There continues to be ongoing debate about how fairly the U.S. tax system taxes individuals based on their income. One of the most hotly debated issues is how much tax the top 1 to 10 percent of America’s income earners should pay. This is something that we have written about for more than a decade. Moreover, we have discussed the counterintuitive, yet historically proven, idea that reducing the top marginal tax rates increases government revenue. It can also shift the burden of tax from lower- and middle-income citizens to the highest earners.
According to the Tax Foundation, in 2017, the top 50 percent of all taxpayers paid 97 percent of all individual income taxes, while the bottom 50 percent paid the remaining 3 percent. The top 1 percent share of federal individual income taxes rose to 38.5 percent, from to 37.3 percent in 2016. In contrast, the top 1 percent of all taxpayers (taxpayers with adjusted gross income of $515,371 and above) earned 21.0 percent of all AGI in 2017 and paid 38.5 percent of all federal income taxes. In 2017, the top 1 percent of taxpayers accounted for more income taxes paid than the bottom 90 percent combined.
The top 1 percent paid a greater share of individual income taxes (38.5 percent) than the bottom 90 percent combined (29.9 percent). The top 1 percent of taxpayers paid a 26.8 percent average individual income tax rate, which is more than six times higher than taxpayers in the bottom 50 percent (4.0 percent).
As the country faces a mounting national debt it is important to grow the overall economy and also increase tax revenues. The debate is how to do this – yet we have seen that by reducing the highest tax brackets both can be achieved.
Our progressive tax system taxes people at different rates based on their income; and adjusts the annual tax brackets each year to account for inflation. Your taxable income and filing status determine which rate applies to you.
Typically, the income thresholds that determine the tax brackets are adjusted each year to reflect the rate of inflation. The purpose behind these changing levels is that they can help prevent taxpayers from ending up in a higher tax bracket as their cost of living rises, and they can lower taxes for people whose compensation has not kept up with inflation.
However, the U.S. federal tax rates will remain the same until 2025 as a result of the Tax Cuts and Jobs Act of 2017. In 2023 and 2024, there are seven federal income tax rates: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent and 37 percent.
Different Types of Taxes
The U.S. government collects many different types of taxes as sources of revenue. Individual income taxes are the largest source of tax revenues, representing more than half (54 percent) of total annual receipts. Income taxes are levies on wages and salaries, income from investments and other income.
The issue of tax “fairness” can be confusing because the taxes that Americans pay differ at various points in the income distribution. For example, affluent Americans pay a larger share of their income in individual income taxes, corporate taxes and estate taxes than lower-income groups do. In contrast, lower-income groups owe a greater portion of their earnings for payroll and excise taxes than those who earn more money. In fact, taxpayers whose incomes are in the bottom 80 percent of all incomes pay, on average, more in payroll taxes than they do in income taxes.
Because of the U.S. system of tax benefits and transfers, such as taxpayer-funded programs like Medicaid and public housing assistance, the lowest-earning Americans actually receive more from the government than they pay in income taxes, according to a recent analysis of tax data from the Tax Foundation.
The Laffer Curve: A Counterintuitive Paradox
Sometimes, when the conversation turns to making sure the top 1 to 10 percent pay “their fair share,” people argue that the solution is to increase the marginal tax rates. However, that’s not true. Ironically, and somewhat counterintuitively, increasing the marginal tax rates will lower the effective amount the government collects. This phenomenon is illustrated by the Laffer Curve.
The Laffer Curve is a theory that supply-side economist Arthur Laffer (who is from Youngstown) developed in 1974 to show the relationship between tax rates and the amount of tax revenue collected by governments. The curve is used to illustrate Laffer’s argument that sometimes, cutting tax rates can increase total tax revenue. The Laffer Curve was used as a basis for tax cuts in the 1980s, with apparent success. However, some people criticized the theory on the basis of its simplistic assumptions and on the economic grounds that increasing government revenue might not always be optimal.
Economic activity generally responds to tax changes. If you increase the tax on cigarettes, for example, some people will smoke less, while others will shift to smoking illegal, untaxed cigarettes. Income taxes also trigger a response. If you increase the tax rate on wages and salaries, some people will work less. (Some will also work more to recoup lost after-tax income, but evidence suggests that the disincentive effect dominates.) Similarly, if you increase tax rates on returns to saving and investing — such as through interest, dividends and capital gains — some people will save and invest less. (Here, too, some people may save more to maintain the same after-tax savings, but evidence suggests that the disincentive effect, though small, still dominates.)
