Carried Interest: The Investment Industry Loophole That Won’t Die
Carried interest or “carry” is one of the most enduring controversies in the U.S. tax code. It allows private equity, hedge fund, venture capital, and real estate fund managers to pay a significantly lower tax rate on a substantial portion of their income than typical wage earners, despite the fact that this income functions essentially as performance-based compensation. While reform proposals have circulated for decades, none have succeeded. Why does this provision persist? And how much additional revenue could it generate?
What Is Carried Interest?
Carried interest is the share of profits that investment fund managers receive from their funds’ returns, typically amounting to 20% of the fund’s net profits above a specified threshold. It is designed as a performance incentive and is paid in addition to a fixed management fee, usually around 2% of assets under management (AUM) [1]. Crucially, carried interest is not compensation for capital invested, but rather for services rendered —choosing investments, managing risk, and executing deals. Despite this, the income is often taxed at long-term capital gains rates.
The Historical Basis: Sweat Equity
The roots of carried interest lie in early 20th-century oil and gas partnerships. General partners received a share of the profits “carried interest” for contributing expertise and labor rather than capital. This treatment later spread to real estate and private equity, where it was viewed as a form of “sweat equity” [2]. The U.S. tax code under Subchapter K (1954) reinforced this idea: partners in a partnership are taxed according to the character of the income earned by the partnership. So, if the fund earns long-term capital gains, the General Partner’s (GPs) carried interest is also taxed as capital gains [3].
While it makes sense for a passive investor to receive capital gains treatment, applying the same to GPs who contributed no capital but are actively compensated for performance is where the controversy begins.
Investment Funds: Business Model and Revenue Structure
Funds like hedge funds, private equity, and venture capital operate as pooled investment vehicles. Their compensation structure is typically known as “2 and 20”:
2% management fee on Assets Under Management (AUM, paid annually)
20% performance fee on profits earned beyond a hurdle rate [4]
The management fee provides stable income, while carried interest represents the bulk of the long-term upside. Here’s a breakdown of estimated annual carried interest income by sector in the U.S. (2024):
Sector
U.S. AUM
Estimated Carry
Hedge Funds
~$5.5T
~$30B [5]
Private Equity
~$4.5T
~$47B [6]
Venture Capital
~$1.0T
~$12B [6]
Real Estate Funds
~$1.2T
~$6B [7]
Infrastructure/Credit
~$0.8T
~$3B [7]
Total (U.S. carry)
~$98B/year
Table 1 Source: LCH Investments, McKinsey, AICPA
This $98 billion represents income largely taxed at capital gains rates, despite functioning as labor-based compensation.
Figure 1 Source: (See Table 1)
Capital Gains vs. Ordinary Income vs. Carried Interest
From an economic perspective, carried interest behaves like ordinary labor income: it’s earned by providing a service (investment management), not by risking capital. Yet, under current law, it receives the same tax treatment as capital gains.
Income Type
Definition
Risk Exposure
Top Federal Tax Rate
Ordinary Income
Wages, salaries, bonuses
None (guaranteed)
37%
Capital Gains
Return on investment of one’s own capital
High
20% (+3.8% NIIT)
Carried Interest
Share of gains from managing others’ capital
Low to none
20% (+3.8% NIIT)
Table 2
In practice, carried interest is taxed at a flat 20% (plus 3.8% NIIT for high earners – the Net Investment Income Tax, see NIIT definition), the same as long-term capital gains, so long as the underlying investment is held >3 years (a provision added by the 2017 Tax Cuts and Jobs Act) [8]. Unlike genuine capital gains, which are typically generated from capital that was originally earned as income and thus already taxed once, carried interest often represents compensation for services and receives favorable capital gains treatment without prior income taxation. This has led critics to argue that capital gains may be doubly taxed, while carry is taxed just once—and at the preferential rate.
