The first striking feature of the fiscal state of the United States, when compared with those of other developed countries, is its small size. As of 2009, among the 34 members of the Organization for Economic Cooperation and Development (OECD), a collection of the world's most economically advanced democracies, the United States had the third-lowest ratio of taxes to GDP (see chart). But it is important to look at pre-recession data, which better reflect long-term trends. In 2006, before the financial crisis struck, OECD tax statistics showed that total taxes in the United States -- at all levels of government: federal, state, and local -- were 27.9 percent of GDP, three-quarters the percentages in Germany and the United Kingdom and about half of those in Denmark and Sweden. Among the rich democracies in 2006, only South Korea had lower taxes.
The reason for this discrepancy is not that the United States has lower personal income tax revenues than its OECD counterparts. In fact, in 2006, personal income taxes at the federal, state, and local levels in the United States came to 10.1 percent of GDP, just above the OECD average of 9.2 percent. Instead, the disparity results from the low effective rates -- or nonexistence -- of other forms of taxation. To take one example, in 2006, the U.S. corporate income tax at all levels of government collected 3.4 percent of GDP, compared with an average of 3.8 percent across the OECD. During that same year, according to the OECD, U.S. social insurance taxes brought in 6.6 percent of GDP, compared with an average of 9.2 percent among the OECD nations. Yet the biggest difference between the United States and other OECD countries is in consumption tax revenue. Most U.S. states have sales taxes, and the federal government maintains excise taxes (taxes on such goods as alcohol, cigarettes, and fuel) and customs duties (taxes on imported goods). Yet none of those taxes currently collects the same amount of revenue as a value-added tax (VAT) would (a VAT is a consumption tax that collects revenue from the value added by each business at each stage in the chain of production of a given product). OECD statistics show that VATs bring in an average of 6.7 percent of GDP among the OECD nations, accounting for the majority of the difference in total tax revenues between the United States, which does not have a VAT, and the rest of the OECD.
U.S. tax revenue is not only low but also consistently low, having equaled roughly the same share of the economy for 60 years. Since the tremendous growth of the federal government during World War II, federal tax revenues have hovered around 18 percent of GDP. This stability has also proved to be true of state and local tax levels, which have fluctuated between eight and ten percent of GDP over the same period. Over that time, taxes in the other OECD countries have grown more than in the United States. In 1965, total tax revenues stood at about 25 percent of GDP in the United States and across the rest of the OECD. But by 2000, tax revenue represented 30 percent of GDP in the United States and 37 percent in the rest of the OECD. The enacting of VATs throughout the OECD during the 1960s and 1970s accounts for much of the difference. It also accounts for the steadiness of European tax revenues through the global financial crisis. By 2009, total tax revenues had dropped to 24 percent of GDP in the United States, but they had fallen just two points, to an average of 35 percent of GDP, in the other OECD countries.
Although tax receipts have composed approximately the same share of GDP for decades in the United States, their composition has changed. In particular, the corporate tax has plunged as a source of federal revenues, from 30 percent in the 1950s to ten percent today. As Republicans are quick to point out, the United States does have one of the highest statutory corporate tax rates in the developed world. Combining the federal and state levels, the top rate of these taxes is 39 percent, compared with an average of 36 percent across the G-7 and 31 percent across the OECD. Yet as with the individual income tax, the United States applies these statutory rates to a narrower base of taxpayers than other advanced countries do, due to various corporate tax credits and breaks, such as the accelerated depreciation of machinery and equipment and the deferral of taxes on income earned abroad. As a result, according to a report issued by the U.S. Treasury Department, between 2000 and 2005, on average, U.S. businesses paid an effective tax rate of only 13 percent, nearly three percent below the OECD average and the lowest rate among the G-7 countries.
Whereas corporate tax revenues have fallen, revenues from payroll taxes for programs such as Social Security and Medicare have grown. The Urban-Brookings Tax Policy Center found that these taxes rose from 23 percent of federal revenue in 1970 to 40 percent in 2010. In fact, the majority of Americans pay more in payroll taxes than in federal income taxes. This is the case in part because the United States imposes payroll taxes on all wages without the exemptions and deductions so common to individual and corporate income taxes and in part because the Earned Income Tax Credit, which helps offset the federal income and payroll taxes of low-wage workers, reduces or eliminates income taxes for many with low earnings.
Even as payroll tax revenues have risen, the individual income tax, which in 2010 accounted for 42 percent of national revenue, has remained the main source of federal income. According to the Urban-Brookings Tax Policy Center, for decades prior to the Bush tax cuts of 2001-3, despite many alterations to tax bases and rates, the individual income tax provided a steady and large percentage of federal revenue. That is because the government tended to compensate for changes in rates by expanding or shrinking the tax base when necessary. During the 1970s, the tax code featured 25 income brackets and a top rate of 70 percent. Legislation passed during Ronald Reagan's presidency reduced the number of brackets to just two, dropped the top rate to 28 percent, ended a number of tax breaks, and pegged the brackets to inflation, ending so-called bracket creep, in which inflation forced taxpayers into higher tax brackets even though their real incomes stayed flat. President George H. W. Bush brought the top rate back up to 35 percent, and President Bill Clinton further raised it to 39.6 percent, but each administration added a number of new tax breaks, from an expansion of the Earned Income Tax Credit to a credit for a child's tuition. The Bush tax cuts reduced taxes on capital gains and dividends and on estates and cut the top tax rate yet again, to 35 percent.
The largest tax reductions from these changes went to high-income households. In fact, the United States currently taxes top earners at some of the lowest effective rates in the country's history. Data from the Internal Revenue Service (IRS) show that the top one percent of taxpayers paid an average federal income tax rate of 23 percent in 2008, about one-third less than they paid in 1980, despite the fact that their incomes are now much higher in both real and relative terms. Although the rich enjoyed by far the largest tax cuts, the middle class is also paying lower taxes. In 2011, the effective federal income tax rate for a family of four with a median income was just 5.6 percent, compared with 12 percent in 1980. And because of the Earned Income Tax Credit, about 40 percent of low-income U.S. households do not pay any federal income tax.
Altogether, the adoption and continuation of the Bush tax cuts has slashed federal revenues by about three percent of GDP, to levels not seen since shortly after World War II. As a result, the individual income tax now constitutes a smaller share of the economy than it did 30 years ago, falling from 10.4 percent of GDP in 1981 to 8.8 percent in 2005. By permitting extensive loopholes, failing to create effective consumption taxes, and cutting individual income taxes, the United States has created a tax system that collects far less revenue relative to GDP than many of its OECD counterparts.
The remarkable thing is that if you just get revenues back to that historic 18% of GDP and cut military expenditures back down from 6% to their normal level under 2% there basically is no budget problem.