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Much of Wealthiest Households’ Income Escapes Annual Tax or Gets Special Breaks

High-income, and especially high-wealth, tax filers enjoy many generous tax benefits that can dramatically lower their tax bills, our new report explains. Eliminating or limiting these preferences would make the tax code more progressive and help offset income inequality. It also would raise significant revenue that could fund key priorities and better enable policymakers to address the nation’s fiscal challenges.

A typical middle-income person’s income comes mostly from labor (through wages or a salary). Her income and payroll taxes are withheld from each of her paychecks, and early each year she calculates her tax liability for the prior year; if it exceeds the withheld taxes, she pays the balance by April 15.

Wealthy people, in contrast, get a large share of their income from capital (investments such as stock), and they can keep much of it off their annual tax returns. As the graphic below shows, high-wealth filers may accumulate capital gains (i.e., increases in the value of their investments) year after year as the investments appreciate, but they don’t owe tax on those gains until they “realize” (or take) the gain, usually by selling the appreciated asset. As a result, they can defer taxes on these gains indefinitely and, if they die and pass the assets on to their heirs, the capital gains are never taxed. That means, in effect, that these taxpayers can make the voluntary decision whether to pay tax on many capital gains.

Our report discusses various issues with the taxation of capital gains and wealth, but its central point is simple: much of the income of wealthy people doesn’t show up on their annual tax returns and, when it does, it often receives special breaks. Reform is needed.