Tax the Rich?

Some background before we begin the debate

Oct 20, 2021

President Biden announced his 2022 budget proposal on May 28th and it has proven to be every bit as controversial as one might have expected. The budget proposal calls for $6tn of spending in fiscal 2022, a significant reduction from the covid-inflated levels of spending in 2020 and 2021 ($6.5tn and $7.2tn respectively), but a 33% increase from the level of pre-covid spending in 2019 under President Trump ($4.5tn). And President Biden’s proposed annual spending would increase further in subsequent years. The budget as originally proposed includes $4.5tn of cumulative multi-year spending for infrastructure, public health, climate change, child care and other social programs, and would be funded in large part by tax increases on corporations and the “rich”. It was clearly a “progressive” proposal.

But before we begin to debate the specifics of any new tax legislation proposed or passed by Congress, let’s review some of the basics about the US tax system, focusing primarily on the federal tax system and specifically on how it impacts people across the income and wealth distribution.

What are the primary sources of US federal tax revenue? The federal government estimates that it will receive $4.2trn of revenue in fiscal 2022. (The federal government’s fiscal year runs from October 1-September 30, so we are now several weeks into fiscal 2022.). Approximately half of total tax revenue ($2tn) will come from individual income tax. Another 35% ($1.5tn) will come from payroll taxes, which fund Social Security and Medicare among other programs. Corporate taxes will provide about 10% ($400bn). The balance will come from various other sources, including the estate tax which will provide less than 1% of the total.

How much of federal taxes are paid by top earners? Presidential candidate Mitt Romney got himself into hot water, and rightfully so, when he said to a group of Republican donors in 2012: “47% of Americans will vote for President Obama no matter what. These are people who are dependent upon government….They think they are victims and that government has a responsibility to care for them, that they are entitled to this…. We will never convince them to take personal responsibility for their own lives….They pay no income tax (repeated twice)!” You can listen to Romney’s comments here, which I encourage you to do.

There is so much wrong with Romney’s comments that it is hard to know where to begin. But let’s focus for now on Romney’s claim that 47% of Americans pay no income tax. Was he right about that at least? And if so, what are we to make of this fact?

Income tax. The short answer is yes, Romney was right about the income tax. The US federal income tax is structured to be highly progressive and it is. Marginal tax rates start at 10% applied to the first $10,000 or so of taxable income (after exclusions) and increase to 35+% on single taxpayer incomes above $500,000 or so. In 2018, the top 1% of taxpayers paid about 40% of all federal income taxes and the top 10% paid 70%, leaving 90% of all taxpayers to pick up the remaining 30%. And yes, close to half of all taxpayers effectively paid no federal income tax.

This outcome is only partly attributable to the progressive rate structure of the US federal income tax, however. It is also the result of the highly skewed distribution of income in this country. Yes the top 1% paid 40% of all federal income tax, but they also received 20% of the total income earned in this country. And the top 10% of taxpayers (which includes the top 1%), who paid 70% of total federal income taxes, received 50% of the total income. Combine a skewed distribution of income with a progressive income tax, and you get the results shown above. This should surprise no one.

But let’s put this into a bit more context. The US median household income in this country is around $65,000 a year and the mean is about $95,000 (due to the skewed distribution). These are household incomes, not individual incomes, which are much lower. In contrast, household income at the 90th percentile (the bottom of the top 10%) is around $200,000 and at the 99th percentile (the bottom of the top 1%) it is above $500,000. These are the folks candidate Romney was soliciting for votes and money, a demographic that George W. Bush jokingly described at the 2000 Al Smith dinner as “the haves and the have mores”. President Bush went on to say to his wealthy white tied audience: “Some people call you the elite; I call you my base”. Whatever you think of George W. as President, you have to admit he did have a good sense of humor.

Payroll taxes. Income taxes contribute 50% of total US federal tax revenue and payroll taxes contribute another 35%; all the other federal taxes combined contribute just 15%. Both income and payroll taxes are charged against personal income, but in very different ways. We have described above the progressive rate structure of the US federal income tax, the burden of which falls disproportionately on a relatively small number of high-income US taxpayers. The burden of payroll taxes falls on a very different and much lower income demographic however. Whereas the federal income tax is highly progressive, the payroll tax is not. The payroll tax is regressive, meaning that lower income individuals pay a larger portion of their total income as payroll tax than do higher income individuals. Although the rate structure of the payroll tax is generally proportional, not graduated like the income tax, payroll taxes are only charged against employment income (wages and salary), whereas income tax encompasses all sources of income, including investment income, the distribution of which is also highly skewed. And the largest component of payroll tax, the Social Security tax, applies only to the first $140,000 or so of employment income, which means that the highest income individuals incur payroll tax on a relatively smaller percentage of their total employment income than do lower income individuals.

