Tax Plans: Equity Analysis

Update 524 — Tax Plans: Equity Analysis
Tax Code as Cause and Cure of Inequities

President Biden shook markets yesterday with details of his tax plan he rolled out previously and precisely during the 2020 campaign. Democrats in Congress have a slew of tax proposals on the table as well, many of which are currently under discussion.

The last generation has seen income and wealth disparities in America growing every passing year. There are many ways to tackle inequality, but the most obvious is to use the tax code. Each tweak to the tax code affects the equity equation, so why not make these changes with intention? Below, we evaluate current tax proposals with regard to their impact on this equation.  

Good weekends all,

Dana

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On Tuesday, the Senate Finance Committee held a hearing examining outcome disparities in the federal tax code. Democrats at the hearing called attention to features of the tax code that disproportionately benefit white Americans and called for greater transparency from the IRS to illuminate racial injustices resulting from tax policies. With President Biden seeking to raise taxes on the wealthy to fund his American Families Plan, tax equity and the definition of a “fair share” will become a focus of the upcoming tax debate. 

Inequitable Outcomes Due to the Code

After decades of Republican tax cuts and ineffective tax enforcement, the wealthiest 400 families now pay a lower effective tax rate than most working Americans. As tax collection on the wealthiest households plummeted, income inequality spiked in the United States, demonstrating the effect the tax code can have on income distribution.

Effective Tax Rate of the Wealthiest Families vs. the Bottom 50% 

Source: Emmanuel Saez and Gabriel Zucman, Graph produced by the Washington Post

The federal tax code features the following key sources of inequity: 

• Preferential Treatment of Capital Income: The majority of Americans earn most of their household income from wages, which are taxed at a top rate of 37 percent. But the wealthiest one percent receive the bulk of their income through capital gains, which are taxed at a top rate of just 20 percent. The richest one percent accounts for 14 percent of total wage income, but 72 percent of total capital income.

• Rampant Tax Avoidance: Per the National Bureau of Economic Research, 36 percent of all unpaid federal income taxes were owed by the top one percent, amounting to around $175 billion in uncollected revenue annually. Overall, the annual tax gap may be as high as $1 trillion. A primary reason for this tax gap is Republicans’ successful effort to hobble the Internal Revenue Service’s enforcement capacity by slashing its budget by around 20 percent over the past decade. Examinations of millionaires’ tax returns have dropped from over 12 percent in 2010 to less than four percent in 2018. 

• Inequitable Tax Incentives: The tax code is riddled with loopholes, deductions, exemptions, and credits that benefit the wealthy. While roughly 90 percent of Americans take the standard deduction, itemized deductions are used disproportionately by wealthy households to write off the cost of paying mortgages, charitable contributions, and state/local taxes. Republicans further exacerbated the abuse of the tax code by repealing the overall limitation on itemized deductions, which disproportionately benefit white households over families of color.

Paying a Fair Share?

A significant majority of Americans agree that the tax code is unfair. A 2019 Pew poll found that 80 percent of respondents were bothered either “a lot” or “some” by the “feeling that some wealthy individuals don’t pay their fair share” of taxes; 82 percent felt the same about corporations. Ensuring an equitable tax code in which all pay their fair share would involve significant reforms: a tax code that treats capital earnings equal to labor income, fewer loopholes such as the carried interest deduction, and stronger enforcement by the IRS to counter tax evasion.

In recent weeks, several Northeastern representatives, Democrats included, have said they will vote against any tax changes that do not include a repeal of the $10,000 cap on the State and Local Tax deduction. Repealing this cap would be regressive — an estimated 62 percent of the benefits would go to the top one percent of earners.

Legislative Proposals Addressing Tax Equity 

The Biden Administration and Congressional Democrats are pushing to make the American Rescue Plan Act’s expansion of the Earned Income Tax Credit (EITC) and the Child Tax Credit (CTC) permanent. The ARP temporarily boosted the EITC for childless workers by tripling the maximum credit, expanding the eligible income range, and allowing workers aged 19-24 and over 65 to receive the credit. Making these EITC expansions permanent would provide financial security to 17 million low-wage childless workers, 5.8 million of which are currently taxed into or deeper into poverty. 

The ARP also increased the fully refundable portion of the child tax credit from $1,400 per child, to $3,600 for children under 6 years old and $3,000 for children 6 and older. This CTC expansion is projected to cut childhood poverty in half. Keeping the CTC fully refundable would also increase access to the credit for many families of color.

Distributional Effect of the Expanded Child Tax Credit 

Source: Institution on Taxation and Economic Policy

Additional legislative proposals aimed at combating inequity in the tax code likely to receive consideration this Congress include:

• The Carried Interest Fairness Act, sponsored by Sen. Baldwin and Rep. Pascrell. This bill eliminates the carried interest loophole by requiring high-earning investment managers to pay the same 37 percent tax rate that Americans pay on wage income, rather than the 20 percent capital gains rate. 

• A “Mark-to-Market” tax, proposed by Senate Finance Chair Ron Wyden, would tax unrealized capital gains of those with over $10 million in assets or $1 million in income at the same wage income rates average Americans pay every two weeks. 

• Sen. Sanders/Rep. Gomez’s For the 99.5% Act restores the estate tax to pre-2009 levels and closes the stepped-up basis loophole. Restoring the estate tax would affect the top half percent of Americans with estates worth over $3.5 million and would progressively tax larger estates. Closing the stepped-up basis loophole would tax huge unrealized gains on inheritors of property. 

• In 2019, Sen. Van Hollen and Rep. Beyer introduced a Millionaires’ Surtax that applies a 10 percent tax to all incomes above $1 million for individuals and $2 million for couples. 

• Rep. Ro Khanna’s Stop CHEATERS Act would increase IRS funding by $100 billion over the next decade to strengthen enforcement and mitigate tax avoidance by wealthy individuals and corporations. 

Tax Equity and Biden’s Plan

Recent news reports suggest that President Biden will call for increases in the top marginal tax rate to the pre-TCJA level of 39.6 percent and the capital gains rate to levels that could make the wealthiest individuals pay as high as 43.4 percent on investment income. These proposed tax increases would serve as pay-fors for Biden’s forthcoming American Families Plan, which is expected to include $1.5 trillion in new spending on poverty reduction, education, child care, and more. 

Most changes to the federal tax code affect equity, but some more than others. A near-doubling of the capital gains rate would finally bring an end to the preferential treatment of capital income over labor income which disproportionately benefits the wealthiest Americans, allowing them to avoid paying their fair share of tax on their income. If implemented as proposed, these tax increases would not only raise a significant amount of new revenue but also make the tax code — and the overall economy — fairer.