Taxation, system of compulsory contributions levied by a government on persons, corporations, and property, primarily as a source of revenue for government expenses and other public purposes. Taxation may, however, be employed for other economic and social objectives. It may serve, for example, as a method for developing a well-balanced economy by fostering or curtailing various forms of business activity, or it may be used to bring about social reforms through a redistribution of wealth.

The effectiveness of any government depends on the willingness of the people governed to surrender or exchange a measure of control over their persons and property in return for protection and other services. Taxation is one form of this exchange.

In medieval times, taxes were customarily paid not in money but in the form of labor or other in-kind payments (such as work on local roads or supplies of grain or other farm produce). As long as the government's services consisted largely of military actions and the provision of roads and other public works, in-kind taxation satisfied most governmental needs reasonably well. Rulers could levy work crews or troops by requiring each noble to produce a number of laborers or soldiers suitable to the noble's rank or estates. In the same manner, grain levies could be imposed on landowners, both to feed the workers or troops and to provide for various other government needs. In modern industrial nations, although taxes are levied in terms of money, the fundamental pattern remains: The government designates a tax base (such as income, property holdings, or a given commodity); applies a tax-rate structure to the base; and collects the tax (equal to the base multiplied by the applicable rate) from the stipulated legal taxpayer.

Tax systems, even today, are as varied as the nations that devise them, ranging in complexity from in-kind arrangements to computerized revenue systems. Simple tax mechanisms are suitable only to the needs of those governments that are extremely limited in scope. When government responsibilities are extensive and diverse (as, for example, when taxes are used to modify economic inequalities and to distribute benefits in ways that are considered equitable), the supporting system of taxes must be technologically sophisticated. Elaborate networks of fiscal reporting become essential, as does a standard of public education adequate to ensure a high degree of taxpayer compliance.

Tax systems perform differing functions, depending on the responsibilities expected of the enacting government. In a complex, trilevel government such as that of the United States, for example, the benefits expected from federal, state, and local taxes vary greatly. Lower levels of government are comparatively limited in the kinds of taxes they are authorized to levy. Local governments traditionally depend most heavily on property taxes, and state governments on sales and income taxes. State and local governments are required to keep their expenditures within the budgetary limits, determined by their own revenues augmented by payments received from higher levels of government (such as federal grants-in-aid). The federal government, however, can create money; it does not have to raise enough from its tax system to balance its budget. The federal tax system, moreover, does not function solely as a way to raise revenue but is also the basic instrument of U.S. fiscal policy. In concert with its control over the money supply (that is, its monetary policy), the government aims to maintain the stability of the economy (as evidenced by price and employment levels). In depressed periods, for example, taxes may be lowered and budget deficits incurred so that consumers will have money to buy goods and investors will have capital to put into industry, thus stimulating production. In prosperous times, tax increases and budget surpluses may be needed to hold down or prevent the inflation caused by too much money chasing too few goods.

Among the tax systems of other nations, wide variations exist in how money is raised and spent. Tax and expenditure policies reveal the fundamental value system of a society. Most democracies today derive their general notions of what constitutes a good tax system from four principles enunciated in the 18th century by the British economist Adam Smith.

Of fundamental importance is that any tax must be fair葉hat is, citizens should be taxed in proportion to their abilities to pay (a concept that Smith defined somewhat ambiguously as "in proportion to the benefit they derive from the government"). A tax is considered fair if those who have the means to pay are assessed either in proportion to their capacity to pay or, depending on the situation, in proportion to what they receive from the government. Both "ability to pay" and "benefits received," therefore, are respected criteria of equity. Where general, widely dispersed services of government are concerned, the two criteria are often indistinguishable, because people of greater wealth usually have a greater stake in the well-being of the community. When government services confer identifiable personal benefits on some individuals and not on others, and when it is feasible to expect the users to bear a reasonable part of the cost, financing the benefits, at least partly, by taxing the people who benefit is considered fair. (Obviously, this method does not apply to such services as public welfare payments.) Taxation in accordance with appropriately applied standards of ability to pay or of benefits received is said to meet the requirements of vertical equity (because such taxation exacts different amounts from people in different situations). Just as important is horizontal equity葉he principle that people who are equally able to pay and who benefit equally should be taxed equally.

The application of a tax should be clear and certain. This principle, considered very important by Smith, has often been underestimated in modern tax systems (in which open and impartial administration usually can be taken for granted). In nations where the application of taxes is uncertain and arbitrary, however, the public can have no confidence in the system. Even in the U.S., high rates of inflation have sometimes created fears and uncertainties about rising tax bills and the fairness of imposing taxes on inflated values. Such reactions demonstrate the importance of clarity and certainty as principles of a respected tax system.

Compliance with a tax should be easy and convenient. In the U.S., for example, compliance with income tax laws increased dramatically after a system of withholding tax payments from payrolls was introduced.

A good tax system should be structured so that it can be administered efficiently and economically. Taxes that are costly or difficult to administer divert resources to nonproductive uses and diminish confidence in both the levy and the government. Worse still, waste can also be created by excessive tax rates; economic efforts are then shunted from high- into low-yielding activities, from productive enterprises into tax shelters, and from open, aboveboard transactions into hidden, off-the-record participation in the underground economy. When this happens, the important principle of tax neutrality (which maintains that a tax should not cause people to change their economic behavior), implied by Smith, is violated.

In designing tax systems, governments customarily consider three basic indicators of taxpayer wealth or ability to pay: what people own, what they spend, and what they earn. Historically, agriculture, as the oldest industry, became the earliest lucrative tax base. Thus, among major revenue sources, the property tax on land and its produce is the oldest of modern taxes.