In many cases, lowering taxes can actually increase government revenues. If new businesses, new investments and new hiring are spurred by the prospects of better after-tax returns, the taxes paid by these new or growing businesses and employees can more than make up for the lower rates of taxation.
The Effective Tax Rate vs. the Marginal Tax Rate
Misunderstandings about two different types of tax rates — the effective tax rate vs. the marginal tax rate — often create confusion in discussions about taxes.
A taxpayer’s average tax rate, or effective tax rate, is the share of income that he or she pays in taxes. In contrast, a taxpayer’s marginal tax rate is the tax rate imposed on his or her last dollar of income.
Taxpayers’ effective tax rates are usually much lower than their marginal rates. People who confuse the two can end up thinking that taxes are much higher than they actually are. There is a big difference between these two rates. In fact, it has been the case that by cutting income tax rates for the top 1 percent of income earners, tax revenues go up, and these folks pay more tax.
According to the Tax Foundation, the top federal income tax rate was 91 percent in 1950 and 1951 and also between 1954 and 1959. However, the top 1 percent paid an effective tax of only 16.9 percent. In 2019, the top marginal rate was 37 percent, yet the effective tax rate was 26.8 percent.
Politics Drive Tax Rates
Intuitively, it makes sense that if you raise tax rates, tax revenue will go up and that if you raise tax rates on the wealthiest Americans, they will pay a larger share of the income tax. But it doesn’t work that way. In fact, policies meant to help lower- and middle-income Americans often end up hurting them. This is not an economic debate; the facts stand for themselves. This is simply and, unfortunately, politics. Never before have we seen such extremes proposed as we are seeing now.
Yet the debate continues about raising tax rates in the face of mounting government deficits. History objectively shows us the impact of lowering tax rates. Thus, any debate about their efficacy is purely political.
Some of today’s issues — such as health-care reform, Social Security and immigration — are often difficult to quantify objectively because we have not had experience with proposed changes. On the other hand, we do have objective experience with income tax cuts and their impact.
The Historical Impact of Tax Cuts
Tax cuts have historically shifted the tax burden from middle-income people to the wealthiest Americans, while creating jobs and increasing government revenue. Critics, often with the best of intentions, have said that extending tax cuts and further reducing income taxes will benefit the rich over the poor and will lead to more deficit spending. This simply is not the case.
The only reason any informed person would propose raising income tax rates is to gain votes or to intentionally hurt lower- and middle-income Americans.
Bernie Sanders proposed a 97 percent tax on the wealthiest Americans in his Corporate Accountability Plan. Elizabeth Warren has proposed a 70 percent marginal tax rate. The Biden/Harris tax plan would increase the effective tax on those making more than $400,000.
But the reality is that today, the wealthiest Americans are paying the bulk of all income tax already.
Critics of Tax Cuts Ignore History
The public is told that the country cannot afford tax cuts due to government spending on entitlements, defense and all the other important things the government does. While cutting taxes in the face of mounting deficits may seem counterintuitive, critics are ignoring history. Past income tax rate cuts have increased government revenues, boosted our economy, created jobs and shifted the tax burden away from low-income families to the middle- and upper-income folks.
There is no doubt that we will have to deal with excessive government spending to balance the federal budget. Independent of that, extending and expanding the recent tax cuts, while closing loopholes, is a proven way to increase government revenue and benefit all Americans. This strategy shifts the tax burden to those who can most afford it.
The Economic Recovery Act of 1981, also known as the Reagan tax cuts, was the biggest reduction in U.S. taxes of the past 70 years — possibly even the biggest ever. These cuts were then followed by a series of tax increases that, if you add them all together, were almost as big as, or even bigger than, the 1981 cuts, depending on the measure you use.
A Bloomberg analyst believes the 1981 tax law was a positive, if perhaps overdone, change in direction. He says, “Cutting the top tax rate to 50 percent from 70 percent may well have increased the amount of money coming into the Treasury, as incentives to avoid taxes were reduced and incentives to make lots of money increased.” He adds, “The positive economic and behavioral effects of the 1981 cuts recouped about a third of the revenue losses. So it also took spending cuts and tax increases to move the federal budget into surplus territory.”
TEFRA Increased Taxes and Revenue
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) is a law passed in 1982 that was designed to reduce the federal budget deficit through a combination of tax increases, spending cuts and tax reform measures. The legislation reversed some elements of the Economic Recovery Tax Act of 1981 (ERTA), also known as the Kemp-Roth Act. Both pieces of legislation were passed early in the presidency of Ronald Reagan.
