Center for Economic Analysis

Background

The federal government spent nearly $2 trillion more than it collected in taxes during the fiscal year ending September 30. That gap, known as the federal deficit, continues to add to the national debt.  Paying interest on the national debt is now the fourth largest budget item.  The government spent $1.3 trillion or 12.8 percent of its entire budget on interest payments on the national debt.  The accumulated impact of these budget deficits will make interest payments an increasingly important part of the U.S. budget and crowd out other government programs.  High levels of government borrowing can also put upward pressure on interest rates, making mortgages, car loans, and business borrowing more expensive.

Perhaps in a response to this as well as the accumulation of income and wealth into a smaller share of the population, there have been calls to change the tax system.  This generally includes a tax on wealth and higher income tax rates on households that earn high incomes.  Many Americans believe higher-income households should pay a larger share of taxes than they currently do. The reality is somewhat more complicated.  The U.S. tax system is fairly progressive, as incomes go up so do tax rates.  Wealth is also taxed through property taxes and capital gains taxes.  Property taxes are used to pay for schools and local government services, although there is a federal tax deduction for property taxes paid.  Capital gain taxes are only paid when an asset is sold.

To better understand this debate, it helps to look at who pays federal taxes today and what role tax changes could realistically play in reducing deficits and the national debt.

Income Taxes

Income taxes are the primary source of federal government revenue accounting for 51 percent of revenue (Michel and Forster).  Most of these taxes are paid by the highest income earners.  According to the IRS, in 2023, the top 1 percent of households paid 26.3 percent of all income taxes; the top 5 to 2 percent paid 18.7 percent of all income taxes, and the top 10 to 6 percent paid 14.2 percent of all income taxes.  In other words, the top 10 percent of all households by income paid 59.2 percent of all income taxes.  Conversely, the bottom 50 percent of households by income paid 3.7 percent of all income taxes. 

In terms of income the top 1 percent households earned 20.6 percent of total U.S. income; the top 5 to 2 percent of households earned 15.8 percent of all U.S. income; and the top 10 to 6 percent earned 11.2 percent of all income.  The top 10 percent of households earn 47.6 percent of all income in the U.S. 

In short, high-income households pay a larger share of income taxes than their share of total income.  While tax rates could be adjusted to increase the taxes paid by high income households, the amount raised will not be enough to substantially reduce the deficit.  There simply are not enough high-income households.

 Capital Gains Taxes

Capital gains taxes are paid when someone sells an asset, such as stock or real estate, for more than they paid for it.  It is a type of tax on wealth although it is incurred only when an asset is sold.  Common examples are real estate and stocks.  If the asset is held for less than one year, the capital gain is treated as ordinary income and taxed at the marginal tax rate of the taxpayer.  If the asset is owned more than one year, the capital gain is taxed at a lower rate.  The maximum capital gains tax rate is 20 percent although certain high-income households pay an additional 3.8 percent Net Investment Income Tax. 

Households that earn less than $96,700 pay no capital gains tax on the sales of assets.  Households that earn more than $96,700 but less than $600,050 pay a 15 percent capital gains tax, and those than make more than $600,050 pay a 20 percent rate.  Art and collectables are taxed at a maximum 28 percent.

The key point to capital gains taxes is that they are often taxed at a lower rate than income.  Supporters argue that lower capital gains tax rates encourage investment, entrepreneurship, and economic growth.  However, if wealth redistribution is a goal of tax policy, treating capital gains like ordinary income would be one approach, although politically it could be difficult.

Implications

Despite some political rhetoric, the U.S. income tax system is fairly progressive.  Also, there simply are not enough billionaires to tax to generate large additional tax revenue.  The fundamental issue is that given current levels of government spending no one is paying their “fair share.”  Either tax rates for most Americans will have to rise or government spending will have to be dramatically reduced.  Given obligations for Social Security, Medicare, and interest payments on the national debt, major reductions in government spending will be extremely difficult. 

Raising the capital gains tax has perhaps somewhat more potential.  While this will also not generate sufficient revenues to balance the budget it would raise revenue while having an impact on the distribution of wealth.