Capital Gains Tax Bracket vs. Carry
Here is a breakdown of capital gains tax brackets for 2024:
Filing Status
0% Rate (Up to)
15% Rate
20% Rate (Over)
Single
$47,025
$47,026 – $518,900
$518,900
Married Filing Jointly
$94,050
$94,051 – $583,750
$583,750
Head of Household
$63,000
$63,001 – $551,350
$551,350
Table 3 Source: IRS
Since fund managers receiving carry usually earn far above these thresholds, virtually all carried interest is taxed at the top capital gains rate of 20%, plus the 3.8% NIIT surtax.
Legal Challenges and Political Inertia
Although tax authorities have long been aware of the mismatch, the IRS has not reclassified carry as ordinary income, likely because of how entrenched it is in partnership tax law (Subchapter K). Carried interest has also withstood numerous legislative challenges:
2007-2008: Bipartisan proposals led by Rep. Sander Levin (H.R. 2834, 110th Cong.) and Sen. Chuck Grassley aimed to reclassify carried interest as ordinary income, but did not advance into law. Levin’s proposal passed the House as part of H.R. 3996 in November 2007 and again in 2008 as part of H.R. 6275, but both efforts stalled in the Senate [12]
Obama-era budgets called for reform repeatedly [9]
Trump’s TCJA (2017) only tightened the holding period requirement to 3 years
Biden and Sen. Ron Wyden have proposed closing the loophole, but efforts remain stalled due to intense lobbying by financial firms [10]
How Much Revenue Is At Stake?
Including all asset classes, the U.S. investment management sector extracts an estimated $98 billion/year in carried interest. With a 17% tax delta between capital gains and ordinary income rates (37% – 20%), the maximum additional federal revenue from reclassifying carry would be around $16.7 billion/year [11]. Actual revenues are likely to be less than estimate.
Scenario
Tax Rate
Tax Paid (on $98B)
Current (capital gains)
20% + 3.8% NIIT
~$23.3B
If taxed as ordinary income
37%
~$36.3B
Delta
~17%
~$13–17B/year
Table 4 Source: Tax Project Estimates on Table 1 Data
Given the $6.4 trillion federal budget in FY2024, this amounts to ~0.25% of total outlays. While $16 billion is a lot of money, given the energy and controversy behind it, it does little to improve the Federal Revenue. In terms of budget impact – we rate this more of a political talking point than a transformative reform.
Conclusion
The carried interest loophole remains due to a combination of legal precedence, institutional inertia, and powerful lobbying. While economically it has been widely criticized by both Republicans and Democrats, its closure would raise relatively modest revenue. It may also be seen as a question of fairness in that it is given preferential rate treatment versus ordinary income earners and is only available to a small highly compensated group. Nonetheless, for many reform advocates, it remains a glaring example of tax code inequity: a compensation scheme masquerading as investment income, allowing some of the wealthiest Americans to pay lower tax rates than ordinary income earners.
Citations
[1] Preqin Alternative Assets Report (2023) [2] Fleischer, Victor. “Two and Twenty: Taxing Partnership Profits in Private Equity Funds.” NYU Law Review, 2008. [3] Internal Revenue Code, Subchapter K, §702(b); Rev. Proc. 93-27 [4] Hedge Fund Research (HFR) Industry Report, 2024 [5] LCH Investments Hedge Fund Report, Jan 2024 [6] McKinsey Global Private Markets Review, 2024; Bain Global PE Report, 2024 [7] AICPA Private Capital Markets Update, 2024 [8] Tax Cuts and Jobs Act, Pub. L. 115–97, Sec. 1061 [9] Congressional Budget Office: Budget Options Report (2016) [10] U.S. Senate Finance Committee, “Ending the Carried Interest Loophole Act,” 2022 [11] Tax Project estimate using $98B x (37% – 20%) [12] The Venture Alley: “Carried Interest Tax Legislation Won’t Go Away,” Jan 2012, https://www.theventurealley.com/2012/01/carried-interest-tax-legislation-wont-go-away/
Tax auditing is a mechanism used by the Internal Revenue Service (IRS) to ensure compliance with the Tax Code, including tax evasion, underreporting of income, inflating deductions, and other fraudulent practices. Tax auditing plays an important role in maintaining the integrity and effectiveness of the United States’ revenue collection and ensures the equal application of Tax Code to generate revenues used to support essential government services.
