March 11, 2020

Five Approaches to Taxing Wealth in the United States

The 2020 election is in full swing and candidates have put forward a range of new fiscal and economic policy proposals. In particular, a number of current and former candidates have suggested adding new sources of revenue through various types of taxation of wealth.

At $23 trillion and growing, the national debt is a threat to our future economy and the election is a perfect time for a conversation about policy solutions that will put our country on a more sustainable path. Well-designed tax policies could help improve our fiscal outlook while also addressing rising concerns over income and wealth inequality.

Proposals to increase taxes on wealthier households have generally taken one or a combination of these five approaches:

  • Creating a wealth tax
  • Adjusting how capital gains are taxed
  • Increasing marginal tax rates on high-income earners
  • Raising the estate tax
  • Increasing or eliminating the cap on payroll taxes

Keep reading for an overview of each approach, common criticisms, and the potential for raising additional revenues.

Wealth Tax

A wealth tax would impose a levy on an individual’s or household’s net worth above a certain threshold. Most proposals recommend implementing this new form of taxation as an addition to our current tax system rather than as a replacement for features such as the income tax. Proponents of such a proposal highlight its potential to enhance the progressivity of the tax code and its ability to raise revenues to reduce the deficit or fund spending proposals.

For example, a 2 percent wealth tax on net worth above $100 million would yield a $58 million wealth tax bill for an individual with a net worth of $3 billion (see table below).

Example: 2 percent wealth tax with a $100 million exemption threshold on an individual with $3 billion in net worth

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Critics of a wealth tax question its constitutionality; they also argue that a wealth tax would be difficult to enforce, resulting in fewer additional revenues. Those concerns are amplified when examining the varying levels of success of certain European countries who have implemented versions of a wealth tax.

Revenue estimates diverge based on assumptions about thresholds for applying the tax, measurement of assets, and the ability to evade the provisions. As an example, estimates of potential additional revenues from a wealth tax on household net worth above $50 million range from 1.5 to 3 percent of the total federal revenues collected in 2019.

Take a deeper dive on the wealth tax

Capital Gains Tax

The capital gains tax is an existing levy on income received from the profitable sale of a capital asset — such as stocks, bonds, or real estate — if the asset was held for more than one year. That profit, known as a capital gain, is generally taxed at a lower marginal rate than ordinary income; most profits are taxed at rates of 0, 15, or 20 percent depending on an individual’s income.

The capital gains tax typically applies to higher-income individuals. In 2016, individuals in the top 1 percent received 22 percent of their income from capital gains compared to less than 1 percent of income for individuals in the bottom 80th percentile.

High-income individuals receive a greater portion of their income from capital gains

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In 2019, revenues from capital gains totaled $193 billion, or 11 percent of total individual income tax revenues.

Proponents for increasing the tax’s burden note that it could raise additional revenues and promote a more equitable tax system. Critics of the capital gains tax argue that lowering the tax could increase economic growth and promote entrepreneurship.

Proposals related to capital gains include:

  • Increasing the capital gains tax rates: The Penn Wharton Budget Model estimates that increasing the top rate from 20 percent to 24.2 percent would increase revenues by $66 billion over a 10-year period.
  • Removing the ‘step-up’ clause for capital assets bequeathed after death: Property or stock bequeathed to heirs is taxed on the appreciation in its value after it is transferred to them, not from the original date of the investment, effectively reducing an heir’s tax liability. Eliminating that clause would increase revenues by $105 billion over a 10-year period, according to the Joint Committee on Taxation.
  • Taxing capital gains on an accrual basis: If assets were taxed annually based on their current value, it would raise around $1.7 trillion over 10 years, according to a study from tax policy experts at New York University.
  • Indexing capital gains for inflation: Unlike the other proposed changes discussed here, indexing would effectively reduce capital gains taxes. The Tax Policy Center estimated that this could decrease federal revenues by $20 billion per year.

Read more about how the capital gains tax works

Marginal Income Tax Rates

About half of federal revenues stem from the individual income tax. That tax is based on a set of tax brackets and marginal tax rates.

