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February 25, 2013
Economic Analysis: Is the Income Tax Really Progressive?
by Martin A. Sullivan

Full Text Published by Tax Analysts®


This article originally appeared in Tax Notes on December 14, 2009


By Martin A. Sullivan -- martysullivan@comcast.net

The IRS recently released data that show that as income rises, effective income tax rates also rise -- up to a point. In 2007 the effective income tax rate leveled off at 24.1 percent for households with adjusted gross income between $1 million and $2 million. For higher incomes, the rate declines. For taxpayers with AGI above $10 million, the rate is 19.7 percent. Overall, as shown in Figure 1, the schedule of effective income tax rates in the United States is not steadily upward sloping but hump-shaped. The income tax is regressive at the upper end.

Figure 1. Effective Income Tax Rates By Income Category, 2007



Source: IRS Statistics of Income Division, Individual Complete Report (Publication 1304). Table 1.1, "Size and Accumulated Size of Adjusted Gross Income," for tax year 2007, available at http://www.irs.gov/taxstats/indtaxstats/article/0,,id=96981,00.html.

There is a simple explanation for this. The statutory tax rate on capital gains and qualified dividends is 15 percent. As shown in Figure 2, as income rises, the proportion of income in the form of capital gains and qualified dividends grows rapidly. For example, an average household with AGI between $50,000 and $75,000 receives 2.3 percent of income in this form, while the comparable figure for the average household with AGI over $10 million is 60.9 percent.

Trend Over Time

How long has this been going on? Figure 3 tells the fascinating story of taxes paid by millionaires for the dozen years from 1996 through 2007. In 1996, when there was no preferential rate for capital gains, taxpayers with AGI above $1 million had an effective income tax rate of 30.8 percent. In mid-1997 the capital gains rate was reduced to 20 percent, and the average rate declined to 28.8 percent. Between 1998 and 2000, the rate remained between 27.5 percent and 27.7 percent.


Figure 2. Capital Gains and Qualified Dividends as a
Percentage of AGI, 2007



Source: IRS Statistics of Income Division, Individual Complete Report (Publication 1304). Table 1.1, "Size and Accumulated Size of Adjusted Gross Income," for tax year 2007, available at http://www.irs.gov/taxstats/indtaxstats/article/0,,id=96981,00.html.

The 2001 Bush tax cuts reduced statutory tax rates across the board, but for millionaires the benefit was muted by declining capital gains resulting from the stock market crash. In 2003 a rising stock market combined with a reduction in the capital gains rate to 15 percent and the extension of that rate to dividends brought the effective income tax rate for millionaires down to 24.8 percent. It declined steadily from 2004 to 2007, when it reached 22.1 percent. The decline is attributable to an increasing share of capital gain and dividend income in millionaires' AGI.

What about the future? Because of the stock market crash of 2008, capital gains realizations have probably declined. So it is likely that when the 2008 and 2009 IRS data become available, we will see an increase in the effective tax rate on millionaires. President Obama plans to restore the top individual rate to 39.6 percent and the capital gains tax rate to 20 percent in 2011. If history is any precedent, this would restore the millionaire effective income tax rate to somewhere in the 27-28 percent range.

Conclusion

Images like the hump-shaped income tax schedule in Figure 1 tend to stir heated debate. Most liberals strongly favor a completely progressive income tax. This "soak-the-rich" attitude in turn riles up conservatives. And then it's toe-to-toe class warfare. There is no economic science here to provide guidance. These are value judgments, and anything goes. But it is probably fair to say that most people do not know that effective rates decline at high income levels and many people would find that unfair.

My casual impression is that some people favor progressive rates and about an equal number favor flat rates. Very few openly endorse regressive rates. Nevertheless, that is what we have in the United States. The data in this article clearly show that high-end regressivity is largely the result of a preferential rate on capital gains. The most straightforward way to restore progressivity to the U.S. income tax is to increase the capital gains tax rate.


Figure 3. Effective Tax Rate on U.S. Incomes
Over $1 Million, 1996-2007



Source: IRS Statistics of Income Division, Individual Complete Report (Publication 1304). Table 1.1, "Size and Accumulated Size of Adjusted Gross Income," for tax year 1996 through 2007, available at http://www.irs.gov/taxstats/indtaxstats/article/0,,id=96981,00.html.


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