Republican Senator Robert Dole, who was the chair of the Senate Finance Committee at that time, was the legislation’s architect. TEFRA was meant to raise more revenue by closing loopholes in the tax system, introducing stricter compliance and tax-collection measures, increasing excise taxes on cigarettes and telephone services and increasing corporate taxes.
TEFRA was the biggest tax increase in U.S. history, when adjusted for inflation, and quickly followed the Economic Recovery Tax Act (ERTA) of 1981, which, as mentioned, was the biggest tax cut in U.S. history. Following the passage of ERTA, the United States fell into the second half of a “double-dip” recession, and the U.S. budget deficit soared.
According to a paper published in 2006 by the U.S. Department of the Treasury, most of the bills enacted before 1982 were tax cuts. During that period, inflation was relatively high, and the individual income tax parameters were not indexed for inflation. Without indexation, inflation can push taxpayers into higher tax brackets without any increase in real income. This phenomenon is called “bracket creep,” and it increases federal revenue as a percentage of GDP without any legislative action. In fact, when inflation is relatively high and bracket creep is particularly intense, as it was through much of the 1970s, policymakers have to cut taxes repeatedly to maintain the desired level of taxes.
TEFRA was created in response to the recession at the time. The legislation faced fierce opposition from those who felt that taxes should be increased, not decreased, to offset government shortfalls. Sounds like a familiar debate, doesn’t it?
Revenue Increases Typically Come from the Wealthiest Americans
The highest-income Americans generally pay more of their income in taxes than the rest of the population. The top one-fifth of households earn 54 percent of all income and pay 69 percent of federal taxes, and the top 1 percent earn 16 percent of the income and pay 25 percent of all federal taxes, according to the Congressional Budget Office (CBO).
Across-the-board tax cuts were implemented in the 1920s as the Mellon tax cuts and in the 1960s as the Kennedy tax cuts. In both cases, the reduction of high marginal tax rates actually increased tax payments by “the rich.” It also increased their share of total individual income taxes paid. According to the IRS, in 1981, the top 1 percent of income earners paid 17.6 percent of all personal income taxes. But by 1988, their share had jumped to 27.5 percent—after the top tax rate had been cut from 69.13 percent in 1981 to 28 percent in 1988.
Reagan’s detractors point to his lack of sensitivity for social issues and the legacy of his deficit spending — yet his legacy is a positive one. In the seven years following the Reagan tax cuts, almost 20 million well-paying jobs were created. Moreover, the tax burden was shifted from low- and middle-income families.
According to the Joint Economic Committee for the US Congress report (1996), the share of the income tax burden borne by the top 10 percent of taxpayers increased from 48 percent in 1981 to 57.2 percent in 1988. Meanwhile, the share of income taxes paid by the bottom 50 percent of taxpayers dropped from 7.5 percent in 1981 to 5.7 percent in 1988.
The middle class also benefited — “middle class” being defined as those between the 50th percentile and the 95th percentile for income. The income tax burden of the middle class declined from 57.5 percent in 1981 to 48.7 percent in 1988. This 8.8 percentage point decline in middle-class tax burden is entirely accounted for by the increase borne by the top 1 percent.
If the so-called experts would channel all the intellectual energy, they are using to debate historically established facts into other subjective issues, and not promoting partisan rhetoric, all Americans would benefit.
Our team focuses on net returns for clients — what you make after income taxes and expenses. We take a very proactive approach for tax-smart investing to minimize the income taxes our clients are subject to. Every financial move you make has potential tax implications. We are here to guide you as you plan for the future to ensure that you are not paying more than your fair share of taxes.
Randy Carver, CRPC®, CDFA®, is the president and founder of Carver Financial Services, Inc., and is also a registered principal with Raymond James Financial Services, Inc. Carver Financial Services, Inc., was established in 1990 with the vision of making people’s lives better — clients, team and community. With this mission, Carver Financial Services has grown to be one of the largest independent financial services offices in the country, managing $2.3 billion in assets for clients globally, as of March 2023. You can reach Randy directly at firstname.lastname@example.org and in the office at (440) 974-0808.
Any opinions are those of Randy Carver and not necessarily those of Raymond James. This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete.
Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we do not provide tax or legal advice. You should discuss tax or legal matters with the appropriate professional.