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     Taxation is the imposition of a mandatory levy on the citizens
     of a country by their government. In almost all countries tax
     revenue is the major source of financing for public services.

     History

     Despite the adage that nothing is certain in the world but
     death and taxes, taxation has not always been the chief source
     of revenue for governments. The Athenians, for example, had use
     of the revenues from publicly owned mines and tribute from
     conquered countries. In the feudal hierarchy of the Middle
     Ages, funds flowed upward in the form of rent fees and fees
     paid in lieu of military services. The distinction between
     taxes and other compulsory payments, however, was not clear
     cut. In modern times the great petroleum-producing nations of
     the Middle East realize enough revenues from their oil
     production to allow their citizens freedom from the burden of
     heavy taxation.

     A codified system of taxation was introduced by the Romans. In
     the early republic a POLL TAX was levied against each citizen,
     but as foreign tribute began flowing into Rome, the poll tax on
     Romans was forgiven. The emperor Augustus (r. 27 BC-AD 14)
     introduced PROPERTY TAXES and INHERITANCE TAXES at the
     beginning of the imperial period, and later emperors imposed
     taxes on a long list of products.

     During the Middle Ages kings derived most of their income from
     their feudal holdings and generally needed to levy taxes only
     to pay for their expensive wars. Because ordinarily such taxes
     could be collected only with the consent and aid of the nobles
     and other large landholders, monarchs found it necessary to
     call these landholders into session to approve such taxation.
     These sessions of landholders evolved into parliaments and
     other legislative bodies. Thus the need of the monarchy for tax
     revenues can be said to have been one of the causes of the rise
     of parliamentary government. In fact, many of the
     constitutional changes that have taken place in the modern
     world have resulted from the struggle between monarch and
     legislature over the collection of taxes. In Great Britain the
     Glorious Revolution of 1688 established Parliament's authority
     over taxation.

     "No taxation without representation" was one of the rallying
     calls of the colonists in the American Revolution. After
     independence was achieved, the United States tried to operate
     as a central government under the Articles of Confederation.
     Probably the major weakness of the new government was its
     inability to levy taxes on its behalf. The U.S. Constitution
     gave the federal government power to levy TARIFFS (an exclusive
     right) and excises, but it required that direct taxes be
     apportioned among the states according to population. In 1913
     the ratification of the 16TH AMENDMENT to the Constitution made
     possible the adoption of the federal INCOME TAX, which has
     remained the mainstay of the federal revenue system. In 1985,
     $396 billion in federal personal and corporate income taxes
     accounted for 54 percent of the total federal revenue of $734
     billion.

     In the United States, state and local units of government also
     use the income tax but rely on other tax sources to a greater
     extent than the federal government. The PROPERTY TAX has
     traditionally been the backbone of the local revenue system. In
     addition, most states and many local units of government impose
     sales taxes. Nearly all the states levy taxes on tobacco,
     alcohol, gasoline, and amusement. Most also impose INHERITANCE
     TAXES.

     Classifying Taxes

     Ultimately, taxes are the price paid for publicly provided
     services. In a democracy a majority of citizens (or their
     representatives) vote to impose taxes on themselves in order to
     finance, through the public sector, services on which they
     place value but which they believe cannot be adequately
     provided by market processes.

     Taxes, which drain money from the private sector, must
     ultimately be paid by a reduction in private consumption or
     investment expenditures. Determining which individuals or
     households actually reduce their private consumption or wealth
     as a consequence of a tax is not always straightforward. The
     economic units that are nominally assigned legal tax liability
     are often able to shift the actual burden of the tax onto other
     sources. Some taxes are not shifted at all; others may be only
     partially shifted.

     Whether or not a tax is shifted provides one basis for
     classifying taxes. A tax is said to be direct if the economic
     unit that is legally assigned tax liability bears the full
     burden of the tax. The personal income tax, for example, is
     generally regarded by economists as a direct tax. An indirect
     tax is one that is shifted either wholly or in part. Any tax
     legally imposed on a commodity (see SALES TAX; VALUE-ADDED TAX)
     must be an indirect tax because ultimately only individuals (or
     corporations) can bear the burden of taxes. An indirect tax is
     said to be shifted forward if consumers of the taxed object
     bear the tax burden in the form of a higher price for the good.
     Backward shifting occurs when suppliers of productive resources
     to a taxed industry earn lower incomes as a result of the tax.

