- Too much of billionaires' true economic income is not getting counted on their tax returns.
- We can count more capital gains as income, to make them report more income and pay more tax.
- To do this, eliminate "stepped-up basis" rules and prevent double deduction of charitable giving.
- See more stories on Insider's business page.
ProPublica has obtained years of federal income tax information for the 25 wealthiest Americans, and has released an analysis comparing their federal income tax bills to the rise of their net worth over the period from 2014 to 2018, showing their federal income tax bills added up to just 3.4% of their wealth gains.
ProPublica calls this their "true tax rate." While I have some quibbles with their analysis, the investigation does demonstrate a real problem: The wealthiest Americans are paying less income tax than our tax policies are supposed to collect from them, and less than is fair.
But I also have a hopeful message. There are solutions available to this problem, and they don't need to involve a wealth tax, which is appealing as a political soundbite but faces enormous political, constitutional and administrative challenges.
Our income tax is not defining "income" correctly. Adopting a more comprehensive definition of income would make it possible to collect more tax from the likes of Jeff Bezos and Elon Musk. In fact, closing just two major loopholes would get us a long way toward that goal.
What is income?
If you ask an economist what "income" is, they're likely to point to a concept called "Haig-Simons income," which says your income for a given period is equal to your expenses plus the change in your net worth. This makes intuitive sense: your income either gets spent or saved, so if you add up your spending and your savings, that's your income. But unrealized gains create issues for this definition in relation both to the tax code and to popular conceptions of income.
Suppose your house was worth $300,000 a year ago, but is worth $350,000 today. Did your house produce $50,000 of income to you over the last year? Haig-Simons would say so, but few people think about things that way. Your home's appreciation doesn't actually feel like income until you sell it. And this is also how the tax code works: Asset appreciation isn't counted as income until the asset is sold.
This is the main tax "avoidance" strategy demonstrated in the ProPublica article. The wealthiest Americans owned interests in major companies whose stocks rose. They didn't sell their shares, and therefore didn't report any income related to that appreciation.
Of course, that's not cheating - it's just how the law works. And it would be fine so long as the gains got taxed eventually: if the tax liability is building up and sure to be paid in a future year when the gain actually gets realized, that's fine. The problem is that our tax code too often allows rich people to never pay taxes on those gains.
Joe Biden wants to close the "step-up in basis" loophole
One of the biggest problems with the way our tax code treats unrealized gains is that you get a big bonus for holding on to your assets until you die.
If you buy an asset for $200,000 and it's worth $800,000 when you die, the IRS then readjusts the value and your heirs only pay taxes on realized gains above the new $800,000 value. The $600,000 in gains accrued during your lifetime never get treated as taxable income. This creates a huge incentive for wealthy people to hold assets instead of selling them, and is a major way their true economic income gets excluded from tax.
But the tax code doesn't have to work this way. In fact, President Biden has proposed to change the law so that death is a "realization event." If a person has more than $1 million of unrealized gains when they die, those gains over $1 million would be subject to capital gains tax as though they sold them on their death bed. Not only would this generate more tax, it would eliminate much of the incentive for rich people to cling to specific assets, so it would encourage more capital gain realizations (and more tax payments) even before they die.
Of course, there is political resistance to this idea, partly because it would also raise taxes on people who are rich but much less rich than Jeff Bezos.
Still, if the goal is to get these ultra-wealthy to pay more, you could offer an exemption much larger than $1 million per decedent, reducing collections from the merely rich while still capturing much more of billionaires' true income as taxable income.
Defining income better makes higher tax rates possible
Capital-gain income, income made from selling investments like stocks, bonds, etc., has almost always been taxed at a lower rate than wage income. There are several policy justifications for this, but a major reason capital gains tax rates need to be lower than wage tax rates is that capital gains taxes are relatively easy to avoid.
You can jack taxes on high earners' wages and salaries up very high - likely 70% or higher - before you have to worry that the higher rate is going to cause them to report so much less income that they pay less tax overall. But economists typically estimate that the "revenue-maximizing" tax rate on capital gains is much lower, closer to 30%, mostly because there are better strategies to avoid capital gain taxes.
But if you eliminate the stepped-up basis loophole, the government can collect more tax in three ways. First, taxes will be imposed directly on appreciated assets at death. Second, the impossibility of avoiding tax entirely through delay will encourage more wealthy people to go ahead and realize taxable gains before they die. Third, with a key avoidance avenue eliminated, the government can impose a higher capital gains tax rate and still expect that high earners will grimace and pay it.
This is why Biden has paired his plan to raise capital gains tax rates to as much as 43.4% on the highest earners with his plan to abolish stepped-up basis at death. The former policy does not work well without the latter one.
Charitable deductions are calculated in a way that is too favorable to the rich
Besides unrealized gains, one of the obvious ways the wealthy people discussed in the ProPublica investigation avoid tax is by giving their wealth to charity.
I am not one of those people who is grumpy about billionaire philanthropy. I think the tax code should reward charitable donations. But the way we hand out tax benefits for charitable giving now is excessively generous to the wealthy, while ordinary people get little or no tax benefit for their own charitable donations. The rules need to change.
Suppose you are an affluent person and you donate $10,000 to charity. Your marginal federal income tax rate is 24% and you itemize deductions, so this donation reduces your tax bill by $2,400, or 24% of the amount you donated.
Now suppose you're rich and you donate $100,000 worth of appreciated stock to charity. You bought this stock many years ago for just $20,000. Donating an appreciated asset is not a gain realization event, so not only do you get to reduce your taxable income by $100,000 - the value of the donation - you also never have to pay the capital gains tax on the $80,000 in value the stock gained. Plus, your income tax rate is higher - 40.8% on ordinary income, though just 23.8% on capital gains - which means your $100,000 deduction reduces your federal income tax liability by $59,840, or 59.8% of the amount donated, compared to if you had simply sold the appreciated stock.
