Tax the rich has become a popular political mantra. It’s an ancient political strategy that leverages a popular villain to gain the masses support. And it’s further fueled by a repetitive soundbite we hear over and over – that billionaires pay less in taxes than their secretaries. Or that specific ultra-wealthy individuals paid no taxes in a given year. So what is the financial reality? How much do the rich pay in taxes? And is it actually less than other Americans? Let’s dive in to answer this question – the latest in my Financial Fact or Fiction series, based on the questions YOU submit!
How Much Do the Rich Pay in Taxes?
To address this week’s Financial Fact of Fiction question, first you need to have some background and history on US taxes. What are the different ways our Federal government generates revenues, who pays those revenues, and what are the actual rules and laws around how taxes are currently assessed?
Let’s take a dive into the current US tax code, along with data on households from the IRS and Federal Reserve surveys to understand:
- The different sources of Federal revenue currently and over time
- How various taxes are currently calculated and who pays them
- What varying income groups actually paid in income taxes
- Wealth vs. income distribution
Where Does the Federal Government Get Its Money From?
The Federal government collected an estimated $3.6 trillion in tax revenues in FY2021 (government calendar ends September 30th). Nearly half of all government revenue comes from personal income taxes (47.6%), with social insurance and retirement receipts representing the next largest category (36.2%). These are the contributions to social security and Medicare that come out of your paycheck every month, also known as FICA (or Federal Insurance Contributions Act), of which you pay half and your employer pays the other half.
If we break FICA taxes down by payor, we as individuals pay nearly 2/3s of all Federal taxes, while corporations pay just over 1/4, and the small balance is from Excise Taxes (2.1%), and Other (6.6%), which includes Estate and Gift Taxes.
If we look at those some Federal Tax Receipts normalized for the size of the economy, or relative to GDP, over nearly 90 years, Federal Tax Receipts have averaged just over 16% of GDP. For FY2021, they were 16.3% of GDP. This is despite large variations in and changes to the tax code over time.
Income taxes became and have remained the largest component of Federal Tax Receipts ever since the aftermath of the Great Depression and the subsequent need for funding both for World War II and the start of social insurance programs, which have expanded over time.
Corporate taxes have become a shrinking piece of Federal Tax Receipts, however, social insurance has significantly increased, and corporations do fund half of those.
Now that we know the different sources of Federal Tax Receipts, let’s delve into who pays what…
Social Insurance or FICA Taxes
Let’s start with social insurance, or FICA taxes. These are taxes the government collects to fund Social Security and Medicare. They are not being put in a dedicated account with your name on it. They are funding current government obligations for these programs.
Every paycheck you see a line item for FICA on your check. What many people may not know is you only pay half of the FICA taxes, while your employer pays a matching amount every month to the government.
In 2021, current social insurance tax rates are 12.4% for Social Security and 2.9% for Medicare, of which you pay half and your employer pays the other half. Social security taxes are only paid on wages up to $142,800. Medicare taxes are paid on ALL wages, with an additional +0.9% paid by the employee on wages in excess of $200,000.
No one is immune from social insurance taxes. Everyone with earned income pays them, even the self-employed. However, they are only applicable to wage income, not investment income.
Some have argued the income cap on Social Security makes these taxes regressive. Because Social Security taxes are only paid on the first $142,800 of income, high-income earners pay a lower rate of their income. So do the rich pay less in taxes for social insurance? As a percent of their income, yes, but in terms of absolute dollars, they do not.
Why is there an income cap? Mostly, because there always has been one. When Social Security was first established, it was proposed that the rich, or high-income earnings, not be part of it at all – it was to help low-income earners in retirement. Instead, Congress put an income cap on it and included everyone. Today, some argue that removing or raise the cap could be a way to fix the Social Security funding problem.
Do the rich pay less in social insurance taxes than you do?
As a percent of their income, yes. In terms of total dollars, no.
Personal Income Taxes
Here’s the big category – both in terms of how much revenue it generates for the Federal government – and the real question everyone is asking: how much do the rich pay in taxes? And is it really less than you do?
First, let’s start with how income taxes are actually calculated. Federal income taxes are progressive, and always have been. This means the more income you make, the higher the tax rate. The most recent change to the tax law, the Tax Cuts and Jobs Act of 2017 (TCJA), increased the standard deduction for everyone in an attempt to simplify tax filings and encourage more standard deductions and fewer itemized ones.
No one pays any income taxes up to their standard deduction. Then, your income flows through the tax brackets. Everyone pays the same rates, and the rates get higher on the additional income earned at higher income levels. If you make $700,000 a year, you don’t pay 37% on all of your income, just on the income from $628,301 to $700,000.
In a moment, I’ll walk through some examples of exactly how this works.
Many like to point to the fact that marginal income tax brackets were much higher in the past. And they were – but the people who actually paid them were few and far between. In the early days of income taxes, back in the 1930s-1940s, marginal income taxes on the highest tax brackets were 60 to upwards of 90%+. But, they applied to max income brackets initially over $1,000,000, and that was back in the 1930s. When it was over 90%, it applied to max income brackets that would be the equivalent of $4-5 million today, which contrary to popular belief, would impact fewer than 0.1% of all taxpayers today, or less than 150,000 tax filers.
Do the rich pay less in personal income taxes than you do?
As a percent of their income, no. In terms of total dollars, no.
