Introduction
The U.S. tax system is complex, with various codes that either help or hinder taxpayers. Unfortunately, many of these tax codes disproportionately affect middle- and lower-income taxpayers, making the system inequitable. In this blog post, we explore several specific tax codes and policies that place an undue burden on everyday Americans and offer potential reforms to address these inequities.
1. The Regressive Nature of Payroll Taxes
Payroll taxes fund essential programs like Social Security and Medicare, but they disproportionately affect lower-income individuals. The tax is a flat rate (6.2% for Social Security and 1.45% for Medicare) applied to earned income, and both employees and employers share this burden. However, a significant flaw in the payroll tax system is the Social Security wage cap.
In 2024, the Social Security wage cap limits the amount of taxable income to $160,200. This means that individuals who earn above this amount do not pay payroll taxes on their additional income. As a result, higher-income earners effectively pay a lower percentage of their total income toward Social Security than lower-income workers.
2. The Complexity of Itemizing Deductions
The U.S. tax code allows taxpayers to either take the standard deduction or itemize deductions for things like mortgage interest, charitable donations, and medical expenses. However, itemizing deductions is often more beneficial for higher-income individuals who have more significant deductible expenses.
For middle- and lower-income taxpayers, itemizing can be a complicated and time-consuming process that often requires the help of a tax professional. As a result, many taxpayers opt for the standard deduction, missing out on the potential savings that wealthier taxpayers can take advantage of through itemizing.
3. Capital Gains Tax Preferences
Capital gains, the profits made from selling investments like stocks, are taxed at a lower rate than ordinary income. For example, long-term capital gains are taxed at a maximum rate of 20%, while the highest income tax rate is 37%.
This preferential treatment of capital gains primarily benefits wealthy individuals who derive a significant portion of their income from investments. On the other hand, middle- and lower-income individuals, who rely more on wages for their income, are taxed at higher rates. This disparity contributes to growing income inequality and places an unfair burden on wage earners.
4. The Step-Up in Basis Loophole
The estate tax is a federal tax on the transfer of wealth from deceased individuals to their heirs, but it only applies to estates valued at more than $12.92 million (as of 2023). One of the most controversial tax benefits available to heirs is the step-up in basis.
When an asset is inherited, its value is “stepped up” to the current market value. This means that any appreciation in value that occurred during the original owner’s lifetime is not subject to capital gains tax. This loophole allows heirs to avoid paying taxes on the increase in the value of inherited assets, which disproportionately benefits wealthy families and entrenches generational wealth.
5. Tax Breaks for Large Corporations
Large corporations often exploit tax loopholes that allow them to significantly reduce their tax burden. For example, corporations can:
- Deduct Interest Payments on Debt: This reduces their taxable income and results in lower tax bills.
- Carry Forward Losses: Companies can use past financial losses to offset future profits, reducing their taxable income.
- Utilize Offshore Tax Havens: Some companies shift profits to low-tax or no-tax countries, avoiding U.S. taxes.
These tax strategies are often unavailable to small businesses and individual taxpayers, resulting in a tax system that favors big businesses and shifts the burden to ordinary Americans.
Potential Reforms for a Fairer Tax System
- Remove or Raise the Social Security Wage Cap: Eliminating the wage cap would ensure that higher-income earners contribute more equitably to Social Security.
- Simplify the Tax Code: Simplifying the tax code would make it easier for middle- and lower-income taxpayers to take advantage of deductions and credits.
- Tax Capital Gains Like Ordinary Income: Treating capital gains as ordinary income would ensure that investors pay taxes at the same rate as wage earners.
- Close Corporate Tax Loopholes: Closing loopholes that allow corporations to reduce their tax burden would create a more equitable system where businesses pay their fair share.
Conclusion
The U.S. tax code contains several provisions that disproportionately affect the common taxpayer, particularly those in middle- and lower-income brackets. By addressing these inequities and implementing meaningful reforms, the tax system can become more equitable, ensuring that all Americans, regardless of income level, contribute fairly while still receiving the benefits of a well-functioning government.