Now suppose you donate $1,000 to charity. Your income is more towards the median for an American family, and you take the standard deduction instead of itemizing. In most years, a charitable donation doesn't reduce your income tax liability at all. But for 2020 and 2021, there's a special provision allowing people who take the standard deduction to additionally deduct $300 in charitable contributions. Your marginal income tax rate is 12%, so this deduction reduces your tax bill by $36, or 3.6% of the amount donated.
That all doesn't seem fair, does it?
We can make charitable deductions more fair while still encouraging charity
There are ways to improve how we use the tax code to reward charity.
One is to close the loophole about appreciated assets - when you donate an appreciated asset, you should be able to deduct only what you paid for it. That still provides extensive tax savings, but does not allow the rise in asset value to be deducted twice. Essentially, it would mean any donation of $100,000 would shield only $100,000 of income from tax, not more.
Additionally, you could cap the value of charitable deductions, as the Biden administration has proposed to do. Regardless of the actual tax rate paid, Biden has proposed that taxpayers should only be able to reduce their tax liability by 28% of the amount of a donation. This rule would reduce the incentive to give to charity among the wealthiest. But it would also generate revenue that could be used to enhance the charitable deduction for a broader swath of the public, for example by converting the deduction into a more generous and more widely available tax credit.
A more democratized approach to tax incentives for charity could ideally maintain the overall level of charitable giving in society while tilting tax liabilities toward the wealthiest Americans and reducing the influence of billionaires on the priorities of charitable institutions.
If we do these two things, we don't need to do other, harder things
There are other ideas about how to get the wealthiest Americans' reported income for tax purposes closer to their true economic income about which I am much less eager.
One, discussed briefly in ProPublica's story, is to switch from taxing capital gains only upon realization to taxing them every year. If your stock portfolio appreciates by $100,000, you're taxed on that $100,000 this year. If it declines by $50,000, you get a $50,000 tax deduction.
Just because your assets went up in value doesn't mean you have lots of cash to pay new taxes, but because this system would eliminate the tax implications associated with selling appreciated stock, there would be an easy way for taxpayers to finance their tax bills: by selling stock.
But there are problems.
One is that other assets, like real estate, art, and interests in private firms, are not so liquid as stocks. It's also harder to figure out what these assets are worth in years when they don't get sold. So some taxpayers would have good reason to contend their asset appreciation hasn't made them liquid enough to pay more tax today, and they'd also have more ability to argue with the IRS about what their true "income" really was.
The IRS is already strapped for enforcement resources, and while I favor increasing the agency's budget, I am wary of new tax rules that would make enforcement much more complicated and therefore spread even expanded enforcement resources thinly.
Abolition of stepped-up basis would only require tedious arguments about the true value of illiquid assets when a taxpayer dies - a time when we already have to have those tedious arguments in order to calculate estate tax. Taxing unrealized gains would require having these tedious arguments every year, with the IRS facing off against expensive lawyers retained by wealthy people fighting to keep their tax bills down. It would just be much more costly and difficult to implement.
Other proposals to better capture the income of the very wealthy involve taxing unrealized gains only on easy-to-value liquid assets like stocks. We would keep the old method for assets like private companies and art.
This approach would be relatively easy to administer. But it would also create economic distortions. Wealthy taxpayers would prefer illiquid assets to liquid ones, and might make economically inefficient choices, like taking companies private to avoid the new rules. This could have negative effects on the economy.
There is hope for taxing the rich
Back in 2015, when I was at The New York Times, the paper ran an exposé on how the top 400 taxpayers in the country were paying lower tax rates than they had been two decades earlier. Their effective federal income tax rate had fallen from the 26.4% in the mid-1990s to 16.7% in 2012. The story attributed this to increased use of creative strategies to shield their income from tax.
Hours after the article was published, the Obama Administration responded by publishing data from 2013, showing that in just one year, these taxpayers' effective tax rate had zoomed back up to 22.9%, closing more than half the gap.
What happened here? Well, tax rates for high earners were cut in 1997, 2001, and 2003. And then, in 2013, parts of the Bush Tax Cuts expired and tax increases on high earners included in the Affordable Care Act came into effect. So the story seems pretty straightforward: cut rich people's taxes and they pay less in taxes; raise their taxes and they pay more in taxes.
Much of the typical response to stories like the one from ProPublica is unproductive: conservatives pointing out that this is just how and liberals dreaming up extremely complex approaches like wealth taxes that will never be imposed. The experience in 2013 suggests these approaches are both wrong.
Look to 2025
The experience from 2012 to 2013 shows that very rich people's income tax bills are responsive to changes in income tax policy. We don't need entirely new taxes to get them to pay their fair share. We just need to define income more comprehensively, make deductions more rational and equitable, raise rates where economically appropriate, and properly fund enforcement at the IRS.
There is a reason the Biden administration is focusing its tax policy efforts in the areas I am describing: These reforms work within our existing tax system and are administrable. And while I do not see major tax increases passing in the current congress, many provisions of the Trump tax cuts are set to expire in 2025. If Democrats control the presidency or either house of Congress then, Republicans will be forced to work with them on a bipartisan deal to set new tax policy terms.
That's a reason Democrats need to focus on getting Joe Biden reelected in 2024. Just as Barack Obama's reelection in 2012 paved the way for the tax increases on the wealthy that became effective in 2013, a Biden win in 2024 should set the stage for a tax bill in 2025 that makes billionaires pay their fair share - within the existing income tax system.