Consumption Taxes

Consumption Taxes
A consumption tax is a tax levied on sales of goods or services. The most important kinds of consumption taxes are general sales taxes, excise taxes, value-added taxes, and tariffs.

General Sales Taxes
A general sales tax imposes the same tax rate on a wide variety of goods and, in some cases, services. In the United States, most states and many local governments have a general sales tax. The country has no national general sales tax. State sales taxes range from 3 to 7 percent, and local sales taxes range from a fraction of 1 percent to 7 percent. In Canada, all provinces except Alberta impose a general sales tax on goods. In some provinces, the provincial sales tax and the federal goods and services tax (GST) are combined into a single tax known as the harmonized sales tax (HST). Local governments in Canada do not have the authority to impose general sales taxes.

Although sellers are legally responsible for paying sales taxes, and sellers collect sales taxes from consumers, the burden of any given sales tax is often divided between sellers and consumers (for more information, see the Effects of Taxes section of this article). Most states exempt certain necessities from sales tax, such as basic groceries and prescription drugs. Both individuals and businesses pay sales tax.

Excise Taxes

Federal, state, and local governments levy excise taxes, which are sales taxes on specific goods or services. Excise taxes are also called selective sales taxes. Goods subject to excise taxes in the United States and Canada include tobacco products, alcoholic beverages, gasoline, and some luxury items. Excise taxes are applied either on a per unit basis, such as per package of cigarettes or per liter or gallon of gasoline, or as a fixed percentage of the sales price.

Governments sometimes levy excise taxes to pay for specific projects. For example, voters in a city might approve a tax on hotel rooms to help pay for a new convention center. Some national governments impose an excise tax on airline tickets to help pay for airport improvements. Revenues from gasoline taxes typically pay for highway construction and improvements. Excise taxes designed to limit consumption of a commodity, such as taxes on cigarettes and alcoholic beverages, are commonly known as “sin taxes.”

Another type of excise tax is the license tax. Most states require people to buy licenses to engage in certain activities, such as hunting and fishing, operating a motor vehicle, owning a business, and selling alcoholic beverages.

Value-Added Tax

In Canada and Europe the favored form of consumption taxation is a value-added tax (VAT). In this system, the seller pays the government a percentage of the value added to goods or services at each stage of production. The value added at each stage of production is the difference between the seller’s costs for materials and the selling price. In essence, a VAT is just a general sales tax that is collected at multiple stages.

In the production of apple pies, for example, the farmer grows apples and sells them to a baker, who turns them into a pie. The baker sells the pie to a restaurant owner, who sells it to a consumer. At each stage, the producer adds value to the commodity by processing it with capital (machines) and labor. The farmer, the baker, and the restaurant owner each charge their customer a VAT. However, they can each claim a credit to recover the tax they paid on purchases related to their commercial activities.

Tariffs

Tariffs, also called duties or customs duties, are taxes levied on imported or exported goods. Import duties are considered consumption taxes because they are levied on goods to be consumed. Import duties also protect domestic industries from foreign competition by making imported goods more expensive than their domestic counterparts. In the United States, import duties were the largest source of federal revenues until the introduction of the income tax in 1913. Today they account for only a small portion of federal revenues.

Property Taxes

In principle, a property tax is a tax on an individual’s wealth—the value of all of the person’s assets, both financial (such as stocks and bonds) and real (such as houses, cars, and artwork). In practice, property taxes are usually more limited. In the United States, state and local governments generally levy property taxes on buildings—such as homes, office buildings, and factories—and on land. There is no federal property tax. In 1998 property taxes accounted for 2.3 percent of state tax revenues and 73 percent of local tax revenues. The Canadian constitution allows the federal government to levy property taxes. However, currently only local and provincial governments collect property taxes. The property tax is by far the largest source of revenue for local governments.

The property tax is often unpopular with homeowners. One reason is that, because homes are not sold very often, governments must levy the tax on the estimated value of the dwelling. Some citizens believe that the government overvalues their homes, leading to unfairly high property tax burdens.

