Why Is The Effective Tax Rate Of High-Income Taxpayers So Low?

Our first glimpse of individual income tax returns affected by the Tax Cuts and Jobs Act indicates that the 2017 tax law seems to have benefited higher-income taxpayers the most and, as in prior years, the income tax is not progressive at the high end.

Recently published data by the IRS Statistics of Income division show that as a percentage of adjusted gross income, taxpayers with AGI between $200,000 and $5 million got the largest cut, equal to 2.3% of their AGI, from 25.5% to 23.2%. The average tax cut across all taxpayers was 1.2% of AGI, from 15.4% to 14.2%.

The figure shows that for all income categories (except for AGI between $5,000 and $10,000), income taxes were cut by the TCJA. The income category with the highest effective tax rate was for returns with between $2 million and $5 million. That rate was 27.5% in 2018. Rates for higher-income categories were lower: 27.3% for AGI between $5 million and $10 million and 24.8% for AGI greater than $10 million.

What Makes the Difference?

As F. Scott Fitzgerald wrote about the rich: “They are different from you and me.” What tax benefits provide particularly favorable tax treatment to high-income taxpayers?

The table below shows tax benefits — including deductions, income with preferential rates, and credits — that are significantly larger for the two IRS SOI AGI categories greater than $5 million relative to all returns with AGI less than $5 million.

By far the biggest contributor to reducing the taxable income of the highest incomes is capital gains, a large portion of which is taxed at preferential rates. Charitable contribution deductions, qualified dividends (taxed at capital gains rates), and the deduction for state and local taxes also disproportionately benefit the over-$5 million folks compared with the rest of the population.

This is a far from perfect analysis of the progressivity of the tax system. The numerator of the calculated effective tax rates shown in the figure excludes payroll taxes, excise taxes, estate taxes, and corporation income taxes. The denominator does not include available income measures excluded from AGI (like tax-exempt interest), and it excludes unrealized capital gains. But these data are hard facts, and as long as they’re interpreted with caution they provide useful information.