Capital Gains Taxes
Capital gains taxes are part of personal income taxes, but are applied to investment income. Many may be surprised to know that they are also progressive, with higher income earners (no matter the source of the income) paying higher capital gains tax rates than lower-income earners. Capital gains rates are 0% 15%, or 20%, depending on your income. For those with Modified Adjusted Gross Income (MAGI) over $200,000 for single filers or $250,000 for married filers, you will also pay an additional +3.8% in capital gains taxes, which was put in place as part of the Affordable Care Act.
To be eligible to pay these lower capital gains tax rates, an investment must be held for the long-term, measured as for at least one year. Short-term gains, on investments held for less than a year, are taxed at ordinary income rates listed above.
Most of the variation in tax rates paid by different income groups is because of the capital gains tax rate. Passive, long-term investment income is taxed at a lower marginal rate than wages and salary, and the extremely wealthy have far more investment income than earned income.
Why are capital gains taxed less? To encourage investment, which grows the economy and creates jobs. Others also already view it as double-taxation – you invest money you earned as income and paid taxes on, and investments generate investment gains from corporate earnings they already paid taxes on as well.
Do the rich pay less in capital gains taxes than you do?
As a percent of their income, no. In terms of total dollars, no.
Simple Income Tax Examples
Here are a few examples walking through the math of income tax brackets, social insurance taxes, and capital gains taxes for different scenarios – from someone in the top 1% to the average family to a single person in the bottom 50%.
You might notice the biggest tax breaks come from 1) being married and 2) having tax deductions, aka children.
So… How Much Do the Rich Pay in Taxes?
When you add all that up, do the rich end up paying less in taxes than you do? The latest available data from the IRS summarizes 2018 taxes. In that year, over 144 million personal income tax returns were filed, with an average effective tax rate paid of 13.3% (this does not include social insurance but does include capital gains).
The top 0.01% do pay lower effective tax rates (25.6%) than the top 0.1%, who pay 27.3%, and the top .001% pay lower effective tax rates (22.9%) than the top 1%, who pay 24.9%, but otherwise, they all pay higher effective income tax rates than anyone else.
What does it take to be in the top 1%? Adjusted gross income over $540,000.
What about the top 0.001%? Adjusted gross income over $68.9 million, not billions or trillions as you might have imagined. And that only represents 1,443 tax filers.
Whether you look at it in terms of the effective tax rate or in aggregate dollars, how much in taxes they pay, the top 1% pay more in taxes than you do. The top 1% combined pay an average effective tax rate of 25.4%. They earned 20.9% of all 2018 income reported and paid 40.1% of all income taxes collected.
Now, are there specific individuals who may claim lots of losses, tax credits, engage in tax saving strategies to minimize their taxes and in some years pay little to no taxes? Probably. I don’t have private, individual tax filing information. But in aggregate, the rich most definitely pay more in taxes than anyone else – and this isn’t an opinion; it’s based on the actual taxes collected and reported by the IRS.
What accounts for the variation in tax rates among the top 1%? Income composition. The extremely high income earners have far less income from salary and wages, with the bulk of their income generated by capital gains, with a max tax rate of 23.8%.
What about for years before 2018? Before the TJCA of 2017, the most major change to taxes in 30 years went into effect? Tax rates fell for ALL income groups in 2018, but the overall trends remain similar, and the share of taxes paid by the top 1% higher than all others consistently in every year.
… and from 2001 to 2018, the share of taxes paid by the top 1% actually increased by 7%, from 33% to 40%, including an increase of the share paid by the top 1% by 1.5% from 2017 to 2018, while the bottom 90% saw their share decrease by 7%.
Do the rich pay less in income taxes than you do?
As a percent of their income, no. In terms of total dollars, no.
Why Do People Claim the Rich Don’t Pay Their “Fair Share”?
The debate around who should pay more taxes and how much they should pay has far more to do with concerns over income and wealth inequality than how much is actually being paid in income taxes.
No one takes concern with the fact that the top 1% paid 40% of all income taxes in 2018. They are upset that the top 1% earned 20% of all income in 2018, while the bottom 50% earned just 12%. The impact of this income distribution on net worth, compounds over time to similar effect.
The top 1% of income earners held 27% of total wealth in Q2 2021, according to the Federal Reserve. If you look at it based on wealth, it’s even more tilted in the favor of the top 1%.
The calls for the rich to pay their “fair share” is based on beliefs that more progressive taxation policies could redistribute wealth and address income and wealth inequality. You could look at the data of the last 20 years, where the tax share has shifted to the top 1%, with no improvement to income or wealth inequality, as an indication that it may not work.
There is also a critical difference between wealth and income. Income is taxed. Wealth, largely, is not. When we talk about millionaires and billionaires, we are talking about their net worth, or total wealth… not their income in a given year. Hence, the renewed calls for a wealth tax or billionaires tax.
Another source of contempt in this debate is not only distribution by income, but the generational distribution of wealth. Gen X and Millennials have far less share of net worth than prior generations did at the same age. This is in part because older generations are living longer and still hold some of it, but it’s also a function of the debt burdens younger generations now carry, especially student loans.
Hopefully, this lays out the facts of current tax policy and ongoing debate more clearly. How much do the rich pay in taxes? Depending on who you characterize as rich, the top 1%, who earned at least $540,000 in income in 2018, paid 40% of all income taxes, while earning 20% of all income. Definitely not LESS than anyone else. As to whether or not that is fair and they should pay more? That’s a matter of opinion for you to decide now given all the facts.
Do you know what your effective tax rate is? Did you learn anything new about tax policy that you didn’t know or understand before? Remember – the tax and income strategies of the rich? Anyone can follow them. Earned wages are taxed far more than passive investment income. It’s simple, not easy. Spend less than you make, so you have money to save and invest, so you can ultimately generate low tax passive income and work less!
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