Echoing other reports from this year, the White House Council of Economic Advisors (CEA) published a report Thursday that estimates an approximate average federal individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. rate for the top 400 wealthiest households in the U.S of 8.2 percent, lower than typically estimated for top earners. The CEA arrived at a lower taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. rate by including in income an estimate of unrealized capital gains, e.g., from corporate equity. However, this accrual-based measure of income requires an accrual-based measure of tax, including corporate taxes, to produce a complete analysis of effective tax rates.
Doing so results in a substantially higher effective tax rate for the top 400—23 percent, according to one estimate.
First, some context. Under the current income tax system, individuals are generally taxed on their realized, or cash, income, consisting of wages and salaries; investment income like dividends and capital gains; business income, such as that earned by farms, partnerships, and LLCs; and retirement income.
If an individual owns an asset like a stock, a house, or a small business, they do not pay taxes on increases in the value of their assets until they realize a gain through a sale. Until they sell, any gain in the value of a stock or a business is a “paper gain,” meaning they have not received proceeds to be taxed.
One implication is that individuals can have large amounts of wealth tied up in paper gains while earning smaller amounts of taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. . This is not the result of a unique U.S. policy. In fact, most countries in the Organisation for Economic Co-operation and Development (OECD) tax capital gains when they are realized and at lower rates than the U.S., and tax capital income overall at lower average tax rates.
That brings us to the main problem with the CEA report: the failure to account for corporate income taxes. The CEA report calculates an approximate average tax rateThe average tax rate is the total tax paid divided by taxable income. While marginal tax rates show the amount of tax paid on the next dollar earned, average tax rates show the overall share of income paid in taxes. for the top 400 wealthiest households by comparing individual income taxes paid to a constructed measure of income that includes the paper gains based on Forbes 400 data (a questionable data source itself).
A significant share of those paper gains come from corporate equities. For instance, many of the top 400 wealthiest households are business founders who own stock in the corporation they founded, and they may hold onto the stock for a long time. They would not pay income taxes on those equities or on the value of the business while they hold onto it. However, the corporation would owe corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. es on its profits each year.
Counting the corporate profits as income to these individuals without also counting the corporate income taxes paid on the profits is misleading. It understates the tax rate paid on that income. Over the long run, stock price appreciation is driven by the earnings of corporations, so the activity driving the growth in unrealized gains is being taxed each year at the entity level by the corporate income tax.
For an example of how much the corporate income tax matters, we can look at estimates from economists Emmanuel Saez and Gabriel Zucman. They look at a different, but overlapping, population of the top 400 households by income and they include corporate retained earnings associated with these households to provide a more comprehensive measure of accrued income.
Saez and Zucman find that the average total tax rate on the top 400 households by income is 23 percent. The average individual income tax rate is 9.2 percent, similar to the CEA findings for the top 400 wealthiest households. This tax rate is fairly stable over time, averaging at 11.4 percent annually between 1950 and 2018.
However, the corporate income tax adds another 10 percentage points of tax on the top 400 households by income, along with about 1 percentage point from the estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. and 2.3 percentage points from sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. . Importantly, the corporate tax burden is levied every year, regardless of whether individual taxpayers realize capital gains.
Some estimates find a total average tax rate that is even higher than Saez and Zucman. For example, economists David Splinter and Gerald Auten find that the top 0.01 percent of taxpayers by income (a larger grouping than the top 400) faced an average total tax rate of 37.4 percent in 2014.
The CEA report also argues for moving the tax system towards the problematic “Haig-Simons” definition of income, where income is defined as one’s consumption plus change in net worth. Building the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. on a Haig-Simons definition of income leads to multiple layers of tax on saving and investment that can be economically damaging and administratively complex.
The above analysis indicates the current federal tax system already contains multiple layers of tax on saving and investment, e.g., taxes on corporate income, shareholder income, and estates. Furthermore, the current federal tax system is already quite progressive and redistributive.
Rather than moving further towards Haig-Simons taxation and increasing the tax burden on saving and investment, a more constructive reform would be to tax the consumption of higher earners; for example, through a progressive consumption tax.
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