Taxes Commentary

Effective vs. Marginal: The Rate Illusion

The top federal income tax rate is 37%. The effective rate paid by all individual filers averages approximately 14.7%. This gap (more than 22 percentage points) reflects the fundamental structure of the American tax system: a progressive rate schedule layered with deductions, credits, exemptions, and preferential treatment for certain income types that collectively reduce actual tax burdens well below headline rates.

For high-income households, the gap is even more revealing. Taxpayers earning over $10 million annually often pay effective rates below 25%, because a large share of their income comes in the form of long-term capital gains and qualified dividends, taxed at a maximum of 20% (plus the 3.8% net investment income tax), rather than the 37% rate applied to ordinary income. This structural preference for investment income over earned income is one of the most significant drivers of wealth concentration in the tax code.

Capital Gains: The Wealth Accelerator

Long-term capital gains receive preferential tax treatment in the United States (taxed at 0%, 15%, or 20% depending on income, compared to ordinary income rates of 10% to 37%. This preferential rate applies to profits from selling stocks, real estate, and other investments held for more than one year. When combined with the "step-up in basis" at death) which effectively eliminates capital gains taxes on appreciated assets passed to heirs, the capital gains system creates a powerful wealth accumulation mechanism for those who own appreciating assets.

The practical effect is that a hedge fund manager earning $50 million in carried interest may pay a lower effective tax rate than a physician earning $500,000 in salary. The tax code, in this sense, rewards asset ownership over labor, a dynamic that compounds over generations.

The TCJA Cliff

The Tax Cuts and Jobs Act of 2017 reduced individual tax rates, nearly doubled the standard deduction, limited state and local tax (SALT) deductions, and cut the corporate rate from 35% to 21%. Many of these individual provisions are set to expire at the end of 2025, creating a fiscal cliff that would automatically raise rates for most taxpayers. Whether Congress extends, modifies, or allows these provisions to expire will be one of the most consequential tax policy decisions in decades.

State Tax Competition

States compete aggressively for residents and businesses through their tax policies. Nine states (including Florida, Texas, Tennessee, and Nevada) levy no state income tax. Others, like California and New York, impose rates exceeding 10% on high earners. This creates a powerful incentive for wealthy households and businesses to relocate, a trend that accelerated during the remote-work era.

The $10,000 SALT deduction cap imposed by the TCJA amplified this dynamic, effectively raising the cost of living in high-tax states. Combined with state and local tax revenue of approximately $3.8 trillion, the state tax landscape creates wide variation in after-tax income depending on where Americans choose to live.

Tax Policy and Wealth Concentration

The tax code is not neutral in its effects on wealth distribution. Preferential capital gains rates, tax-deferred retirement accounts, the mortgage interest deduction, estate tax exemptions, and pass-through business deductions all interact to create a system that, in aggregate, favors asset holders over wage earners. Corporate tax receipts of roughly $480 billion represent a historically low share of total federal revenue, down from nearly 30% in the 1950s to under 10% today.

The cumulative effect of these tax preferences is a system that enables faster wealth accumulation for those who already have wealth, while those who rely primarily on wages face the full weight of payroll taxes, income taxes, and consumption taxes. Any meaningful discussion of wealth inequality in America must reckon with the tax code as a primary mechanism (not merely a reflection) of the distribution of economic resources.