The primary tax system Americans interact with each year when they file their taxes is the income tax
This tax season, the IRS expects to receive more than 168 million individual tax returns, which will take Americans approximately 2 billion collective hours to complete. As we file our taxes, it is natural to wonder where the $4.9 trillion the Federal government collected last year came from and what it funds.
Government data shows that the federal tax system is highly progressive. The highest‐income Americans pay a disproportionate share of income taxes and face the highest average tax rates across all federal taxes. We are also lucky to live in a relatively low‐tax country, but Congress continues to spend well beyond its means. If spending stays on its current path, interest on the debt and other mandatory programs—primarily Social Security and health spending—will consume every dollar of revenue by 2031.
Income taxes are highly progressive
The primary tax system Americans interact with each year when they file their taxes is the income tax. The latest Internal Revenue Service (IRS) data on income taxes for the 2020 tax year shows that the federal income tax system is highly progressive and has become more progressive over time.
The lowest‐income half of Americans paid an average income tax rate of 3.1 percent, while the top 1 percent of income earners paid a 26.0 percent rate. Across all taxpayers, the average income tax rate was 13.6 percent.
High‐income earners also pay a disproportionate share of the income taxes relative to income earned. Figure 1 shows that as a share of adjusted gross income (AGI), the top half of income earners paid 97.7 percent of federal income taxes. The top 1 percent earned 22.2 percent of total income and paid 42.3 percent of all the income taxes. The top 10 percent earned 49.5 percent of the income and paid 73.7 percent of the income tax.
Since 2001, the earliest we have consistent IRS data, average income tax rates have fallen for all five income groups. Rates have fallen the furthest for those with the lowest income, declining from 4.9 percent in 2001 to 3.1 percent in 2020. For the top 1 percent, average tax rates fell from 27.6 percent in 2001 to 26.0 in 2020. During this same time, the share of income taxes paid by the top 5 percent increased from 52.2 percent to 62.7 percent, while the share paid by all other taxpayers declined.
Total federal taxes are also highly progressive
For all but the top 10 percent of income earners, Americans pay more payroll tax than income tax each year. Because the payroll tax rate is a flat 15.3 percent on wages below a $147,000 cap (split evenly between the employee and employer), they offset some of the highly progressive income tax system.
The federal government raises slightly more than half of its revenue from income taxes, about 30 percent from payroll taxes, and 10 percent from the corporate income tax. The remaining revenue comes from smaller sources, such as taxes on estates, tariffs, and excises.
The U.S. Treasury’s Office of Tax Analysis also estimates that the entire federal tax system is highly progressive, even after accounting for payroll, corporate, and other taxes. Figure 2 shows that average tax rates climb as incomes increase. The lowest 20 percent of income earners, measured by adjusted family cash income, face average tax rates that are either negative or close to zero. A negative tax rate means that the taxpayer is a net beneficiary of the tax system, likely receiving refundable tax credits, such as the Earned Income Tax Credit (EITC) and Child Tax Credit (CTC).
The top 10 percent of income earners pay an average tax rate of 26.7 percent. Treasury also breaks the higher income earners into even narrower slices, showing that as incomes rise, so do tax rates, even at the very top of the income distribution. The highest earning 0.1 percent, pay an estimated average tax rate of 32.4 percent.
Spending is the real tax rate
The United States is a low‐tax country compared to similar countries around the world. Low taxes are a benefit to American workers and employers. In 2019, I estimated that a worker making about $40,000 in the United States would pay $6,000 more in taxes if he moved to the average European country where higher taxes are necessary to fund bigger welfare states. Beyond additional money in your pocket, lower tax rates also have broader economic benefits that foster innovation, higher living standards, and more job opportunities.
Just looking at current taxes obscures the fact that the U.S. federal government has run a budget deficit every year since the early 2000s, financing through government debt spending levels that are consistently higher than tax revenue. Even after the 2017 tax cuts expire at the end of 2025 and revenues remain well above the historical average, the gap between taxes and spending is projected to continue to grow as retirement and health spendingincrease at unsustainable rates. The Congressional Budget Office recently estimated that spending on interest and other mandatory programs will surpass revenue raised in 2031, leaving Congress to finance all other spending with additional debt.
Eventually, something has to give, either taxes will need to rise, or spending needs to fall. But the current system, where the top 10 percent of income earners pay 60 percent of all federal taxes, is unsustainable. No other large, peer welfare state supports its high spending without higher taxes on middle‐class taxpayers. If the American people continue to demand high levels of government spending, politicians should be clear; big government means higher taxes and slower economic growth for all Americans.
Originally published by the Cato Institute. Republished with permission under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.
For more from Budget & Tax News.
For more public policy from The Heartland Institute.