This article examines tax auditing in the U.S., providing a data-driven analysis of audit processes, how businesses and individuals are audited, and the implications for tax compliance, non-compliance, and government revenue.
Internal Revenue Service and Tax Auditing
The Internal Revenue Service (IRS), established in 1862 to pay for the Civil War by collecting income taxes, administers the Federal Statutory Tax Law, the main body of which is the Internal Revenue Code (IRC), referred to as Tax Code or Tax Law, and ensures that taxpayers meet their tax obligations (1). The IRS’s mission is to “provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and to enforce the law with integrity and fairness to all” (2).
IRS tax auditing provides a necessary function of the United States’ tax administration system, ensuring the equal compliance of America’s tax collection. The process involves examining and verifying tax returns and financial records to ensure compliance with federal tax laws.
IRS Audit Types
Tax auditing is a tool the IRS uses to verify the accuracy of tax returns and to enforce tax law. The IRS generally has two types of audits: Correspondence and Field audits.
Correspondence Audits: Correspondence Audits make up most audits, are generally automated, and most involve mail-based verification of specific issues with the Taxpayer to verify and/or correct. In FY 2022, 85% of IRS audits were correspondence audits (626,000 audits of Individuals) (3). They are common for low-income taxpayers and Earned Income Tax Credit (EITC) claimants.
Field Audits: Field Audits occur when IRS agents meet taxpayers in person for a financial review. Field audits are generally more intensive and often target higher-income individuals, businesses, and complex financial situations. Since they involve in-person examinations by IRS agents, they are resource-intensive but often lead to substantial revenue adjustments. On average, Field Audits recommended additional taxes of over $85,000 per audit while Correspondence Audits averaged $6,000 recommended additional taxes per audit (4).
IRS Audit Statistics
Typically, the IRS releases detailed statistics on tax audits and compliance activities annually in the IRS Data Book, which provides insights into the agency’s operations, including the number of audits performed in a given fiscal year (5). For instance, in Fiscal Year (FY) 2023, the IRS closed 582,944 tax return audits, resulting in $31.9 billion in recommended additional tax (6). In FY 2023, individuals made up about 76% of all IRS audits, while corporations accounted for around 24% (7). In fiscal year 2024, IRS collected about $5.1 trillion in taxes and paid out more than $553 billion in tax refunds, credits, and other payments (8).
Figure 1: Ratio of IRS Audits for Businesses and Individuals (Source: IRS)
Figure 2: Comparison of IRS Returns, Audits, and Criminal Investigations. (Source: IRS)
Taxpayers and Audits
From a taxpayer’s standpoint, audits can be time-consuming, emotional, and costly. However, most Americans believe paying taxes is a civic duty (9). Tax audits can influence taxpayers reporting honestly as they play an essential role in maintaining tax compliance and ensuring accurate revenue collection.
Many taxpayers hire professional assistance, adding to their expenses. Critics argue that audits impact honest taxpayers who must navigate complex tax laws despite making a good-faith effort to comply (10, 43).
Furthermore, the IRS already possesses vast amounts of financial data from employers, financial institutions, and third-party reports. For an estimated 40% of taxpayers, the IRS can assess tax compliance and auto-file without taxpayer submissions or audits (11). This has led to calls for automated submissions with pre-filled tax returns and automated verification systems.
Legal Tax Avoidance: Involves minimizing tax liabilities available in the tax code. This is every taxpayer’s legal right, and they may fully optimize to the extent allowable by law.
Tax Evasion: This is a criminal offense and is a specific form of Tax Fraud that focuses on illegal tax avoidance. This may include aggressive tax avoidance schemes that may leverage underreporting income, inflating deductions, or using loopholes or tax havens outside the bounds of legal avoidance.
Tax Fraud: This is a criminal offense and covers a wide range of fraudulent activities including underreporting, concealing income, or otherwise avoiding paying taxes. The main feature of tax fraud is the taxpayer’s intent to knowingly not pay taxes they know are lawfully due.
Factors Impacting Tax Audits
The IRS uses algorithms and data analytics to identify tax returns with a higher likelihood of inaccuracies or fraud (12). Taxpayers across all income levels are subject to audits, but the audit rate varies significantly based on income and other factors. For instance, the overall audit rate in 2019 was approximately 0.29%, though certain groups faced higher-than-average scrutiny (13).
