Why Do We Pay Taxes?
What Your Federal, State and Local Taxes Buy You
We pay taxes because the federal, state, and municipal governments enact tax laws. That tax revenue pays for a variety of government services. The federal government collects about the same as the state and local governments combined.
Kinds of Taxes
Federal. The federal government will receive $3.6 trillion in tax revenue in fiscal year 2020. Half comes from personal income taxes. A third comes from payroll taxes, which is also a tax on income. Corporate taxes only pay 7% of the burden. The rest is paid by excise taxes, tariffs, estate taxes, and earnings from the Federal Reserve's holdings.
State. States collected almost $1.6 trillion in 2016. This is the year with the most recent figures available. More than one-third of state revenue comes from the federal government. Most of that pays for the Medicaid health care program for low-income families.
Sales taxes contribute 23.1%. Income taxes contributed 18%. Charges and fees for state universities, public hospitals, and toll roads add another 18%. States receive 5% of their income from license fees, estate taxes and severance taxes. Only 2.4% is from corporate income taxes. States keep business taxes low because they compete to attract companies and their jobs.
Local. This category includes cities, school districts, and counties. They collected $1.6 trillion in 2016. More than one-third of their revenue comes from intergovernmental transfers. That includes state government aid for school districts and federal government payments for low-income housing.
Property taxes contribute 29.8%. Fees for water, sewage, and parking meters add 22.6%. Sale taxes furnish 7.2%. Some cities charge stadium and business license fees, supplying 2.4% to the total local revenue base. Other cities also charge income taxes, providing 2% to the total.
How the Government Uses Taxes
Federal. When Tax Day comes along each April, we feel that much of our income goes into a black hole called the Internal Revenue Service. We might feel better if we could see where our federal tax dollars go.
In FY 2020, the federal government plans to spend $4.7 trillion. The largest national expense is payments to recipients of Social Security. That's $1.1 trillion. But that's funded by our payroll taxes and investments by the Social Security Trust Fund. Think of these taxes as saving for your future.
The next largest service is defense at $989 billion. That includes support agencies like Homeland Security and the Department of Veterans Affairs. Military spending prevents attacks that subsequently didn't happen. It's also spent overseas in wars. It's hard to measure the benefit you receive from this because you don't see it.
The third largest service is Medicare at $679 billion. Payroll taxes only cover 60% of these expenses. Like Social Security, you are paying for services you'll receive after you turn 65.
Medicaid is the fourth largest service at $418 billion. You only receive this if your income falls below a certain level. Even if you never need it, you benefit by helping low-income children and their families receive preventive care. Without it, they use the expensive hospital emergency room as a primary care physician. You pay for that through higher hospital and insurance fees. Studies have also shown that medical care is critical to allow children to become productive members of society.
The government is spending more and more on the interest on the national debt. For FY 2020, it's $479 billion.
The interest payment is growing because Congress routinely follows deficit spending. Your state and local governments must follow balanced budget laws. Otherwise, they'd overspend too. The federal budget deficit gets added to the debt each year. It allows us to receive services now that we don't have to pay for until the future.
All other government agencies total $676 billion. The largest is Health and Human Services at $89.6 billion. It's the administrative arm for Medicare and Medicare. The Department of Education is $62 billion. Many well-known agencies are much smaller. For example, NASA only spends $21 billion.
State. In 2015, states spent $1.3 trillion. More than 40% of state budgets went to social services, including Medicaid, welfare, and public housing. States administer federal funds for these programs. States spent 18% of their budgets on higher education. Just 9% went to hospitals, 8% to roads, and 4% to corrections. State police forces only cost 1%.
Local. Local governments spent $1.5 trillion. Of that, 40 % went to education and libraries. Just 10% went to hospitals and 6% to police. Localities spent 4% each on welfare programs and roads.
Many cities have underfunded their pension funds. Detroit, Michigan, and Stockton, California declared bankruptcy. They defaulted on their municipal bonds so they could protect pensions and improve other services.
Federal. The Constitution gives Congress "the power to lay and collect taxes." Congress takes direction from the president's annual budget. Most changes to taxes begin in the White House. The president will mention it in the State of the Union Address. It will also be in the budget. The Treasury Department drafts the legislation. The president then submits it to Congress.
The tax bill starts in the U.S. House of Representatives.
The House Ways and Means Committee must approve the bill first. The Committee reviews it, calling in experts to weigh the pros and cons. Industry leaders discuss how it will affect their businesses. The committee asks the Treasury Secretary to explain the details. It even gives the public a chance to weigh in. The Committee then votes on the new tax. It drafts the legislation that's submitted to the House.
Once the House approves it, the bill goes to the U.S. Senate Finance Committee. It holds its own hearings. It then writes its own legislation that it submits to the full Senate. If the Senate agrees with the House bill, it sends it to the president for signature.
More often, the Senate comes up with its own version. The House and the Senate have their own agendas. The Senate sends its version back to the House. If the House disagrees, it forms a Conference Committee to iron out the differences. That final version is sent to the president for signature. By then, it may have become a completely different bill.
The entire process is one giant negotiation between elected officials from different states and parties. Various industry lobbyists are also influential. Special and general interest groups also weigh in.
State. Each State's legislature decides what kinds of taxes to impose. They also approve rate increases. They must determine if the taxes will be enough to pay for spending. They must also compare their tax structure to those of competing states.
Local. Most taxing authorities have elected representatives, such as city councils, boards, or commissions. They decide the types of taxes for their jurisdiction.
The Bottom Line
We pay taxes to fund a variety of federal, state, and local services. Half of Americans' tax burden is for federal programs. Most of this pays for Social Security, Medicare, and Defense. State and local taxes pay for Medicaid, infrastructure, and libraries.