A marginal tax rate is the rate applied to specified ranges of taxable income. There are seven marginal tax rates in the current individual income tax system. Taxable income ranges are referred to as tax brackets and those brackets vary according to filing status.

The Congressional Budget Office estimates that an increase of 1 percent on the two highest existing brackets would increase federal revenues by $123 billion over 10 years. In the example below, Noah and Emma’s combined salary falls within the first six tax brackets. Their income level is below the threshold for the seventh and highest bracket. If their top bracket was taxed an additional 1 percentage point, Noah and Emma would owe an additional $197 on their taxes, bringing their effective tax rate up from 20.6 percent to 20.7 percent.

Four Simple Scenarios That Show How Marginal Rates and Tax Breaks Affect What People Actually Pay

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There are also proposals to add new tax brackets for top earners. The Tax Foundation estimates that adding a bracket to tax income over $10 million at a marginal rate of 70 percent would raise revenues by an estimated 0.4 percent over 10 years.

Skeptics assert that higher-income taxpayers will use their resources to avoid taxation through clever accountants and tax attorneys. Furthermore, since the top 1 percent earn a significant portion of their income from capital gains (which are taxed at lower rates), an increase in marginal tax rates on wages and salaries might not be that impactful.

Learn more about marginal tax rates

Estate Tax

The estate tax is a levy on assets, including real estate, stock, and cash, that are transferred upon the death of an individual. In 2020, the federal estate tax will be 40 percent and will apply only to estates valued above $11.58 million — that threshold is referred to as the exemption amount. The Tax Cuts and Jobs Act set the current exemption amount at more than twice its previous level, but that provision expires at the end of 2025, at which point the exemption amount will return to $5.49 million (adjusted for inflation thereafter).

Revenues from the tax currently constitute less than 1 percent of tax revenues but there are several proposals in favor of making adjustments in order to increase revenues.

Proposals include:

  • Replacing the estate tax with an inheritance tax based on how much a person receives rather than how much a donor gives or bequeaths. This method is already in place in several states.
  • Tightening up loopholes — such as special trust arrangements or valuation discounts — that allow for wealthy individuals to lower tax liability.
  • Returning to prior parameters — for example, in 2002, the threshold subject to the estate tax was $1 million and the rate was 50 percent. In 2010, the threshold was $5 million and the tax rate was 35 percent.

Opponents argue that the tax provides a disincentive for asset accumulation, thereby reducing the amount of saving and investment, and therefore restraining economic growth.

Payroll Taxes

More than 35 percent of revenues collected by the federal government take the form of payroll taxes, which are paid by both the employee and employer to fund social insurance programs like Medicare and Social Security. The Medicare payroll tax is levied on all income; both employees and employers contribute 1.45 percent of workers’ earnings to the program. However, the Social Security portion of the tax is levied at 6.2 percent on income only up to a certain amount. That tax cap is set annually, with the 2020 maximum set at $137,700.

Economists consider the Social Security tax to be regressive, because as an individual’s earnings increase above the cap, the portion of total income that is taxed decreases. Each year, 6 percent of the working population earns more than the taxable maximum.

High earners pay a lower proportion of their income in payroll taxes

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Proponents of increasing or eliminating the Social Security tax cap argue that it would strengthen the Social Security trust fund and make the tax less regressive. An analysis from the Congressional Budget Office estimated that phasing out the tax cap could boost revenues by up to $1.2 trillion over the next decade.

Opponents argue that increasing or removing the taxable maximum would weaken the correlation between the amount individuals pay in Social Security taxes and the amount they receive from the program during retirement.

Read more about how payroll taxes work

Conclusion

Ultimately, there are many approaches, yet little consensus, for reducing income and wealth inequality by leveraging the nation’s tax system. As the national debt continues to rise, so does the need for creative policy solutions that are both fiscally and economically responsible.


Related: Two Years Later, What Are Economists Saying About the Tax Cuts and Jobs Act?


 

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