Anaya Nolan
The US tax system has long been criticised for favouring the rich over the poor, with the world's first trillionaire expected within the next ten years. While federal taxes reduce income inequality, with high-income households paying a larger share of their income in taxes, the overall US tax code is still moderately progressive, with substantial regressive elements contributing to rising inequality. For example, the SALT deduction is claimed by 75.1% of Americans earning $1 million or more, compared to 58.6% of those earning between $500,000 and $1 million, and the average amount deducted is far higher for high-income households. Additionally, lower-income households typically pay a higher share of their income in sales taxes and payroll taxes than high-income households.
| Characteristics | Values |
|---|---|
| Federal taxes reduce income inequality | High-income households pay a larger share of their income in total federal taxes than low-income households |
| Progressive federal taxes | The distribution of after-tax income is more equal than income before taxes |
| Gini index | The index has a value of zero when income is distributed equally across all income groups and a value of one when the highest-income group receives all the income |
| Standard deduction | In 2023, the standard deduction is $27,700 for married couples, $20,800 for single parents, and $13,850 for singles |
| Child tax credit | The child tax credit was increased from $1,000 to $2,000 per child under 17 and added a new $5,000 for other dependents |
| Payroll tax | The payroll tax rate for households in the lowest income quintile is 6.3%, compared to the average rate of 6.8% for all households |
| Excise taxes | Low-income households pay federal excise taxes on specific products, such as cigarettes, alcohol, and gasoline |
| Corporate tax | Low-income households pay a small amount of corporate tax |
| SALT deduction | The average SALT deduction for taxpayers earning less than $50,000 is $4,686, while those earning $200,000 or more claim an average of $9,735 |
| Tax breaks | Wealthy individuals and corporations take advantage of tax breaks and loopholes to reduce their tax burden |
| Tax havens | Corporations and individuals stash profits in tax havens, depriving countries of much-needed tax revenue |
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What You'll Learn
Rich Americans are taxed at lower marginal rates
While the richest Americans do pay the highest marginal income tax rates, this fact needs to be contextualized. Marginal tax rates apply only to the portion of income within each bracket, not the entire income. This means that as income rises and moves into higher brackets, only the portion of income within that bracket is taxed at the higher rate.
The US tax code is progressive, meaning that as income increases, the tax rate also increases gradually. This system aims to ensure that taxpayers contribute according to their ability to pay, and that moving into a higher tax bracket does not result in a lower overall take-home pay. However, despite the progressive nature of the tax system, there are still regressive elements within the code. For example, low-income households may pay higher state and local taxes, and sales taxes. Additionally, the rich can benefit from skewed income tax deductions, loopholes, and rate preferences.
Some argue that raising marginal tax rates on the rich may not be the best way to address fiscal challenges. When rates are higher, the rich tend to report less income and shift more income to the corporate sector, making the income distribution more opaque. Additionally, higher marginal rates may reduce incentives to work, save, and invest, potentially reducing economic growth and government revenue. Instead, it may be more effective to reduce credits, deductions, exemptions, and exclusions to generate more revenue.
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Low-income households rarely itemize deductions
When preparing their income tax returns, taxpayers have the option to either take the standard deduction or itemize and deduct certain expenses, such as state and local taxes, mortgage interest, charitable contributions, and some medical expenses. The standard deduction is a flat dollar amount that reduces the amount of income subject to taxation. For the 2022 tax year, the standard deduction ranged from $12,950 for a single filer to $25,900 for a married couple filing jointly. The standard deduction is adjusted annually for inflation and varies based on the taxpayer's age, marital status, and dependency status.
Itemized deductions, on the other hand, allow taxpayers to deduct specific expenses from their taxable income. While anyone can technically itemize their deductions, high-income households are more likely to do so because they tend to incur more expenses that can be deducted. Additionally, the per-dollar tax benefit of itemized deductions is higher for taxpayers in higher marginal tax brackets. As a result, eliminating or limiting itemized deductions would have a more significant impact on the after-tax income of higher-income households.
Furthermore, low-income households typically pay a smaller share of their income in federal taxes due to tax credits, such as the earned income tax credit (EITC) and the child tax credit (CTC). These credits can result in negative federal income tax rates, meaning low-income households may receive refunds exceeding the amount of tax they owe. While low-income households may still be subject to payroll taxes and excise taxes, their overall tax burden is generally lower compared to high-income households.
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Federal taxes reduce income inequality
However, federal taxes have done little to offset increasing income inequality over the past 40 years. Income inequality has increased sharply over this period, and the tax system has not kept up with these changes. While federal taxes have become more progressive, they also began shrinking in 2001 due to tax cuts during the George W. Bush, Barack Obama, and Donald Trump administrations. A lower average tax rate has offset the equalizing effect of increased tax progressivity, leaving the effect of federal taxes on income inequality largely unchanged.