     In addition to the direct-indirect classification, taxes are
     also often classified as being either proportional,
     progressive, or regressive. These classifications depend on the
     relationship between the tax base--the value, income, or wealth
     being taxed--and the average tax rate--the amount of tax,
     usually expressed as a percentage, imposed on each unit of the
     base. If the tax rate remains constant when the tax base varies
     in size, the tax is a proportional one. If the rate increases
     as the base increases, the tax is progressive. A regressive tax
     is characterized by the tax base and average tax rate varying
     in opposite directions. A slightly different definition of
     progressive, proportional, or regressive taxation is useful for
     analyzing the equity characteristics of indirect taxes. Under
     the equity definition, the tax burden is traced to the actual
     bearer and then related to income or wealth. A tax is
     progressive in this case if the tax burden expressed as a
     percentage of the income of the taxpaying unit rises with
     income. It is proportional if the tax burden is a constant
     proportion of income, and the tax is regressive if income
     received and the percentage of income paid in taxes vary in
     opposite directions.

     Excess Burden

     The direct burden of a tax borne by the individual taxpayer is
     the transfer of individual purchasing power to the public
     sector. If, in addition, the tax distorts the taxpayers'
     choices in ways that prevent their attaining maximum
     satisfaction with their remaining income, the tax is said to
     have generated an excess burden. The personal income tax can
     provide an example of this problem.

     Suppose an individual is earning an hourly wage of $5 and,
     given that wage, chooses to work 50 hours per week. In his or
     her opinion, the $5 received for the 50th hour of work exactly
     compensates for the hour of leisure activity foregone in order
     to earn it. The additional $5 that could be earned by working a
     51st hour is not enough in his or her view to compensate for
     that additional hour of leisure activity foregone. Now, suppose
     that an income tax of 10 percent is imposed. For each hour the
     individual works, the government collects 50 cents in tax
     revenue.

     At the lower net hourly wage of $4.50, the individual may
     choose to reduce his or her work effort to 42 hours per week.
     That individual's gross earnings are now $210, out of which
     $21.00 in tax revenue is collected.

     To see how an excess burden may have been generated by the
     income tax, consider the following alternative way of
     collecting the same amount of tax revenue from the individual.
     Suppose that the taxing scheme simply assessed a fixed tax
     liability or lump-sum tax (also called a capitation, or head,
     tax) of $21.00 on the individual regardless of how large or how
     small his or her money income was.

     Now he or she might well choose to work more than 42 hours per
     week under this taxing scheme because the net monetary reward
     for the 43d and each successive hour of leisure foregone is now
     $5 rather than the $4.50 obtained under the income tax. Given
     the fixed tax liability of $21.00, the individual now possibly
     might choose to work the same 50 hours per week as he or she
     was working prior to imposition of any tax. Tax revenue, and,
     implicitly, publicly provided services remain the same under
     both the income tax and the lump-sum tax; but with the latter
     tax, in this case, the individual is able to make a better
     allocation of time between work and leisure. The choice to work
     the extra 8 hours per week under the fixed tax indicates that
     he or she prefers 50 hours of work per week with a net income
     of $229.00 to 42 hours of work and weekly income of $210.00.
     The inability to achieve this preferred position with an income
     tax is an indication of the excess burden of that tax.

     Unfortunately, almost all taxes have the potential for
     generating excess burden. Taxes may alter the relative prices
     of commodities, discouraging consumption of those goods as they
     become relatively more expensive after the tax. Some taxes also
     affect business firms' choice with respect to the combination
     of capital and labor to be used in production processes. The
     only tax that does little to impede efficient resource
     allocation in the private sector is a lump sum tax of the type
     described above. Individual choices are not distorted by this
     type of tax because tax liability is fixed and cannot be
     altered by any change in the taxpayer's behavior. The
     efficiency advantages of the lump-sum tax, however, are offset
     by its failure to measure up to the standards of equity or
     fairness commonly used to evaluate tax instruments.

