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Taxing High Incomes, Large Fortunes More Effectively

November 13, 2019 at 9:30 AM

Policymakers who seek to raise more revenue from the nation’s wealthiest individuals could, for instance, strengthen the estate tax, raise the top personal income tax rate, end preferential treatment of capital gains and dividends, or impose new taxes on very wealthy households, our new report explains.

Much income of the wealthy doesn’t show up on their annual tax returns, and much of what does enjoys special breaks. Our report outlines a range of proposals to tax high incomes and large fortunes more effectively, either by taxing more types of income or by improving the taxation of income that is already taxed.

These options don’t constitute elements of a single, overall proposal — rather, some options are complementary to others, while other options are alternatives. Nor are they the only possible ways to raise revenue in a progressive manner. But all would help counter the decades-long increase in wealth inequality and generate significant revenue that our nation badly needs.

Taxing More Types of Income

  • Ending “stepped-up basis.” Currently, if someone holds an investment (e.g., stock) until death, neither she nor her heirs will ever owe capital gains tax on its growth in value during her lifetime. Policymakers should end this tax break, known as “stepped-up basis,” by taxing the capital gains of affluent households when their assets are transferred to heirs. They could design the measure to shield most or all middle-class households; President Obama, for example, proposed repealing stepped-up basis for most capital gains over $350,000 (including $250,000 for personal residences and $100,000 of other gains). Policymakers could set the thresholds at whatever level they choose.
  • Strengthening the estate tax or enacting an inheritance tax. The estate tax is an important backstop to the income tax, taxing income that otherwise would escape taxation. Yet policymakers have weakened it to the point where fewer than 1 in 1,000 estates (i.e., only the very wealthiest ones) owe any estate tax. They should restore a more robust estate tax to ensure that wealthy heirs pay their fair share. For example, they could reimpose the tax’s 2009 parameters: an exemption for the first $3.5 million of an estate’s value (effectively $7 million for a couple) and a 45 percent top rate. Or they could replace the estate tax with an inheritance tax, which is levied on the income that heirs receive rather than on the value of the estate itself.
  • Adopting “mark-to-market” taxation of capital gains. Currently, high-wealth filers can accumulate capital gains every year as their investments appreciate, but they don’t owe tax on those gains until (or unless) they “realize” the gain, usually by selling the appreciated asset. This deferral feature makes taxes on capital gains largely voluntary for many high-income people. Policymakers could institute a mark-to-market system for wealthy households, which would impose tax annually on assets’ gain in value, whether or not they have been sold. To ensure that the system applies only to wealthy households, policymakers could exempt all capital gains for taxpayers below a specified income or wealth threshold.
  • Imposing a wealth tax on households with extremely large fortunes. An alternative to a mark-to-market system would be a wealth tax, which would apply to a wealthy taxpayer’s overall capital without regard to her actual gains or losses from that wealth. For instance, Senator Elizabeth Warren has proposed a 2 percent tax on households with more than $50 million in net assets and a 3 percent tax on households worth more than $1 billion.

Improving Taxation of Income Already Taxed

  • Ending preferential rates for capital gains and dividends. One of the simplest ways to ensure that the tax code doesn’t reward wealth over work would be to raise the tax rates on capital gains and dividends to match the prevailing rates on ordinary income (such as wages and salaries). To be effective, this reform would need to be accompanied by other reforms related to the taxation of capital gains, such as a mark-to-market system, as our report explains.
  • Raising the top rate and/or enacting a surtax. Policymakers could raise the 37-percent top income tax rate, which is significantly below the post-World War II average. They also could enact a surtax on incomes over a given threshold (including dividends and capital gains) to help prevent wealthy filers who benefit from preferential rates and other tax avoidance strategies from largely escaping the top income tax rate.
  • Eliminating preferences for pass-through businesses. The 2017 tax law created a 20 percent deduction for certain pass-through business income (income that the owners of businesses such as partnerships, S corporations, and sole proprietorships report on their individual tax returns). The deduction mostly benefits high-income households, and it encourages them to convert their labor income into pass-through business income to take advantage of the deduction. Repealing it and taxing pass-through business income at the same rates as wages and salaries would end the incentive to game the deduction.
  • Raising the corporate tax rate. Many of the reforms above would reduce or eliminate wealthy taxpayers’ incentive to use corporations as a tax shelter. Increasing the corporate rate — which the 2017 tax law cut too deeply, from 35 percent to 21 percent — and broadening the corporate tax base, such as by strengthening rules to preventing offshore profit shifting, would also reduce wealth inequality and raise revenue.

Finally, there is an urgent need to rebuild the IRS’ enforcement function, particularly its ability to ensure that wealthy people pay the taxes they owe. Policymakers should increase IRS funding — particularly its budget for enforcement and related operations support, which has been cut by roughly one-quarter since 2010, after adjusting for inflation. The agency plays an essential role in government, collecting nearly all of the revenue that funds federal programs. Policymakers should give it the money it needs to do its job.

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