Factors: Taxpayer Income
Low-Income Taxpayers: Taxpayers earning below $25,000 annually, particularly those claiming the Earned Income Tax Credit (EITC), faced an above-average audit rate of 0.78% in 2019 (14). EITC is a refundable tax credit designed to support low-to-moderate-income households. However, the IRS estimates that roughly 50% of EITC claims contain errors, contributing to the higher audit rate for this group (15). While the intention of these audits is to ensure proper payment, critics argue that the IRS’s reliance on EITC audits disproportionately affects certain demographics, especially those in low-income brackets (16).
Middle-Income Taxpayers: Individuals earning between $25,000 and $200,000 faced a relatively low audit rate, often below 0.2% (17).
High-Income Taxpayers: While historically subject to higher audit rates, high-income taxpayers saw a notable decline in audits over the past decade. For example, in 2011, approximately 7.2% of taxpayers with income above $1 million were audited. By 2018, that rate dropped to 1.6% (18). In 2021, Accounting Today reported a 72% decrease in IRS audits of millionaires over an eight-year period (19).
Factors: Unreported Income
Unreported Income: A major trigger for IRS automated systems are discrepancies between income reported and information received by the IRS (e.g., W-2s, 1099s, etc.) (20).
Factors: Excessive Deductions
Excessive Deductions: The IRS compares deductions that are significantly higher than the average taxpayers in your income bracket and raises red flags, especially deductions related to business expenses, charitable contributions, and home offices (21).
Factors: Business Losses and Deductions
Business Losses and Deductions: The IRS looks for potential underreporting of income or misclassification of hobbies as businesses that trigger scrutiny. Recurring or substantial business losses, especially for small businesses, may cause the IRS to question whether a business is a legitimate profit-seeking venture (22).
Factors: Errors and Inconsistencies
Errors and Inconsistencies: Calculation errors, typos, or missing data can trigger automated systems to flag these errors that can lead to further review (23).
Factors: Foreign Accounts / Transactions
Foreign Accounts / Transactions: The IRS places increased scrutiny on these transactions due to concerns about tax evasion. Failure to properly report foreign bank accounts or assets can contribute to higher enforcement (24)
Factors: Cash Heavy Business
Cash Heavy Business: Businesses that conduct large portions of their business in cash may draw additional scrutiny as cash transactions are hard to track and subject to underreporting (25).
Figure 4: IRS Audits of Millionaires (2012–2020)(Source: TRAC)
Audit Disparities and Bias
The IRS has been pushed for greater transparency as many of the algorithms and AI that are part of their audit selection process are not provided to the public (26). While these systems are designed to be objective, they can inherit biases based on their design or the data they’re trained on. Several factors including income, race, socioeconomic status, complexity of tax law, and proxy discrimination can occur. For example, certain zip codes or occupations may be disproportionately associated with higher audit rates (27).
Congressional Research has highlighted racial disparities in IRS audit selection (28). A 2023 study by economists at Stanford University found that Black taxpayers are audited at higher rates than other racial groups, even though the IRS does not collect or use data on taxpayer race (29). The disparity appears linked to the reliance on EITC audits, but that does not fully explain why Black taxpayers are disproportionately audited. However, it is important to note that IRS audit algorithms primarily focus on error rates and questionable claims rather than taxpayer race, which the IRS does not collect or use, and the Stanford report did not have race data but instead had to estimate race (30). While the IRS acknowledges these concerns, it has committed to addressing systemic biases in its audit selection processes (31). Modernizing data systems and refining selection algorithms are part of ongoing efforts to ensure audit fairness.
Tax Audits, Compliance and Policy
IRS Tax and Audit data inform policymakers by highlighting areas of the tax code that could improve income generation, social distribution policies, and gaps in tax code that taxpayers use through legal and non-legal means. By analyzing audit data, lawmakers can propose reforms to improve tax code efficiency and effectiveness (32).