     Good and Bad Taxes

     What constitutes a good tax? This issue has always stirred
     lively debate among tax scholars, legislators, and concerned
     taxpayers. Efficiency is one criterion against which a tax
     might be evaluated. The best tax by this standard is the one
     that generates the least excess burden. Most experts would be
     unwilling to accept efficiency as the sole indicator of a good
     tax, however, because the most efficient tax is the lump sum,
     or head, tax discussed above. Despite the desirable properties
     of this tax from the standpoint of efficiency, most people
     would undoubtedly disapprove of the inequity of a tax that
     imposed identical tax burdens on the richest and poorest
     members of society. The best tax systems seek a balance between
     the often conflicting objectives of efficiency and equity.

     The principle of horizontal equity is widely accepted as a
     desirable feature of a tax. Stated simply, this principle
     requires that equals be treated equally with some measure of
     economic capacity or well-being, such as income or wealth,
     typically regarded as the relevant index of equality. Despite
     its apparent straightforwardness, problems do arise in applying
     the standard of horizontal equity. If the household is the
     basic taxpaying unit, for example, does a household with four
     family members have the same economic capacity for taxpaying
     purposes as a single-member household with the same income?
     What if two individuals have identical opportunities to earn
     income but one chooses employment with a high monetary reward
     and the other opts for a job with lower money income but
     greater nonpecuniary advantages (for example, social prestige)?

     A corollary to the principle that equals be treated equally is
     the principle of vertical equity, which suggests that unequals
     be treated unequally. According to this principle, individuals
     should be taxed in accordance with their ability to pay.
     Unfortunately, although the ability-to-pay principle generally
     requires that taxpayers with greater economic capacity pay a
     greater share of total tax burden, it is a subjective standard
     and does not provide clear guidelines with respect to the
     precise allocation of tax shares. A proportional, a
     progressive, or even, within limits, a regressive income tax,
     for example, can collect more in total tax revenue from the
     rich person than from the poor person.

     The concept of minimum aggregate sacrifice in the
     ability-to-pay principle recognizes that a tax, considered
     independently of the public services it finances, involves a
     loss of welfare as a consequence of the taxpayer's loss of
     private purchasing power and seeks to minimize the aggregate
     welfare loss. Based on the assumption that a $1 reduction in
     purchasing power entails a smaller welfare loss the greater the
     individual's (or the corporation's) total income, minimum
     aggregate sacrifice requires extreme progression in the tax
     system in the form of a leveling off of after-tax incomes.

     A weakness of the ability-to-pay principle, however, is that,
     by dealing only with allocation of a predetermined aggregate
     tax burden, it fails to link the tax and expenditure sides of
     the public budget. An alternative tax principle that remedies
     this problem is the benefit principle of taxation. Under the
     benefit principle, an individual's tax burden is based on the
     benefits that he or she receives from public services. The
     benefit principle is, in most instances, difficult to follow
     with great precision because of difficulties with actually
     measuring individual benefits from public services and because
     the people who most need services are often the least able to
     pay for them. In some cases, however, an attempt to follow the
     general guidelines of the benefit principle would appear to
     underlie particular taxes, as, for example, an excise tax on
     gasoline, the proceeds of which are used to finance highway
     building and maintenance.

     In addition to generating revenue to finance public services,
     taxation can be employed to serve other objectives, among the
     most important of which are income redistribution, economic
     stabilization, and the regulating of consumption of certain
     commodities or services. Altering the distribution of income in
     society is a function that many governments perform. Although
     it is not the only means of performing this function, taxation
     is the most explicit, with the revenue collected by taxing one
     group in society transferred directly to another group. The
     size of the government deficit--the difference between
     expenditures and tax revenue--is an important policy variable
     for purposes of economic stabilization (see FISCAL POLICY).
     Adjustments in tax rates are an important means of manipulating
     the deficit. Finally, excise taxes are often imposed on goods
     and services with the objective of reducing consumption by
     raising the price of the taxed commodities. Tobacco and liquor
     are two commodities often subject to this sumptuary taxation.

     PROPERTY TAX

     Property tax is a tax that is levied by a governmental unit on
     various kinds of property. Real property tax, the most common
     form, is levied on land and buildings. Personal property tax is
     assessed on such items as machinery, merchandise, furniture,
     automobiles, and equipment. Intangible property tax is levied
     on such assets as bank savings, notes, stocks, bonds, and other
     securities.