Estate, Inheritance, and Gift Taxes

When a person dies, the property that he or she leaves for others may be subject to tax. An estate tax is a tax on the deceased person’s estate, which includes everything the person owned at the time of death—money, real estate, stock, bonds, proceeds from insurance policies, and material possessions. Most governments levy estate taxes before the deceased person’s property passes to heirs, although many governments do not impose an estate tax on property inherited by a spouse. An inheritance tax also taxes the value of the deceased person’s estate, but after the estate passes to heirs. The inheritors pay the tax. Estate and inheritance taxes are sometimes collectively called death taxes. A gift tax is a tax on the transfer of property between living people.

In the United States, the federal government imposes gift and estate taxes, and some states impose inheritance or estate taxes. However, they are minor sources of revenue because the taxes apply only to very large estates and gifts. Property transferred to a deceased person’s spouse is not taxed. Under the Economic Growth and Tax Relief Reconciliation Act of 2001, estate taxes were to be gradually lowered and then phased out altogether in 2010. Under the new law, the exemption for estate taxes was to rise from $1 million in 2002 to $3.5 million in 2009. However, the new law itself was due to be repealed on the eve of 2011, reverting to the legislation that existed prior to the passage of the act unless Congress agreed to extend it. In 2002 less than 2 percent of all people who die in the United States had estates that were subject to the tax. In 2002 federal gift-tax law allowed each individual to give any other person up to $11,000 per year tax-free. The Tax Relief Reconciliation Act amended other provisions of the gift tax as well. In Canada, there are currently no death taxes, although both the federal and provincial governments levied estate taxes in the past.

Estate and gift taxes are controversial. Proponents argue that they are useful tools for distributing wealth more equally in society and preventing the rise of powerful oligarchies. Opponents argue that it is a person’s right to pass on property to his or her heirs, and the government has no right to interfere. If an individual has paid tax on his or her income while in the process of accumulating wealth, critics ask, why should it be taxed again when the wealth is transferred? Others argue that estate and gift taxes discourage individuals from working and saving to accumulate wealth to leave to their children. On the other hand, the presence of an estate tax might encourage people to accumulate greater wealth in order to reach a given after-tax goal.

Other Taxes

A poll tax, also called a lump-sum tax or head tax, collects the same amount of money from each individual regardless of income or circumstances. Poll taxes are not widely used because their burden falls hardest on the poor. When the British government implemented a system of local poll taxes in 1990, citizens considered the tax so unfair that they held demonstrations—some violent—around the country. The extreme unpopularity of the tax contributed to the downfall of Prime Minister Margaret Thatcher. Her successor, John Major, repealed the tax in 1991. In the United States, the 24th Amendment, ratified in 1964, prohibited the payment of poll taxes as a requirement for voting in federal elections. Until that time, a number of Southern states had used poll taxes to deny poor blacks the right to vote.

EFFECTS OF TAXES

Economists have devoted considerable effort to studying the effects of taxes. In particular, they study how taxes affect people’s behavior, including their choices in working, saving, and investing.

To understand the effect of any tax, one must first determine who bears the burden of the tax. This is not always an easy task. Suppose that the price of a chocolate doughnut is $1.00. The government then imposes on sellers a tax of 10 cents per doughnut. A few weeks after its imposition, the tax causes the price to increase to $1.10. The doughnut seller clearly receives the same amount per doughnut as he or she did before the tax—the tax has not made the seller worse off. Consumers pay the entire tax in the form of higher prices. On the other hand, suppose that after the tax the price increases to $1.04. In this case, the seller keeps only 94 cents per doughnut, and is worse off by 6 cents per doughnut. Consumers are also worse off, however, because they have to pay 4 cents more per doughnut. In this case, retailers and consumers share the burden of the tax.

