tends to be on the lower side of this progression.

There are economics involved in this though, as the more income one has, the less valuable it will be seen to be, in other words the less utility it will have in economics speak. The first batch of income is needed to survive, the next batch to live a somewhat meaningful life, the next to enjoy life to a reasonable degree, and we eventually get to the point where these batches may be seen as entitling people to various levels of luxury or wealth that can be more readily disposed of.

While earning more may mean that you keep a smaller portion of your income, in all cases you do get to keep more, and progressive taxation is not something that you can do anything about, aside from looking to evade it or moving to a more friendly tax jurisdiction.

Evading taxes is actually fairly popular though, not so much by way of just not paying taxes but failing to disclose all your income, and this may occur by way of people using an underground economy to exchange goods and services, or it may be by way of hiding assets in offshore accounts.

Relocating to areas that are more tax friendly is also an option, and this is something that people are doing more of after retirement in particular. If one has the means and enough wealth to justify it, this can be quite helpful in retaining more of it as well as stretching it out further.

Taxes Related to Purchases

The sales tax that we pay with most sales transactions is another obvious form of taxation, although not all sales related taxes are up front. This form of taxation is called consumption tax, and there tends to be a general tax rate levied on all eligible purchases, although this does tend to be very broad and in some places is all encompassing.

If the transaction is off the grid, in other words a private transaction that is not reported, no tax will be paid, and in some cases no tax is due either, as this is aimed at merchants with tax accounts, not someone selling their lawn mower for instance.

Selling automobiles tend to be a different story, since this can be regulated even though the people may not have their sales tracked like merchants do, because vehicles do need to be registered with the government. When doing so, the sale gets reported and taxed.

A lot of the money generated from consumption taxes aren’t just added on to the purchase price, they are included in it. Purchases of such things like tobacco, alcohol, and gasoline are obvious examples, and in some cases the tax collected may exceed 100% of the original price, as governments can set the rate at whatever they want.

When you purchase something, a lot higher percentage of the proceeds may go to the government than we may realize, starting with the taxes that the producer has to pay on it, as well as all taxation from the source of production to getting it home. Even the drive home involves paying taxes on transportation costs, the gas it cost you to go to the store and back for instance.

There are also other taxes such as excise tax or import duties that may apply, all of which increases the price in which the item is sold for. None of this is avoidable though, unless one purchases things on the black market, which usually is not an option nor practical.

The black market does avoid taxation, but it does have its problems, one of them being risk that does get priced in. If the people selling these goods to you risk going to jail, for instance with illegal drugs, you can bet that they will charge for this.

Other Forms of Taxation

If one owns property, then it will be subject to property taxes, although we often will get something out of this, city services or other benefits such as local administration. Property taxes do drive local governments, and property taxes may actually offer the most value among all taxes paid, especially among those who see governments as wasting most of their money and not really benefiting them that much.

Corporate taxes are similar to personal income tax, other than their being assessed on corporate profits. This all gets passed on to their customers though so it’s not like they pay and we don’t, as we always pay in the end, at least en masse.

Capital gains tax does apply to individuals and tends to be assessed at a lower rate than income or business tax, usually half the amount. This capital gains tax break does have its limitations though, and is subject to whatever rules governments wish to impose, including such things as limitations on trades or what may be invested or traded in.

Governments may also assess income earned from dividends preferentially, generally involving dividends paid out by domestic entities, as a means to encourage their people to invest more in companies within their boundaries. There is no particularly good reason for this, other than the benefit of perhaps propping up the share price to benefit those holding the stocks, which often but not always means people living in the country.

Even when you die, the government wants to collect taxes from you, in this case from inheritance taxes. There are some good strategies to look to minimize the impact of this though, for instance bequeathing a significant amount of your estate prior to death. Ironically, you can give it away when you’re alive without tax consequences generally, but once you are gone, all bets are off.

Managing All of This Taxation

While there is some flexibility to how we may manage our tax obligations, most of it is unavoidable as the government does not want to make it too easy for us to avoid all of this, because they cannot afford this to happen.

With that said, there are certainly ways to reduce taxation, and much of this is done with the full co-operation of governments, who even may encourage us to do so. There may be a number of tax breaks available, and therefore it certainly may pay to be aware of all of this.

Generally though, the more we make and the more we spend, the more tax we will pay, and this part is unavoidable. Making less, spending less, and paying less tax is less appealing of course.