The Timing, or When Are We Taxed?
There are two important timelines for understanding the timing implications of taxation. The first timeline is an earning and spending cycle, the short financial cycle (for most Americans this could be thought of the two week paycheck window or the budgeted month). The American taxation strategy is really a consumption tax because it exempts savings from taxation until they are spent. This short cycle shows the difference between a prepaid consumption tax and a postpaid consumption tax. The second timeline is much longer, emphasizing how taxpayers pay nearly all of the taxes for their life in their working years.
Short financial cycle
When a patriotic American earns her paycheck, she is faced with several decisions. She may put some of the money into her retirement savings, health care, a short-term rainy day fund, or she may spend it. An income tax taxes the whole income (What Do We Tax?) - minus the exemptions (What Don’t We Tax?). Congress has created exemptions for both retirement savings and health care, so the amount she puts in these categories is deducted from her income and she is taxed on the remainder, which consists of immediate and forthcoming expenses.
Recalling from What Can Be Taxed that all money is either spent or saved, the exemptions for long-term savings have turned the income tax into a consumption tax (with an health insurance an excepted consumption). Most people spend all of their money on each paycheck, so an income tax is already the same as a consumption tax for them. Those who do save their money delay the taxes on that money until they take it out to spend it; they only pay taxes out of their paycheck for wealth that they are spending at the time. Taxes are therefore paid when the wealth is used to consume. Because this tax is taken before any wealth is actually spent, it is prepaid. The income tax has therefore become a prepaid consumption tax; it is paid only on the money that is spent and it is paid before the money is spent.
When the money is finally spent, excise taxes on things like gasoline are also charged. States sales taxes are usually also charged. These are postpaid consumption taxes; they are charged on money that is spent and they are charged when it is spent, not before.
The short financial, then, consists of prepaid and postpaid consumption taxes. The prepaid consumption taxes are paid with a paycheck by deducting savings from the amount taxed. The postpaid consumption taxes are paid with the purchase by adding taxes to the cost of the item. On a short cycle, these taxes are economically identical and could be charged at either time to have the same effect; it would make no difference if a paycheck was 12% lower or if everything cost 12% more.
Long financial cycle
A taxpayer pays different taxes depending on where they are in the course of her life. As a child, she does not have a job and can’t pay income taxes. In school, she doesn’t pay taxes on her loans. When she gets a job, she finally starts to pay income tax. Finally, in retirement, she doesn’t have a job any more and pays less income tax.
As a child, a taxpayer doesn’t pay income tax because she doesn’t have an income. This means that, for the first sixteen years of her life or so, she will be benefiting from things like roads and public education without paying for it; she is counting on her everyone else to do so.
When the taxpayer leaves her parents’ nest, she might go to college. Most people take out loans for this; those are not taxed now but they are later, through her income, when she uses after-tax money to pay them back. If she receives a scholarship, then the Trump tax plan recognizes the scholarship as income, and she does have to pay taxes on that.
Finally, our patriotic taxpayer enters the workforce. For the next 40 years of her life, a taxpayer will pay income taxes and payroll taxes, deducting retirement savings from the amount she is taxed. These taxes will account for the vast majority of her contributions to the government’s revenue. The income tax is progressive, charging more as she earns more through her career. The payroll tax is regressive; after she passes a threshold, the payroll tax drops sharply. Most Americans pay more in payroll taxes than in income taxes.
Finally, the taxpayer retires. She has saved for retirement. Now, as she cashes in those savings, she she is taxed for their income and pays a lower percentage than she would have while working. Instead of spending the wealth while she was at her peak tax bracket, she saved it for when she no longer had a job and was in a lower bracket. She also gets Social Security, accounting for the majority of tax contributions for contemporary taxpayers. (which some economists point out as quite a distortion - instead of saving for their own retirement, workers are forced to contribute most of their taxes to current retirees, who didn’t save for their retirement, while the work force continues to shrink, promising the contributing workers smaller returns than contributions when they eventually retire)
Because a taxpayer is taxed based on their income at the time, people who earn most of their money quickly (like professional athletes) face a distorted tax system, being charged high tax rates for high salaries even though they are earning for their entire career in an eighth of the time of other careers. Different career paths and lifestyles are considered later, giving perspective an how people are taxed differently based on these factors.
Next: Read Hidden Taxes