The way a tax affects people is called the tax incidence. The statutory incidence of a tax refers to the individuals or groups who must legally pay the tax. The statutory incidence reveals essentially nothing about a tax’s real burden, because as previously illustrated, prices may change in response to a tax. In contrast, the economic incidence of a tax refers to its actual effects on people’s incomes. The economic incidence of a tax depends on how buyers and sellers of the commodity react when the tax is imposed. The more sensitive consumers are to changes in price, the easier it is for them to turn to other products when the price goes up, in which case producers bear more of the tax burden. On the other hand, if consumers purchase the same amount regardless of price, they bear the whole burden.

Taxation in Canada

The first known taxes in Canada were export taxes on furs imposed by the French regime in 1650. The French government soon replaced these with tariffs on imported goods. Tariffs continued to be of major importance during the period of British rule, which began in 1763. The British North America Act of 1867 stated that the provinces could levy income taxes, but could no longer levy tariffs. However, the levying of income taxes on individuals and businesses did not become widespread in the provinces until the end of the 19th century.

In 1917 the federal government, which had relied primarily on excise taxes, created both a personal income tax and a corporate income tax, both of which had previously been levied only by provinces. The federal government introduced a general sales tax in 1920. All the provinces created gasoline taxes in the 1920s and collected taxes on alcohol sales. During World War II the provinces suspended their income taxes.

After World War II, the federal government took over the income tax from the provinces, paying them a fee for this right. In 1962 the provinces regained the right to levy income taxes. All provinces soon imposed individual income taxes. (Except in the province of Québec, provincial income taxes are collected by the federal government and then given over to provincial governments.) Also, from 1973 to 1990, all provinces adopted some form of corporate income tax.

In 1991 the federal government introduced a goods and services tax (GST). This broad-based tax applies to most goods and services, although certain commodities, such as basic groceries and medical supplies, are exempt from the tax. In 2000 Canada adopted one of the largest tax cuts in its history. It was designed to reduce personal taxes an average of 15 percent over a five-year period.

Mortgage

Mortgage, legal instrument that pledges a house or other real estate as security for repayment of a loan. By providing a guarantee that the loan will be paid back, a mortgage enables a person to buy property without having the funds to pay for it outright. If the borrower fails to repay the loan, the lender may foreclose on the property—that is, force the sale of the house to recover the amount of the loan .

The mortgage lending process has two instruments, a note and a mortgage. The note specifies the financial terms of a loan agreement. The mortgage contains a legal description of the property and a statement that pledges the property as security for the loan. However, the word mortgage commonly refers to both parts of the loan agreement as a whole.

GETTING A MORTGAGE

A borrower can obtain a mortgage from a bank, credit union, or other lender. Most lenders require the borrower to have a certain amount of money to use as a down payment toward the purchase of the house. For example, if an individual wants to buy a home priced at $100,000 and the lender requires a down payment of $5000, the individual will apply for a loan of $95,000 to pay for the difference.

A lender requires detailed information about borrowers to assess their ability and willingness to repay a loan. For example, a borrower will be asked about income, employment history, and credit history. The lender will also inquire about any debts, such as a car loan or credit card balances.

Before the lender agrees to a loan, an appraisal of the property by a qualified third party is required. The appraisal provides an estimate of the property's value. The lender wants to be certain that the property is worth at least as much as the loan in case of foreclosure.

If all requirements are met, the lender agrees to the loan. The loan agreement specifies the current interest rate and the loan's repayment terms. The terms of repayment specify how much the regular payments will be, how frequently they will be made, and over how many years. The interest rate and the duration, or life, of the mortgage determine the amount of the payment. Payments are usually made monthly. The life of the mortgage can be 15, 20, 30, or even 40 years.

To accept the loan the borrowers must sign a promissory note that obligates them to repay the mortgage debt. The borrower also promises to keep the property insured against fire and other hazards, and to pay any property taxes that may be owed. If the borrower fails to keep any of these obligations, the loan is considered to be in default, and subject to foreclosure.

The actual transfer of funds and property takes place at the closing. At the closing the lender transfers money to the borrower for buying the house and the borrower signs the mortgage documents. The borrower also pays the lender any fees associated with borrowing the money. These might include origination costs for creating and processing the loan, fees for obtaining reports on credit history, and fees for obtaining an appraisal.