Because no single form of wealth is a perfect indicator of taxpayer ability to pay, most modern nations try to diversify their tax systems. Many people think of ability to pay largely in terms of income. This assumption, however, is losing ground as the inequities in modern income tax systems become increasingly apparent. The property tax has also come under considerable criticism, particularly in the U.S. A comprehensive form of taxation on consumption expenditures has gained support among tax specialists, but public acceptance has been lacking.

No tax is levied with perfect evenness or on a completely comprehensive base; its burden inevitably falls more heavily on some taxpayers than on others. The exemptions, exceptions, and other loopholes in tax laws are partly the result of humanitarian concern for those who might be overburdened; partly, they reflect political pressures; and partly, they come from administrative inefficiency or inability to deal with the extremely complex tax structure. By using a variety of taxes, governments can spread out the inequities and mitigate their impact.

As pressure on revenue systems rises and taxpayers chafe under perceived inequities in the most heavily used taxes, interest grows in levies designed to achieve fairness in terms of benefits received. Aside from simple user charges such as public golf course greens fees and city marina boat-docking fees (which may be thought of more as prices than as taxes), the benefits standard is apparent in many major levies. These include gasoline taxes that are earmarked for road maintenance and construction; business levies collected to provide unemployment insurance; and social security taxes allocated to worker casualty-insurance and retirement funds. The effectiveness of earmarking is a much disputed issue, but it tends to appeal to politicians. Although earmarking can make raising new revenue easier, it can also create budgetary distortions, especially in times of economic stress, when the general fund may be in need while special funds are more than adequately filled.

The economic effects, and therefore the equity, of many taxes cannot be fully understood because of the difficulty in determining where their burdens really fall. Even the individual income tax, which is presumed to fall entirely on the legal taxpayer, has indirect consequences in the economy; it influences decisions to work, save, and invest, and these decisions affect other people. Perhaps the most difficult tax burdens to pin down are those of the corporate-profits tax. Depending on the structure and flexibility of the market within which a corporation competes, the tax may in some cases simply lower corporate profits and dividends; in other cases, it may broadly reduce the incomes of all owners of property and businesses. To the extent that corporations compensate for the tax by raising the prices of their products, the incidence of the tax may be said to be shifted forward to consumers. To the extent that tax-reduced corporate profit margins hold down wages, the incidence of the tax is shifted backward to workers.

Similar disagreements arise over the incidence of local property taxes and over the employers' share of social security payroll taxes. Even the long-established view that retail sales taxes are shifted forward from retailers to consumers is challenged in a world in which wages and government transfers (that is, income payments such as social security) are indexed, or automatically adjusted upward, for inflation. Inclusion of the sales tax in the Consumer Price Index insulates recipients of indexed incomes against inflation-induced tax increases and therefore puts the burden of those increases on the recipients of nonindexed incomes. As awareness grows of the difficulties in pinning down the burden patterns of various taxes, the old distinction between direct (unshiftable) and indirect (shiftable) taxes becomes relatively meaningless.

Despite the difficulties of precise measurement, governments are appropriately concerned with the vertical pattern of the tax burden: Does it fall proportionately more heavily on the rich than on the poor (progressive taxation)? Does it burden everyone to the same degree in relation to taxpaying ability (proportional taxation)? Or does it place a relatively heavier burden on the poor (regressive taxation)? In most modern nations, a generally progressive tax structure is considered desirable for two reasons. First, a progressive tax is considered more equitable (because the wealthy have more ability to pay). Second, extremes of wealth and poverty are considered injurious to the economic and social well-being of a society, and a progressive tax structure tends to moderate such extremes.

On the other hand, tax rates that are too progressive葉hat rise too steeply洋ay discourage both work and investment by removing much of the reward. In the early 1980s concern about this problem in the U.S. and elsewhere attracted the attention of policymakers to so-called supply-side economics葉o economic theories emphasizing the importance of ensuring that taxes do not drain away incentives to invest, either from individuals or from businesses. In 1986 the U.S. Congress instituted a major overhaul of the income tax system.

Contributed By:

George F. Break

This breakdown measures the money supply by degree of liquidity. Liquidity refers to how easy it is to convert money into cash葉he most liquid form of money. Checking accounts represent the next most liquid form because money in a checking account can be easily withdrawn by writing a check. Savings accounts are slightly more difficult to access than checking accounts and therefore are less liquid. Certificates of deposit are less liquid still because often funds cannot be withdrawn before a specified date without a penalty.

Each measure of money includes a portion of the money supply that is more liquid than the next measure葉hat is, M1 is more liquid than M2. The measures are cumulative; each measure includes the forms of money (cash, savings accounts, U.S. treasury bonds, etc.) counted in the previous measure, plus additional, less liquid forms. For example, M2 includes M1 plus certain additions.

Definitions of different money supply measures include a number of technical items, but, in a general sense, M1 is the most liquid and includes cash, travelers checks, and demand deposits幼hecking accounts from which money can be withdrawn on demand. In 1994 M1 in the United States averaged over $1.1 trillion on a daily basis. M2 is less liquid. It consists of M1 plus savings deposits of $100,000 or less. M3 consists of M2 plus savings deposits of more than $100,000. L consists of M3 plus government securities, such as savings bonds and treasury notes.

Economists disagree on the ultimate effects of changes in the money supply. Two important schools of economic thought are Keynesianism and monetarism. Keynesians believe that an increased money supply can lead to increased employment and output. On the other hand, monetarists argue that an increased money supply ultimately only affects prices, leading to inflation, and that output is not increased.