Tax audits play a key role in maintaining compliance. By identifying errors, fraud, and underreporting, audits deter tax evasion and promote voluntary compliance. The IRS estimates that every dollar spent on tax enforcement results in several dollars of additional revenue (33).
In addition to direct revenue collection, audits also generate indirect compliance benefits. Knowing that audits are a possibility encourages taxpayers to report their income accurately and claim only legitimate deductions (34).
Overall, the gap between taxes paid and taxes legally owed is known as the “Tax Gap.” The IRS estimated in 2022 that the gross tax gap was $696 billion (35).
The Cost of Tax Compliance
The cost of tax compliance in the U.S. is a significant economic factor, affecting both individuals and businesses. These costs can be broadly categorized into direct expenses, such as paying for tax services or purchasing tax software, and indirect expenses, which include the value of time spent gathering documents and preparing returns.
The Tax Foundation estimates that American Taxpayers spend approximately $133 billion annually on out-of-pocket tax compliance expenses. Combined with the opportunity cost of time spent, the total compliance burden reaches an estimated $546 billion, nearly 2% of the entire US Economy as measured by Gross Domestic Product (GDP) (36).
Americans spend over 6.5 billion hours annually complying with tax regulations. That is the equivalent of over 3 million full-time employees for a year. This time spent represents a significant loss of productivity. The IRS and the Office of Information and Regulatory Affairs (OIRA) provide estimates of the time required to complete tax forms, and these estimates contribute to the overall calculation of compliance costs (37).
Audit Return on Investment (ROI)
Given the stress they induce and effort that is involved, are audits worthwhile? For fiscal year 2023, the IRS had a budget of approximately $14.1 billion, which includes funding for taxpayer services, enforcement (including audits), operations support, and IT modernization (38). In contrast, the IRS’s auditing and enforcement efforts generated about $39.6 billion in additional tax revenue during the same period (39). The IRS intensified efforts to collect back taxes from high-income individuals in 2024, recovering over $1.3 billion from wealthy taxpayers (40). Simply looking at the direct additional revenue alone, and not the additional revenue collected from the deterrent effect of IRS enforcement in general, comparing the approximate $40 billion in revenue against less than $15 billion in total expenses, of which audits are a fraction, the IRS has a net positive return of over $25 billion, so overall a high ROI and worthwhile endeavor. However, looking at the total cost of compliance borne by the taxpayers of the estimated $546 billion or ~2% of GDP, the net positive returns of the IRS $25 billion don’t appear to be as strong an investment (41).
Figure 5: Audit ROI (Source: FRED, Treasury, Tax Foundation, IRS)
Conclusion
Since the US Federal government moved away from tariffs as the primary source of revenue to income, payroll, and corporate taxes, compliance mechanisms became necessary (42). Tax audits, therefore, are a necessary tool of the U.S. tax system, ensuring accurate revenue collection and promoting taxpayer compliance. While audits can be burdensome, they play a crucial role in deterring fraud, promoting fairness, and supporting the nation’s services and fiscal health.
While necessary, with an estimated burden of tax compliance at ~2% of GDP (36), ongoing efforts to improve audit processes that reduce biases, lower the cost and burden on taxpayers are necessary to build trust and efficiently use taxpayer money. Ensuring transparent policies and continued advancements in data analysis, automation, and simplification, the IRS can strike a balance between enforcement, taxpayer rights, and taxpayer burden, ultimately contributing to a more effective tax system benefiting the whole country.
A lot of news and politicians have been talking about “Fair Share” with regards to citizens paying taxes, particularly the so-called Top 1%. Many of these are based on the belief that Wealthy People aren’t paying their “Fair” share of taxes. Americans, maybe more so than many other nations, have an ethos of fairness and doing the right thing. Americans root for the little guy, the underdog. We take special pleasure when there is an upset and the underdog triumphs – who didn’t like Rudy or the Miracle on Ice? We often view the juggernaut as bad or evil, even though in some aspects we look up to their excellence, and dominance, but we still don’t root for them. Often the longer someone is on the top, the more hated they become, often through no fault of their own other than their continued success. Whatever the psychology behind it, maybe our national pastime of taxation and income class wars is rooted in these same notions of fairness.