In addition, some tax breaks and policies can disproportionately benefit certain groups, reinforcing racial and economic disparities. For example, tax breaks for homeownership, such as deductions for mortgage interest payments and local property taxes, disproportionately benefit White families due to racial and ethnic disparities in homeownership rates. Similarly, the Child Tax Credit (CTC) has been shown to benefit White children more than Black and Latine children, further exacerbating existing inequalities.
To reduce income inequality more effectively, policymakers could consider making the tax system more progressive and addressing racial and economic disparities in tax policies. This includes taxing capital gains and inherited assets at the same rates as income from wages and salaries, as well as removing the CTC's minimum earning requirement to promote the economic prosperity of more families. By making the tax system more equitable and inclusive, income inequality can be further reduced.
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Payroll tax is the largest federal tax for the lowest-income households
Income tax is based on a progressive system, meaning that as someone's income increases into higher tax brackets, only the portion in that bracket is taxed at the higher rate. This means that high-income households pay a larger share of their income in total federal taxes than low-income households, reducing income inequality.
Low-income households typically pay little to no federal income tax, either because their income is lower than the standard deduction or because tax credits offset the tax they would owe. In 2023, the standard deduction is $27,700 for married couples, $20,800 for single parents, and $13,850 for singles. Families with children can also reduce the amount of income they owe in taxes with the child tax credit. However, while federal taxes have become more progressive, they have also shrunk since 2001 due to tax cuts, which has lessened their equalizing effect.
Despite this, low-income households typically pay some federal tax. The largest tax burden for households in the bottom income quintile comes from the payroll tax, followed by excise taxes and a small amount of corporate tax. Payroll taxes are considered regressive, with low- and moderate-income taxpayers paying a bigger share of their incomes in payroll tax than high-income taxpayers, on average. The payroll tax rate for households in the lowest income quintile is 6.3%, just below the 6.8% average rate for all households. In 2021, the bottom fifth of taxpayers paid an average of 6.1% of their incomes in payroll tax, while the top 1% of taxpayers paid just 2.1%.
Payroll taxes are levied on wages and self-employment income, with the revenue going towards funding social insurance programs such as Social Security, Medicare, and unemployment insurance. Both employees and employers pay these taxes, although most economists agree that employees ultimately bear the cost of employer payroll taxes in the form of lower wages.
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Rich Americans benefit more from the SALT deduction
While federal taxes reduce income inequality, they have done little to offset the increasing income inequality over the past 40 years. Federal taxes are progressive, meaning that high-income households pay a larger share of their income in total federal taxes than low-income households. However, low-income households typically pay some federal tax, including payroll tax, excise taxes, and corporate tax.
The SALT (State and Local Taxes) deduction, on the other hand, has been criticized as a handout to the rich. Before the 2017 Tax Cuts and Jobs Act (TCJA), taxes paid to state and local governments could be deducted from federal income taxes. However, the TCJA capped this benefit at $10,000 per year, impacting high-earners in high-tax cities and states. While the introduction of the cap reduced its value to the richest families, the deduction still largely benefits high-income households. Even with the cap in place, around three-quarters of the benefit goes to families in the top fifth of the income distribution, with over 12% going to the top 1%.
Some politicians, such as Senate Minority Leader Chuck Schumer of New York, have argued for removing the cap, claiming that it hurts people affected by the pandemic. However, data suggests that the richest neighborhoods of New York saw a decrease in population as the pandemic hit. Lifting the cap would provide a tax cut primarily to the wealthy, as it would only impact those who itemize their taxes and pay more than $10,000 in state and local taxes. The Tax Policy Center estimates that about 70% of the benefit of lifting the cap would go to the top 5% of earners in the United States.
Instead of seeking to remove the cap, some commentators argue that policymakers should consider eliminating the deduction altogether. They suggest that the SALT deduction is a warped way to do social policy and that it is bad policy, especially during a time of rising inequality. By definition, most of the value of a deduction on income taxes will go to those paying the most taxes, i.e., higher earners. Therefore, it is clear that the SALT deduction disproportionately benefits rich Americans, and its removal or limitation can help address income inequality.
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Frequently asked questions
Federal taxes reduce income inequality because high-income households pay a larger share of their income in taxes than low-income households. However, federal taxes have done little to offset increasing income inequality over the past 40 years.
State and local taxes are less progressive than federal taxes, and some are regressive, meaning low-income households pay a higher share of their income in these taxes than high-income households.
There are several ways in which tax laws favor the rich:
- Rich Americans are taxed at lower marginal rates and tend to earn more of their income from sources other than work.
- Rich Americans are more likely to use the SALT deduction and claim larger amounts, making the overall distribution of SALT regressive.
- Billionaires and giant corporations often pay a smaller percentage of their income in taxes than working families due to tax breaks and tax avoidance strategies, such as stashing profits in tax havens.
- Tax cuts, such as those enacted by Republican-controlled Congresses, have reduced the number of taxpayers paying estate taxes and fueled income inequality.
- Lower tax rates on long-term capital gains and dividends provide greater aid to the rich than to the poor, increasing after-tax income inequality.