     In the United States, use of property taxes is limited to state
     and local governments. The property tax revenue may be used to
     support local education, police and fire protection, sanitation
     removal, street repair, parks, libraries, and other community
     services. Property taxes have come under increasing criticism
     in recent decades. Critics argue that property may not always
     be assessed fairly or consistently. Furthermore, homeowners
     feel that they pay a disproportionate share of the costs of
     government. The reliance of school systems on property tax
     revenues has been the target of the strongest criticism.
     Critics argue that children in poor areas receive a poorer
     education because lower revenues from property taxes result in
     inferior school systems. Lawsuits have claimed that students in
     the poorer districts are denied equal protection of the law.
     The U.S. Supreme Court rejected this contention, however, in
     San Antonio Independent School District v. Rodriquez (1973).
     Despite that ruling, efforts are still being made to reduce the
     dependence of school systems on the property tax.

     In 1978 opposition to the property tax reached a new high in
     California; voters overwhelmingly approved a constitutional
     amendment, known as Proposition 13, that limited the amount of
     property tax that could be levied. The success of Proposition
     13 in California created demands by citizen groups in other
     states that limits be placed on the property tax.

     The church, stated the charter, was to be free. Following the
     ecclesiastical concessions, Magna Carta specified liberties for
     all free men so that all might be defended from royal whim.
     Certain taxes were not to be levied without the common consent
     of the kingdom, whose representatives' decisions were binding
     on all (a forerunner of "no taxation without representation").
     The barons acquiesced in the growth of royal jurisdiction since
     1154, but certain clauses sought to control the direction of
     legal reforms. The evolution of DUE PROCESS was reflected in
     the requirements that proper trial be held before execution of
     sentence and lawful judgment in royal courts.

     INCOME TAX

     The income tax is a levy based on the incomes of individuals,
     families, and corporations. The income tax is the largest
     source of tax revenue in advanced economies. In the United
     States over half of the federal government's tax revenue comes
     from income taxes, with the personal income tax accounting for
     about 45% and the corporate income tax for another 10% of the
     total tax revenue. Most individual states and some local
     governments also levy income taxes, but income taxes are less
     important than other sources of state tax revenue.

     An income tax was first instituted in Britain on a permanent
     basis in 1842. The United States did not use an income tax
     until 1861, as a temporary measure to help finance the Civil
     War; that tax was repealed in 1871. When Congress tried to
     reinstate the income tax, the Supreme Court, in POLLOCK V.
     FARMER'S LAN AND TRUST CO. (1895), declared that it was
     unconstitutional.

     The 16TH AMENDMENT to the U. S. Constitution, which is much
     debated in the Patriot and Tax Freedom Movements, consists of a
     single sentence that allows income taxation. (See separate
     Chapter on the 16th AMENDMENT) The income tax exempted the
     first $3,000 from taxation and taxed the remainder of income at
     graduated rates ranging from 1% for income up to $20,000 to as
     high as 7% for income over $500,000. This was sufficiently high
     relative to income at the time that less than 1% of the
     population was subject to the income tax then.

     The initial passage of the law established a progressive tax
     structure, which means that taxpayers are taxed at a higher
     percentage rate the higher their incomes are. A proportional
     tax would collect at the same percentage rate for all incomes,
     and a regressive tax collects a smaller percent of income for
     higher incomes. The tax structure in the United States has
     remained progressive since the tax was established, although
     specific rates have varied greatly.

     From an initial top rate of 7% in 1913, the top rate rose to
     77% by 1918 to help finance World War I. The top rate fell to
     25% from 1925 to 1928, but by 1936 had risen again to 78%. The
     highest top bracket was 94% in 1944 and 1945 to help finance
     World War II, and it remained above 90% in the early 1960s
     until it was reduced to 70% by the tax act of 1964. In 1981 the
     top rate was reduced to 50%, and it was reduced again by the
     Tax Reform Act of 1986. Effective in 1991 the top rate was 31%.

     One of the most significant events in the history of the U. S.
     income tax was the introduction of withholding during World War
     II. Prior to withholding, individuals were responsible for
     sending their tax payments to the government. Withholding,
     however, requires employers to deduct a part of an employee's
     pay and send it directly to the government to cover the
     employee's estimated income taxes. At the end of the year, the
     income earner computes the income tax due and either pays any
     additional amount or receives a refund from the government for
     payments in excess of the tax due. The withholding system makes
     it much easier for the government to collect taxes and makes
     evasion more difficult.

