Are there better ways to tax the rich?

At the end of 2025, the individual provisions of the Tax Cuts and Jobs Act of 2017 (TCJA) will expire unless Congress acts. Since the law’s passage, criticism has centered on how the law disproportionately reduced taxes for high-income households. Thus, there is good reason to think that any tax bill that addresses these provisions will have to grapple with the broader question of how best to tax high-income households. We address these issues in a new paper in Tax Notes and a short policy brief.

Why is the structure of high-income household taxation important? First, these households earn a significant share of overall income and have substantial ability to pay taxes. As a result, they are expected to bear a significant share of the tax burden. This is a crucial issue to debate but not the one we examine here.

Instead, we focus on better ways to tax the affluent, holding constant the tax burden they bear. A key fact is that affluent households earn income in different forms than the general population. According to IRS data, the top .01% of households by income (the top 1 in 10,000) earn roughly 85% of their income from investments and closely-held businesses. In contrast, households in the bottom 80% of the income distribution earn nearly 80% of their income from labor, including wages, salaries, and fringe benefits.

The taxation of high-income households can create distortions that affect the overall economic efficiency and horizontal equity of the tax code. In the past decade, much of the debate has centered on how the tax code distorts how much taxable income is reported, in what form that income is reported, and when income is realized. Lawmakers and analysts have also considered how taxation influences the types of investments business make, how businesses finance investments, and what legal forms businesses take.

Improving the taxation of high-income households is not as simple as cutting taxes.  Some tax increases on high-income households would reduce distortions. For example, lawmakers could raise taxes on capital income by limiting the extent to which corporations could deduct net interest expense. This would reduce an existing tax provision that favors debt finance by making the taxation of debt-financed business investment more similar to the taxation of equity-financed investment.

And some tax cuts can increase distortions. The canonical example of this is the TCJA’s 20% deduction for pass-through business income, Section 199A. This deduction greatly increased the incentive for owners of closely-held businesses to report their business income as lower-taxed profits rather than wages. For example, $1 of income would be taxed at a maximum rate of 29.6% if reported as a profit but would be taxed at the federal level at a rate of 40.2% if reported as labor compensation.

Tax policies affecting the affluent have important consequences for the distribution of the tax burden, but also the equity and efficiency of the tax system. Ultimately, lawmakers should approach taxation of affluent households the same way they approach tax reform: Construct a tax system that will raise revenue while minimizing distortions.