NCPA - National Center for Policy Analysis

The Paradox of Taxing the Rich

April 13, 2012

Despite the enormous tax burden that the country's wealthy already shoulder, the current political and economic climate has fostered a number of plans that seek to bludgeon away income inequality with punitive tax rates for the rich.  This solution to income inequality portrays three broad misunderstanding about taxes in the United States, says Economic Policies for the 21st Century.

First, advocates mischaracterize the debate by implying that those they seek to tax benefit disproportionately from the current tax structure.

  • The share of income taxes paid by the top 1 percent of income earners has hovered at around 40 percent for the past several years.
  • This is the highest share in the history of Internal Revenue Service tax statistics and due largely to the progressivity of the tax system rather than income concentration.
  • Since 2004, the pre-tax income share of the top 1 percent has been around 20 percent, meaning that the share of income taxes paid by the top 1 percent is about twice as large as their share of income.

Second, the population constituting the 1 percent changes constantly (and is therefore not a group of tax-immune super-millionaires).  Treasury data makes clear that a household in the 1 percent today has less than a 50 percent chance of being in the top 1 percent 10 years from now.

Third, they misunderstand the rational taxpayer's response to higher tax rates on a particular form of income.  With so many financial planning options at their disposal, the country's wealthy will naturally respond to high taxes on income or capital gains by shifting focus to other forms of income.  This phenomenon can be seen in the dynamic between S corporations and C corporations.

  • Income from C corporations is taxed at the corporate income tax rate while S corporation profits are taxed at individual income tax rates.
  • Because the individual rate exceeded the top corporate rate in 1980 (70 percent to 46 percent), businesses filed as C corporations such that C corporations accounted for more than 85 percent of total business receipts in 1980.
  • But when the two rates equalized at 35 percent, more filers used S corporations -- these flow-through businesses accounted for over 50 percent of all business income in 2004.

Source: "The Paradox of 'Taxing the Rich,'" Economic Policies for the 21st Century, April 2, 2012.

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