     THE PERSONAL INCOME TAX

     The amount of personal income tax due is computed in several
     steps. First, total income from all sources is added together.
     Certain types of income are not included in income for tax
     purposes; these are called exemptions. Examples include a
     personal exemption for the taxpayer and for individuals who are
     supported by the taxpayer's income, any fellowship or
     scholarship income used for tuition or books, and for employee
     business expenses such as the cost of travel for a traveling
     salesperson. Total income minus exemptions equals adjusted
     gross income.

     Taxpayers then subtract deductions from adjusted gross income
     to compute taxable income. Items that can be deducted include
     home-mortgage interest payments and charitable contributions.
     In lieu of itemizing these deductions, taxpayers can choose to
     take a standard deduction; exemptions, therefore, can be more
     valuable to taxpayers than deductions because exemptions can be
     taken even if other deductions are not itemized.

     The tax due is computed from taxable income according to the
     tax rate schedule. An important concept in income taxation is
     the distinction between the average and marginal rates of
     taxation. The average rate is the fraction of income paid in
     taxes. The marginal rate is the fraction of any additional
     income that would have to be paid in taxes. The average and
     marginal rates are not the same because, first, some income is
     not taxed--due to exemptions, deductions, and credits; and,
     second, the progressive tax schedule taxes lower levels of
     income at a lower rate than higher levels of income.

     The Tax Reform Act of 1986 simplified the tax structure and
     reduced the total number of tax brackets to four. Lowest income
     taxpayers had an income tax rate of 15%, and as income rose,
     the marginal tax rate rose to 28%, then to 33%, and then back
     down to 28%. For the first time in the history of the income
     tax, the taxpayers with the highest incomes were not in the
     highest tax bracket. In 1991 the two top brackets were combined
     and the tax rate for that bracket was set at 31%. This reduced
     the number of tax brackets to three, with marginal tax rates of
     15%, 28%, and 31%.

     The complexities of the tax code are the result of the attempt
     to achieve a number of goals in its design. The first goal is
     fairness, and, with the income tax, fairness is generally
     interpreted to mean that taxpayers should be taxed in
     proportion to their ability to pay. In trying to implement the
     ability-to-pay principle, the tax code taxes single taxpayers
     more than married taxpayers with nonworking spouses, but taxes
     married couples who both work more than if they both were
     single. Families with children also pay less in an attempt to
     tax the same amount for those with equal abilities to pay.

     The progressive nature of the tax code implements the
     ability-to-pay principle by suggesting that those with more
     income have a more-than-proportional ability to pay. How
     progressive the tax code should be, however, is a matter of
     debate.

     A second goal of the tax code is efficiency, which means
     collecting a given amount of tax revenue at the least cost. The
     efficiency of the tax is affected by the costs of collection,
     such as cost of filling out forms, having the government
     monitor payments, and so on. Efficiency is also influenced by
     the incentives that an income tax introduces against earning
     taxable income. Higher tax rates provide an incentive for
     taxpayers to work less, to do their own work rather than hire
     someone else who will have to pay income tax, and to cheat by
     not reporting income. These incentives can be minimized by
     keeping tax rates low, so the goal of efficiency conflicts with
     the equity goal of progressive taxation.

     Historically, the tax code has also been used to further other
     goals by providing tax incentives. Home-mortgage interest can
     be deducted from taxable income, creating an incentive for home
     ownership. Charitable contributions can be deducted, providing
     an incentive for charitable giving. The use of the tax system
     to provide these kinds of incentives is controversial, and the
     Tax Reform Act of 1986 eliminated many incentives of this type.

     THE CORPORATE INCOME TAX

     In 1960 the corporate income tax comprised 23.2% of federal tax
     revenues. It had fallen to 12.5% of federal tax revenues by
     1980, due to the effects of tax reforms undertaken in the 1960s
     and 70s. The decline resulted from corporations being able to
     shelter more income from taxation through credits, exemptions,
     and deductions. Because of the 1981 tax reform, corporate
     income tax collections made up only 6.2% of federal tax
     revenues in 1983, in large part because the 1981 tax act
     allowed more favorable treatment of depreciation. The Tax
     Reform Act of 1986 contained measures to increase the
     contribution of corporate income taxes to total federal taxes,
     and by 1989 corporate income tax collections made up more than
     11% of federal tax revenue.

