Capital income legislative changes have significantly reduced the federal income tax base and revenues over the past 25 years. A significant portion of capital income is never subject to tax. The massive “leakage” between generating economic income and reporting income on tax forms requires careful analysis of (a) what forms of income do not appear on tax forms, (b) where in the distribution of income this divergence is (c) the evolution of base erosion over time, and (d) the revenue and distributional effects of broadening the income tax base of the capital.
In a recent project, we examine these questions. First, we construct data on reporting units from household data from the Consumer Finance Surveys (CFS) from 1995-2019. The SCF is uniquely qualified for this exercise because it has the wealth data needed to link capital income (missing and reported) to specific types of assets and specific tax units. Tax data alone is not enough to solve these problems, because the income reported to the IRS is already affected by laws, avoidance strategies and avoidance practices. Second, we compare data from the National Income and Product Accounts (NIPA), the Internal Revenue Service (IRS), and SCF aggregate income to better understand what types of capital income do not show up on tax forms. . Third, we use the NBER TAXSIM model to calculate taxes payable under different scenarios.
The outcome of the project includes two research papers and policy briefs as well as a publicly available microdata set that creates tax units from SCF households and reconciles the economic and tax concepts of capital income – with a documentation, code, and data that enable other researchers to use methods and data.
We obtain several key results. Figure 1 shows that, after making conceptual corrections to align the concepts of NIPA and IRS income discussed above, the fraction of NIPA income that appears as SOI income varies by income type and over time. The ratio of IRS and NIPA measures of closely held business income to financial assets is low and has been declining over time. The solid green line in Figure 1 shows that the ratio was 44% in 1994 and fell to 32% in 2018. In other words, the United States moved from taxing less than half of economic measures commercial and financial income to taxation of less than one year. third of this income during this period. The green dotted line shows that removing the adjustments for qualified dividends and qualified business income leaves the ratio at 44% in 1994 and 40% in 2018, a smaller drop. In contrast, the blue line shows that the ratio between the SOI and NIPA measures of all “other” income has been high and relatively constant, at 86% in 1994 and 84% in 2018, most of this small decline not occurring. producing only in recent years. a few years of the sampling period.
We compare the income and distributional effects of two scenarios: one with SCF business income as reported (unadjusted), the other with SCF business income reduced by 50% (adjusted). This latter scenario is driven by the fact that NIPA and SCF closely held companies’ revenues are typically twice as large as those reported on tax returns in SOI data. Thus, the scenario is a rough approximation of what business owners actually report on their tax forms as opposed to what they report in the Survey of Consumer Finances. Figure 2 shows that the revenues in the unadjusted scenario (the solid red line) are well above the published SOI values (the black line). This happens because the scenario produces a higher total income, most of which is attributable to higher business income. The income gap is relatively stable over time, which is consistent with a systematic reporting difference. Income tax revenue in the adjusted scenario (the red dotted line) is $1.517 billion in 2018, almost identical to the IRS figure, reported at $1.510 billion.
The revenue effects of taxing all business income would be substantial. For example, in 2018, tax revenues in the unadjusted scenario are $249 billion, or 16.4%, higher than in the unadjusted scenario. The substantial increase in tax revenue reflects both the doubling of corporate income and the above-average marginal tax rates that additional corporate income faces.
The distributional effects of taxing all business income would also be considerable. We focus on distributive effects by wealth class because income is endogenous to this exercise. The first two columns of Table 1 provide some perspective on the distribution of wealth, including, for example, the fact that SCF households with a net worth of $10 million or more represent only 1% of the population, but own 39% of the wealth.
The distribution of taxes is very different. In the unadjusted scenario, households with wealth of $10 million or more account for 30.3% of taxes. In the adjusted scenario, these same households represent only 27.6% of taxes. The last two columns show that if all business income were included in the tax base, the average tax payable would increase by about $80,000, from $287,830 to $367,145 (28%) for families with wealth of $10 million or more. Taxes would change much less for households with a net worth of less than $1 million, or around 5% of their average business taxes. These results indicate the potential revenue and distributional effects of incorporating all business income into the tax base.
About one in six tax dollars owedD to the federal government are not paid.
More generally, policymakers have a variety of choices if they wish to go in the general direction of broadening the income tax base to include more business income and other types of capital income.
The first is the fight against tax evasion. About one in six tax dollars owed to the federal government is not paid. Tax evasion is particularly high in sectors of the economy that do not feature the typical third-party withholding of wage income. Thus, evasion rates are high among business taxes, including sole proprietors, farm owners, rent recipients, partnerships, etc. Over the past 10 years, the IRS’ own budget has shrunk sharply in real terms, and the number of auditors from high-income households has dropped. Funding the IRS on a sustainable basis and improved reporting – such as the Biden administration’s proposal for banks to report total deposits and withdrawals for accounts with a certain amount of money coming in or out – would help solve these problems.
A second step would be to tax capital gains more. At present, gains are only taxed when they are made rather than when they accumulate, and the biggest loophole in the income tax system is the so-called “angel of wealth” loophole. death”, i.e. capital gains accrued on assets held until death are never subject to income tax. Their basis is increased to the current value of the assets during the transfer of assets. Therefore, many business owners have an incentive to defer the sale of the business, as the gains in the value of the business will be tax exempt upon the death of the owner. The value of the business would be subject to inheritance tax, but as noted below this will not apply to the vast majority of businesses. The obvious choices for capital gains reform would be (a) to remove the base increase at death, (b) to tax the gain at death, or to tax all gains each year based on the accumulation. Taxing mark-to-market assets (such as stocks on the NYSE) on an accrual basis would be straightforward. The taxation of non-traded assets presents challenges, but these can be overcome by a system that includes interest charges for deferred realization (Auerbach 1991). President Biden’s proposal to tax the accrued capital gains of people with more than $100 million in wealth is an important (albeit complicated) proposal that could significantly narrow capital gains loopholes and generate significant revenue.
A third step would be to tighten inheritance tax and other wealth transfer rules. Inheritance tax, which in principle is an important income tax backstop, was virtually gutted in the 2017 tax law, with the exemption level raised to $22.8 million for a married couple. Reducing the exemption and closing the myriad loopholes associated with the tax could go a long way to increasing income, not only at the time of death, but also during the deceased’s lifetime. Wealth transfer taxes will take on particular importance over the coming decades, as people over 65 now hold a larger share of household net worth than at any time in at least the past 30 years. . Over the next 2-3 decades, much of this wealth will likely be inherited by the wealthier members of the younger generations. The fact that the inheritance tax offers such generous exemptions and loopholes during the coming period of high wealth transfers risks losing government revenue and exacerbating inequality.
All of these ideas have the potential to generate significant government revenue, with the burdens heavily concentrated on the wealthiest households.
In conclusion, our work is driven by changes in the distribution of income and wealth, changes in tax policy over the past 25 years, and the presence of long-term federal fiscal deficits. All of these trends underscore the potential importance and fairness of raising taxes for wealthy households. Capital income in general and business income in particular are highly concentrated among these households, but the average tax burden on this income has decreased considerably over time. As this project shows, broadening the tax base to include more business income has a significant impact on income and distribution and policy makers could pursue various policies to increase the burdens on the wealthy and thus increase the income gradually.
This dissertation was funded by the Peter G. Peterson Foundation. The Brookings Institution is funded through support from a wide range of foundations, corporations, governments, individuals, as well as an endowment. The list of donors can be found in our annual reports published online here. The findings, interpretations and conclusions of this report are the sole responsibility of their author(s) and are not influenced by any donation.