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Countdown to Tax Reform, Part V: High-Income Taxpayers and the Entrepreneurial Class

2 min readBy: Scott Hodge

Fiscal Fact No. 37

A key issue surrounding 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. reform is the extent to which the current system affects business activity by taxing sole proprietorships, partnerships and S-Corporations through the 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. code. Are high-income taxpayers entrepreneurs and business owners, or are they simply well-paid individuals with trivial business activity on the side?

Over the past 25 years, the number of taxpayers reporting business activity on their individual tax returns has grown at an exceptionally rapid rate. As shown in Figure 1, between 1980 and 2004 the total number of sole proprietorships, partnerships, farms, and S-Corporations more than doubled, from 13.3 million in 1980 to 27.5 million in 2004. S-Corporations alone grew almost seven-fold, from 545,389 in 1980 to roughly 3.5 million in 2004, and they now far exceed the number of conventional C-Corporations.

Figure 1. Growth in Types of Individual Business Ownership, 1980-2004

Source: IRS, Tax Foundation Individual Tax Model

When we look carefully at the distribution of these tax returns a clear picture emerges: an extraordinarily high proportion of high-income taxpayers have some form of business income (schedule C, E, or F) and that as their incomes rise, so too does the likelihood that they have business activity.

As shown in Figure 2, overall 43 percent of taxpayers in the top 20 percent have business income, twice the percentage of those in the middle income group. Of those taxpayers in the top 1 percent—those earning more than $300,000 and subject to the highest marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. s—nearly three quarters have business income. And for taxpayers with incomes above $1 million per year, nearly 83 percent have business income.

Figure 2. High-Income Taxpayers Are More Likely To Have Business Activity

Source: IRS, Tax Foundation Individual Tax Model

Remarkably, because so many taxpayers now have business income (or are paying their business’s taxes through their individual tax form), Tax Foundation economists estimate that taxpayers with business income paid 54.3 percent of all individual income taxes in 2004.

The data clearly show that a large proportion of high-income taxpayers are engaged in some form of business activity, and these high-income taxpayers pay the majority of income taxes in America today. This suggests the federal income tax code likely has large effects on U.S. business decisions.

(This "Fiscal Fact" is based on theTax Foundation book Putting a Face on America's Tax Returns.