But how regressive is the federal payroll tax? According to Tax Policy Center estimates, in 2020 the bottom fifth of households were expected to pay an average of 6.9% of their incomes in payroll tax, compared to 5.9% for the top fifth and 2.3% for the top 1%. (I am not sure if these percentages are of total employment income or total income from all sources.) And so while candidate Romney may have been right that the bottom 47% of Americans don’t pay income tax, the vast majority of them do pay payroll tax and they pay this tax at higher rates than those with much higher incomes.

Estate taxes. Estate taxes affect very few people and contribute very little to the federal budget—well less than 1% of the total—but they seem to generate a disproportionately high share of the emotion in the partisan public tax debate. The debate over estate taxes seems to have more to do with the issue of perceived wealth inequality in this country than it does with optimizing tax revenue, but this does not mean the issue is unimportant. Quite the contrary, perhaps. But what exactly are estate taxes? How do they work? Who pays them?

“Estate” taxes are a form of wealth tax imposed on the value of net assets (assets less liabilities) owned by the estate of a deceased taxpayer at the date of death. Estate taxes differ from “inheritance taxes”, which are imposed on the amount of money paid out to individual beneficiaries of the deceased’s estate. The US federal government (and some states) imposes estate taxes—or what Republicans like to call “death taxes”—but many other countries have inheritance taxes, which have somewhat different policy implications.

US estate taxes are paid only by the estates of those who die owning a significant amount of property, and under current US tax law very few estates are large enough to incur tax. The estate tax exemption amount (below which no estate tax is due) is currently around $11.5mm per individual taxpayer ($23mm for a married couple), which was doubled under President Trump but will “sunset” and drop by 50% or so after 2025 if not extended by Congress. Estates with net assets above the exemption amount pay tax at a top marginal rate of 40%. Under current law, any accrued but unrealized capital gains embedded in the deceased’s estate at the date of death do not incur income tax, either at the date of death or subsequently, but they are subject to estate tax. This so-called “step up in cost basis” generates a significant tax benefit for wealthy individuals and families who may have decades of unrealized and untaxed gains in their stock portfolios and other capital assets, including the proverbial family business or farm.

Historically only 1-2% of estates owed any federal estate tax and in 2019 the proportion dropped to 0.2% (and about 1% of family farms) due to the big increase in the estate tax exemption as part of the 2017 Tax Cut and Jobs Act signed into law by President Trump. The total estate tax collected in 2019 was about $13bn, an amount which would presumably increase substantially under various Democratic legislative proposals. Recall however that total federal tax revenue in 2022 will be in excess of $4tn, and it may hit $5tn in a few years, so even with a big increase in estate taxes we are still talking about relatively small incremental amounts of tax revenue.

How does this picture change if we include state and local taxes? Of the total amount of tax collected each year in the US (over $7tn), about two-thirds goes to the federal government and one-third to states and localities. The structure and amount of state and local taxes varies greatly across the country, with higher and more progressive taxes generally imposed by wealthier states and localities. (Think blue states on the two coasts.) Several states do not have an income tax (primarily red states), and in those that do have a state income tax the rate structure is often broadly proportional not progressive. In states with income taxes, the top marginal rate runs from under 3% (ND) to over 13% (CA). Virginia’s top marginal tax rate of 5.75% kicks in at income of just $17,000. Only a few cities impose income taxes, most notably New York City, which imposes income tax on all who work in NYC, not just those who live there.

Sales and excise taxes (a form of sales tax) are the primary source of revenue for many states and localities and their tax impact tends to be highly regressive, as low income individuals spend a much larger percentage of their total income than do higher-income individuals. In fact, it is the regressive structure of sales and excise tax which causes the overall tax structure in many states to be regressive, in some cases highly so, and which mitigates much of the overall progressive structure of federal taxes. (See below for more on this.)

Property taxes are a large source of funding for localities, and while property taxes may seem to be highly progressive—rich people have more expensive homes (and often multiple homes) and rich communities generate higher property tax revenues than poor ones—the money raised from property taxes is spent locally, which contributes to community income and wealth disparities. This is a big issue in education funding, as you might imagine, and the controversy is heated.

According to the Institute on Taxation and Economic Policy (ITEP), the overall tax structure in 45 US states is on balance regressive, in some cases highly so. In the ten most regressive states, the lowest 20% of taxpayers paid tax at a rate up to six times higher (as a percent of their income) than did higher income residents. These states are often hailed as “low tax” jurisdictions, but this characterization seems to be true primarily with respect to those taxes imposed primarily on business and wealthy residents, not lower and middle-income households.

