Federal Revenue: Where Does the Money Come From

Federal Budget 101

Taxes are by far the largest source of income (or revenue) for the federal government. The government does receive income from other sources (like fees and interest), but those sources are dwarfed by what we all pay in taxes.

There are three major types of taxes:

  1. Income taxes paid by individuals
  2. Payroll taxes paid by both workers and employers
  3. Corporate income taxes paid by businesses

There are also a handful of other types of taxes, like customs duties and excise taxes, but they make up much smaller portions of federal revenue. This pie chart below shows how much each of these accounted for in fiscal year 2020.

Personal income taxes and corporate income taxes become federal funds, which cover almost all federal spending programs.

Payroll taxes become trust funds. A trust fund is an amount of money that is set aside for a specific purpose and cannot be spent on anything else. Payroll taxes are set aside for Medicare and Social Security. Payroll taxes are taken out of your paycheck before you get it, and might appear on your paystub as FICA, SS, SOCSEC or other names (for Social Security). Your employer also must pay taxes for you for Social Security and Medicare. There are also other trust funds, like the Highway Trust Fund, which comes from gasoline taxes.

Individual Taxes

Income taxes paid by individuals make up the federal government's single largest revenue source. The income tax system is designed to be progressive, which means the wealthy are meant to pay a larger percentage of their earnings than middle- or low-income earners. Due to the complexity of the tax code, however, this is not always the way it works out. In many cases, wealthy individuals end up paying a smaller portion of their income as taxes than the people who work for them.

As of 2020, income tax rates range from 10% for the lowest incomes to 37% for the highest incomes, but only a portion of a person or household’s income is actually taxed at those rates. Income tax rates have also changed significantly over time. In recent decades, the top income tax rate was as high as 90% for the very highest incomes. No one paid 90% of their income in taxes, but people with very high incomes would have to pay most of their earnings above a certain high threshold. Meanwhile, some things are taxed at lower rates, like income from certain investments. Over time, the U.S. individual tax system has contributed the economic inequality we see today.

Corporate Taxes

Corporations pay income taxes similar to those paid by workers. In 2017, Congress reduced the top corporate tax rate from 35% to 21%, where it stands today

As you can see in the line chart below, individual income taxes make up a much larger share of all federal tax revenues than corporate taxes do. The share of federal tax revenue paid by corporations has declined substantially over time.

While the official tax rate for most corporations is 21 percent, the effective tax rate – the rate a corporation actually pays in taxes - varies enormously from one corporation to the next. Some very large and profitable corporations (with names you probably recognize) can even end up paying nothing in corporate income tax. That variation is the result of complexity in the tax code as well as corporations' exploitation of "loopholes" to avoid paying taxes. For example, multinational corporations often send profits to overseas locations to avoid paying U.S. taxes.

Payroll Taxes

While individual and corporate income taxes are designated as federal funds, as described above, payroll taxes are designated as trust funds.

Trust funds can be used only for very specific purposes - mainly to pay for Social Security and Medicare. Social Security, officially called the Old Age, Survivors, and Disability Insurance program, is meant to ensure that elderly and disabled people do not live in poverty. Medicare is a federal program that provides health care coverage for senior citizens people with disabilities.

You can see payroll taxes on your paycheck, labeled on pay stubs as Social Security and Medicare taxes or as "FICA," an abbreviation for the Federal Insurance Contributions Act.

However, the deductions from your paycheck are only half the story of payroll taxes. For every dollar withheld from your paycheck, your employer must also contribute a dollar to these programs.

Borrowing

In most years, the federal government spends more money than it brings in from tax revenues. To make up the difference, the Treasury borrows money by issuing bonds. When anyone buys a federal bond, they are essentially agreeing to loan the federal government money, which it will pay back with interest.

Anyone can buy Treasury bonds, and the Treasury can then use that money to cover federal government costs. Borrowing constitutes a major source of revenue for the federal government, and paying back those loans accounted for about four percent of federal spending in 2020.

Borrowing money also adds to the national deficit – the amount of shortfall the federal government has in a given year, and the national debt – the total amount the federal government owes to lenders.

The federal government has run deficits in most years for decades, and most countries rely on debt to pay for their operations. Borrowing can be a critical way to make ends meet, especially during crises like the pandemic, or when major new investments are needed. Much like household debt, as long as the government is able to pay its debts (which is so far the case), borrowing can be a responsible and legitimate way to meet the country’s needs.