     Taxable income for corporations is computed by subtracting
     allowable expenses from income, but from 1960 to the mid-1980s
     a greater range of expenses was being allowed. An investment
     tax credit allowed the reduction of tax payments by 10% of
     investment expenditures, and firms were permitted to write off
     large depreciation expenses to lower their taxes. The Tax
     Reform Act of 1986 reduced corporate income tax rates, but
     corporations must pay taxes on more of their income, since less
     can be deducted. As a result, corporate income tax collections
     as a share of total federal taxes have increased more than 80%.

     One controversy regarding corporate tax rates is who actually
     ends up paying the tax. Corporations may raise their prices to
     cover the corporate income taxes they pay, which would mean
     that the tax is actually paid by the corporation's customers
     rather than by the corporation itself. If the corporation did
     not raise its prices to cover the tax, then the tax would lower
     corporate profits, so that the stockholders of the corporation
     would end up paying the tax. Since insurance companies and
     pension plans own large blocks of stock, the corporate income
     tax may fall heavily on those industries and their customers.
     Economists agree that the tax is ultimately paid from all of
     these groups, but there is no agreement on who pays how much.

     Another controversy regarding the corporate income tax is the
     issue of double taxation. A tax on corporate income taxes the
     stockholder several times because corporations pay income tax
     on the money they pay out as dividends and then the recipient
     of the dividend must pay personal income tax on the dividend.
     Furthermore, stock is bought with after-tax income; then, when
     the stockholder is paid a dividend from the corporation or
     sells the stock at a profit, the income earned is taxed again.
     Some people argue that corporate income should not be taxed in
     order to avoid double taxation, while others argue that those
     who earn corporate income can best afford to pay taxes. The
     question is closely related to the issue of who ultimately pays
     the corporate income tax, since corporations really only
     collect taxes that are paid by individual stockholders and
     customers.

     TAX POLICY AND TAX REFORM

     Originally, the income tax was seen solely as a method of
     raising revenue, but since World War II it has been used as a
     tool for furthering other goals as well. In 1964 a tax cut
     designed by Presidents Kennedy and Johnson was enacted to help
     the sagging economy. The logic was that a tax cut would give
     consumers more money to spend, which would stimulate business
     activity. This was the first time that income tax reform was
     undertaken primarily to try to fine-tune the economy.

     President Kennedy, also instituted the investment tax credit to
     encourage investment, and throughout the 1960s and 1970s many
     other tax benefits were added to the tax system. Among them
     were oil depletion allowances that made oil exploration more
     profitable, an energy tax credit that provided an incentive for
     energy-efficient investment, and tax exemptions under certain
     conditions for retirement savings and health insurance. Each
     change, taken by itself, had an individual rationale, but the
     cumulative effect of such reforms was to reduce the amount of
     income subject to taxation, which required higher average rates
     to raise the same amount of revenue.

     Throughout the 1960s and 70s inflation had the effect of
     continually pushing taxpayers into higher income tax brackets,
     which provided additional revenue to compensate for the
     increase in tax benefits. Inflation provided enough additional
     revenue that rate reductions to partially offset the effects of
     inflation were also common. The 1981 tax reform act contained a
     provision to automatically index tax brackets to offset
     inflation, making this type of tax reform unnecessary.

     The Tax Reform Act of 1986 was the most comprehensive change in
     the structure of the U.S. income tax since it was originally
     enacted. The cumulative effects of many small tax reforms over
     the preceding several decades had been to increase the number
     of deductions, credits, and exemptions, which had resulted in
     less income being subject to taxation. The 1986 reform was
     designed to lower tax rates while collecting about the same
     amount of revenue, by eliminating most tax preferences and thus
     increasing the amount of income that could be taxed. Reduced
     tax rates also have the advantage of increasing the incentive
     to earn income, while lowering the incentive for taxpayers to
     look for tax shelters to avoid taxation. One measure of the
     success of the 1986 tax reform is that only minor changes were
     made to the income tax structure in the five years following
     that reform.