Combining federal, state and local taxes, ITEP found that in 2020 the top 1% of US income earners paid a 34% combined tax rate, while the poorest 20% of Americans paid an average rate of 20%. (If we looked just at income tax, the rate paid by the bottom 20% would be more like 1%.) So on balance, it would appear that the US tax system overall is still progressive, but to a much lesser extent than that of US federal income taxes, a point conveniently glossed over by candidate Romney.

Why doesn’t Jeff Bezos pay taxes? It is often said that Jeff Bezos does not pay much if anything in the way of taxes, which strikes many people as unfair given that his personal net worth is around $200bn or so. I don’t know how much Mr. Bezos pays in taxes each year, but I suspect that he pays all the taxes he is legally obligated to pay and no more. If in fact Mr Bezos personally pays little or no federal tax, this is almost certainly because he does not have much in the way of currently taxable income. But how can this be?

Mr. Bezos is indeed quite wealthy, with a net worth of around $200bn, and every 1% increase in Amazon’s share price increases his net worth by another $2bn or so. But “net worth” and “wealth” are not the same as “income”, and the federal tax code primarily taxes income, not wealth. I understand that Mr. Bezos works for little or no salary at Amazon (and his other companies), and so he has little or no taxable employment income. Because his companies do not (yet) pay dividends, and he has not sold any shares, Mr. Bezos may not have much in the way of dividend or capital gains income either. And of course Mr. Bezos is still very much alive, so no estate tax is yet due, and his potential estate tax will be much reduced if before he dies he contributes his assets to charity, as other multi-billionaires have committed to do. In the meantime, Mr. Bezos can always borrow against the value of his Amazon stock if he finds himself short of pocket money.

If you think we should collect more taxes each year from folks like Jeff Bezos, welcome to the club. But how do you propose to do it? By taxing as “income” the amount he borrows to fund his spending? Or by taxing as current income his unrealized capital gains, with annual cash taxes due when Amazon’s share price increases and tax rebates when it falls, even if no shares have been sold? OK, but would you yourself want to live by these same rules? Or are you proposing some sort of “billionaire” exception to the federal tax code? If so, perhaps an explicit wealth tax would be a more direct way to do this. (See below for more on the wealth tax.)

How would a “wealth tax” work? This is unclear, but essentially the federal government would seek to collect each year from wealthy individuals a defined percentage of their changing net worth, ie the market value of their personal assets minus liabilities. The tax would therefore be linked to wealth, not income, which are correlated but which are not the same. Think of a wealth tax as similar to property tax, but with a much larger tax base (all capital assets, not just one’s real or personal property). A 1% wealth tax imposed on just Jeff Bezos would raise ca $2bn a year at his current estimated net worth of $200bn. (And a 1% tax on Elon Musk would generate another $2bn or so. Perhaps the two gentlemen can compete to see who pays the highest taxes.) To pay the tax, Mr. Bezos might have to borrow against his Amazon shares, which he presumably does already, and in recent years his annual wealth tax would have been a lot less than the annual increase in the value of his Amazon shares (which over the past 5 years have grown at a compound annual growth rate of 28%).

Corporate taxes. What I call the Jeff Bezos problem (above) is compounded when valuable companies like Amazon also pay little or no corporate-level tax. But again, keep in mind that corporate income tax liability is only incurred when companies report taxable income. Taxable income for IRS purposes differs from taxable income for accounting (GAAP) purposes, however, and many companies (not just Amazon) benefit directly from a variety of tax deductions, exemptions, credits and preferential rates (aka “tax subsidies” or “tax expenditures”) expressly written into the US corporate tax code by our elected representatives. Some companies and industries benefit more from these tax provisions than do others, including those with large R&D and capital expenditures, depleting natural resources, share based compensation expense and international operations in low-tax jurisdictions.

But most profitable companies do pay corporate-level tax, often in large amounts, which raises for our consideration another thorny issue, that of double taxation. Forget Mr. Bezos and Amazon for a moment, and think of a large profitable corporation which pays federal income taxes at something near the statutory rate (now 20%, down from 35% before passage of the 2017 TCJA), and which then distributes a large share of its after-tax profits to shareholders in the form of dividends. These dividend payments are a return of capital (profits) to the owners of the corporation and they are effectively taxed twice, once at the corporate level and then again at the shareholder level. (Dividend payments are not tax deductible to the corporation, unlike interest expense.) Economists debate the question of who actually bears the economic impact of corporate-level tax (shareholders, employees, customers?), but from the shareholders’ perspective it certainly seems like they do.

And in some cases the effective tax rate on corporate profits can be quite high. For example, consider a company with $100 of corporate pre-tax profit, which pays out 100% of its net ((after-tax) income as dividends to taxable individual shareholders. In this case, the effective “see through” income-tax rate paid by the corporate owners (shareholders) may be as high as 48%: $20 paid at the corporate level ($100 of pre-tax income taxed at 20%) plus another $28 paid at the shareholder level ($80 of dividends taxed at 35%). For corporations which do not pay dividends, but rather reinvest their income to grow the business or which buy back shares, the tax impact on individual shareholders (in the form of capital gains tax) is deferred and sometimes much reduced.

