Taxes are the primary source of revenue for most governments. They are simply defined as a charge or fee on income or commerce. Taxes are most readily understood from the perspective of income taxes or sales tax, although there are many other types of taxes levied on both individuals and firms.
Necessarily, taxes raise the price of purchasing the good or resource for firms and consumers. As a result, the quantity demanded and supplied reacts according to the supply and demand curves.
Tax Authority
In the United States, Congress has the power to tax as stated in The United States Constitution, Article 1, Section 8, Clause 1: "The Congress shall have the Power to lay and collect Taxes, Duties, Imposts, and Excises to pay the Debts and provide for the common Defense and general Welfare of the United States. " This power was reinforced in the Sixteenth Amendment to the Constitution: "The Congress shall have the power to lay and collect taxes on income, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration."
It is important to note that Congress has delegated to the Internal Revenue Service (IRS) the responsibility of administering the tax laws, known as the Internal Revenue Code (the Code). Congress enacts these tax laws, and the IRS enforces them. Individual states also have the power to tax as do smaller government entities such as towns, cities, counties, and municipalities.
Purpose of Taxation
On a general level, tax collections provide a revenue source to support the outlays or primary activities of a government including but not limited to public buildings, military, national parks, and public welfare in the form of transfer payments. Taxes allow the government to perform and provide services that would not evolve naturally through a free market mechanism, for example, public parks. However, governments also use taxes to establish income equity and modify consumption decisions .
Income and Outlays (IRS Publication 2105; Rev 3-2011)
Tax revenue is used by the government to support services and activities available to all residents.
Sources of Tax Revenue: Income Taxation
Governments use different kinds of taxes and vary the tax rates. This is done to distribute the tax burden among individuals or classes of the population involved in taxable activities, such as business, or to redistribute resources between individuals or classes in the population. This type of taxation is referred to as progressive taxation because the tax liability increases in proportion to income.
Sources of Tax Revenue: Sales Taxes
Sales taxes are borne by the consumer when s/he purchases certain goods. It is an ad valorem tax: the charged value is based on the value of what is being sold. This is in contrast to an excise tax, where the charged value is based on the number of items being sold.
Sales tax is a form of regressive taxation; the liability is based on the percentage of income consumed, which is higher for low income earners. As a result, individuals earning a relatively lower income will pay a higher proportion of income in the form of sales tax, defining the regressive nature of the tax. Though a general revenue source, sales taxes are also used to modify behavior. For example taxes on cigarettes are meant to dissuade purchase due to the inherent health implications of smoking.