The tax expenditure of the 1%
The Tax Policy Center’s new report on the distribution of tax expenditures strengthens the case for increasing tax progressivity and raising needed revenue by ending the preferential treatment of capital income (subject to a 15 percent tax rate versus a top marginal income tax rate of 35 percent). TPC’s analysis looks at seven broad categories of individual income tax expenditures: exclusions, above-the-line deductions, the preferential treatment of capital gains and dividends, itemized deductions, nonrefundable tax credits, refundable tax credits, and other miscellaneous tax expenditures. Guess which category of tax expenditure provides by far the most lopsided benefit to upper-income households?
That would be the way the tax code preferences capital income over wage and salary income, compounded by the heavy concentration of capital income at the top of the earnings distribution. In 2011, the top 1 percent of households by cash income received a whopping 75.1 percent of the benefit from the preferential treatment of capital gains and dividends. The broad middle class—defined here as the middle 60 percent of households by cash income—received only 3.9 percent of that benefit. Upper-income households also do well by tax exclusions and itemized deductions, but the share of these tax expenditures accruing to the top 1 percent of households—at 15.9 percent and 26.4 percent, respectively—don’t come close to the windfall afforded by a 15 percent rate on capital income.
This should come as no surprise if you’ve read about the Buffett Rule and former Massachusetts Gov. Mitt Romney’s 13.9 percent effective tax rate: Capital income is terribly concentrated at the top of the earnings distribution and the preferential tax treatment of capital income even allows some millionaires and billionaires to pay lower effective tax rates than many middle-class households. Indeed, a recent Congressional Research Service report suggested that the tax reforms most consistent with implementing the Buffett Rule would be raising tax rates on capital gains and dividends. Additionally, TPC’s distributional analysis of taxes on long-term capital gains and qualified dividends shows that the top 1 percent of households by cash income (with income above $533,000) will pay 70.5 percent of capital gains and dividends taxes in 2011, contrasted with just 2.3 percent for the broad middle class (with incomes between $17,000 and $103,000).
Recently, the increasing concentration of capital income at the top of the earnings distribution has been the biggest driver of income inequality, followed by changes in tax policy. Since the mid-1990s, the biggest swing in tax rates has been dropping the top capital gains rate from 28 percent to 15 percent and slashing the top rate on qualified dividends from 39.6 percent to 15 percent. Today’s preferential treatment of capital gains is often considered the most regressive feature of the tax code; taxing capital income as labor income would be an extremely progressive way to raise revenue and push against after-tax income inequality. Eliminating the preferential treatment of capital gains and dividends would raise effective tax rates by 4.5 percentage points for the top 1 percent of households, while raising effective tax rates by 0.1 percentage points or less for the middle class, according to TPC. Doing so would raise substantial revenue from those households best able to contribute to deficit reduction. Measured with interactions, TPC estimates that the preferential treatment of capital gains and dividends cost $77.7 billion in 2011.
Comprehensive tax reform will have to raise more revenue and restore a greater degree of progressivity to the tax code, so that effective tax rates continue to rise with ability to pay. Equalizing the tax treatment of ordinary income and capital income would substantially advance both objectives.