Let me also mention one other issue that we can come back to in a subsequent post: the use of “pass through” tax entities by business owners to avoid entirely the corporate-level tax, with income taxes charged directly to the owners of the business at favorable rates complements of the TCJA. I don’t know if this particular provision of the tax code is under attack by the Democrats, but I wouldn’t be surprised if it is.

What are the major tax breaks we should be aware of? According to a 2020 publication by the Peterson Institute, there are currently more than 200 tax breaks, also known as tax “expenditures”, which can take the form of exemptions, deductions, credits, and preferential rates written into the U.S. Tax code. In 2019, those breaks reduced federal tax revenues by nearly $1.5 trillion. To put this in perspective, $1.5tn equals about 25% of annual spending under President Biden’s proposed budget and it is more than the government spends annually on defense, Social Security or Medicare. But before you jump to any conclusions about costly or unfair “loopholes” in the federal tax code, consider the specific items included on the Peterson list: retirement plan contributions (which are taxed at retirement), reduced tax rates on dividend and capital gains income (which are effectively double taxed), exclusions for employer provided health insurance (received by 50% of American households), the child care tax credit (currently a small amount by international standards), and the earned income tax credit (targeted to the lowest income working Americans).

Which if any of these tax provisions would you propose to change? And who would benefit?

Remind me how the tax law was changed under President Trump? The Tax Cut and Jobs Act (TCJA) was signed into law by President Trump in 2017 and it made several major changes to the tax code: (1) a cut in the statutory corporate tax rate from 35% to 21%; (2) an increase in corporate capital investment incentives (accelerated depreciation); (3) a reduction in the tax rate applied to the owners of pass-through tax entities; (4) a doubling of the estate tax exemption; and (5) a reduction in the marginal tax rate paid by individuals at various income levels (e.g. from 39.7% to 37% at the top income bracket). The TCJA was billed as big boost for business which would stimulate much-needed corporate capital investment and would pay for itself by generating increased tax revenues on a higher base of business income. It did not do either of those two things, but the economy did pick up following passage of the law (post hoc ergo propter hoc?) and the stock market chalked up huge gains in anticipation of increased future corporate after-tax profits. The TCJA was also billed by Republicans as essentially a middle-class tax cut, which it wasn’t either, as the benefits went disproportionately to the owners of businesses and to the highest income individuals. The Republicans hailed the TCJA as a major victory, and the Democrats now want to unwind parts of it. To learn more about the JCOA, read here.

What exactly are the Democrats proposing? This seems to change daily, but let me highlight a few areas of potential tax reform which we can examine in more detail once we have some specific legislation to look at. It seems that Democrats are looking to accomplish the following: (1) to raise more tax revenue generally; (2) to increase the absolute amount and share of taxes paid by high income individuals and businesses; and (3) to expand various tax benefits targeted to low and middle-income individuals and households. So we should expect to see a reversal of some of the TCJA tax cuts for US corporations and top individual earners, an increase in taxes paid by multi-national business, increases in the child-care and earned-income tax credits, and the elimination of the step-up in cost basis on unrealized capital gains at death. It is not at all clear that Democratic-sponsored tax legislation will include other major changes to the estate tax, and as far as I can tell there is no longer any serious discussion of adding a new federal wealth tax. The “progressive” wing of the Democratic Party will not be happy about this, but they need to get their budget through Congress and to do this they need to secure the support of every single member of their own party, including the likes of Joe Manchin (D-W.VA). And the Democrats will have to do this on their own, without support from any single Republican member of Congress.

It is far from clear how all of this will play out in the next few weeks, but stay tuned and expect more posts from me.

Links:

Biden Unveils $6tn Spending Plan, WSJ, 28 May 2022

US Federal Budget Breakdown, The Balance, 3 October 2021

Federal Budget Receipts and Outlays, Coolidge-Biden, The American Presidency Project UCSB

In One Chart: How much the rich pay in taxes, The Heritage Foundation, 3 May 2021

Trends in Income and Wealth Inequality, The Pew Research Center, 9 January 2020

What is the Average Income in the US, The Balance, 3 October 2021

Policy Basics: Federal Payroll Taxes, Center on Budget and Policy Priorities, 17 April 2020

Here’s How Many People Pay Estate Tax, CNBC, 21 September 2021

Fewer than 1% of Family Farms Pay Estate Tax, USDA, 2 April 2021

Breakdown of Federal, State and Local Taxes, Tax Policy Center, May 2020