The Timing, or When Are We Taxed?
There are two important timelines for understanding the implications of taxation. The first timeline is an earning and spending cycle, the short financial cycle (for most Americans this could be thought of as 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 taxpayer earns her paycheck, she must decide what to do with it, and she has several options. She may put some of the money into her retirement savings, health care plans, a short-term rainy day fund, she may spend it, or all (or multiple) of the above. An income tax taxes the whole paycheck (What Do We Tax?) - minus the exemptions (What Don’t We Tax?). Congress has created exemptions for both retirement and health care plans, so the amount she puts in these categories is deducted from her income, and she is taxed on what’s left over.
Recalling from What Can Be Taxed that all money is either spent or saved, the exemptions for certain types of savings have turned the income tax into a consumption tax. Most people spend all of their money from 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. Taxes are therefore paid when the money is used to consume. Because this tax is taken before any money is actually spent, it is prepaid. The income tax has therefore become a prepaid consumption tax.
When the money is finally spent, excise taxes on things like gasoline, tobacco, or alcohol are also charged. States sales taxes are usually also charged. These are postpaid consumption taxes: they are charged when the money is spent.
The short financial cycle, then, consists of prepaid and postpaid consumption taxes. Since these taxes are both consumption taxes, they 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 she is in the course of her life.
As a child, the 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 everyone else to do so.
When the taxpayer leaves her parents’ nest, she might go to college. Most people take out loans for this. Loans are not taxed (yet). However, if she receives a scholarship, the Trump tax plan recognizes that as income, and she is taxed on it.
Next, the taxpayer enters the workforce. For the next 40 years of her life, the 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. Additionally, since she is now paying back her loans with after-tax income, it’s like she is being taxed on those loans too.
Finally, the taxpayer retires. She has saved for retirement. Now, as she cashes out those savings, she is taxed for that income. At this point, she is taxed a lot less than when she was working. Instead of spending this 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 tax bracket. She also gets Social Security, accounting for the majority of tax contributions for contemporary taxpayers. (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. The workforce also continues to shrink, promising the contributing workers returns smaller than their contributions when they retire.)
Next: Read Hidden Taxes