So at the Tax Project, we wanted to use data and facts to understand this a little better, to see if some groups really are not paying their “Fair” share of taxes.
The first question you have to ask is what is the definition of “Fair.” Immediately, this is challenging as it is subjective and has as many definitions as there are people, but let’s assume for this exercise we can have a general consensus so that we may approach this question. Here is how it is defined, and given that “Fair”, we’ll focus on the definition in context of the question as a place to start.
Right away you see the challenge, nobody is free from bias or completely impartial, and no matter how many facts or how much evidence you use there is always some bias. Some may, rightly or wrongly, feel there has been an injustice performed no matter what based on wealth or contribution disparities. Including some that question why we have billionaires altogether, seemingly asking a philosophical question versus any means of requiring the state to eliminate them in a free society. We have all heard of the story of the Billionaire who paid no taxes. So let’s acknowledge up front that we aren’t going to change how people feel, their bias, or what they think – we hope to inform based on the data and let people come to their own conclusions.
Data
The first place to start is the Data, and if you research this you understand that outside of a few leaked individual reports this is Macro data, meaning it looks at the larger picture of taxes by Income group, and does not look at individuals and their returns. So while a deeper dive into more nuanced analysis would be great to really see the outliers and those that are escaping the tax system, reporting like this is not possible with public data. This information is maintained by the IRS for privacy reasons, and there is no research that is allowed that allows the viewing of individual returns for public release. In fact, wider research is limited, for a variety of factors including privacy and the IRS strict restrictions on protecting individual privacy, so what is often available is data on studies done and released by authoritative sources. In this case, an authoritative source is a data source that is a direct source, is credible, accurate, and reliable. The IRS is the authoritative source for individual tax return information, and they come out with macro data on various topics, including Individual Taxes by income group (not an individual’s return) that break down the data in various formats. For our analysis we will focus on Income, and Taxes paid by different tax brackets as grouped by the IRS in their study, for example the Top 1%, Top 25% of Income earners, etc. from the IRS Individual Tax Returns Statistics of Income studies2. This study analyzed over 150 million tax return submissions, across all income groups from which this analysis is derived.
Definitions of “Fair”
As we talked about above, the definition of what is “Fair” varies, but we can come up with a few different buckets. Some people’s definition of Fairness may have nothing to do with how much they are taxed, more that their income is so much higher than a normal person and that in itself is not fair to this group. However, if we stick purely to definitions that can be applied to what is a “Fair” for a Citizen to contribute to society we can group them into a few buckets based on either the rate of taxation or the absolute amount of taxation.
Apportioned (Equal) – Rate Regressive and Amount Equal Prior to the passing of the 16th Amendment in 1913, taxes had to be “apportioned” meaning equally divided. In this case you would take the total amount required in taxes, divide it up amongst the constituents and each would pay the same or “equal” amount. For some, Equal amounts is their definition of “Fair” and in many contexts most people think of this as “Fair.” For example, if you order a Pizza, and someone else orders the same Pizza, you are charged the same amount regardless of your Income and this is considered “Fair” in context. This would be similar to some Flat tax proposals if deductions were eliminated.
Absolute Amount – Rate Regressive, Amount Progressive In this case, you look at the total contribution made by an individual, and not necessarily pay the same rate. Using the Pizza example customer A would pay $25, and customer B would pay $50 for the same Pizza. In this case customer B is paying twice the amount for the same Pizza, which they may not see as “Fair”, however they are willing to contribute more based on the fact that they make 4 times the income as customer A. Customer A knowing that customer B makes 4 times the income, and pays only twice the absolute amount may not think this is “Fair” as this would be a regressive tax (i.e. the tax rate decreases as the tax amount increases) and they would be paying a lower Rate even if their Absolute Amount was double what they paid.
Share of Income – Rate equal and Amount Progressive In this case, you would pay the same rate, regardless of Income, and the more income you made the more you paid, but you would pay at the same rate as all other taxpayers. So if customer A made $50,000 in income and paid 20% in taxes they would owe $10,000. If customer B made $200,000 in income and paid 20% in taxes they would owe $40,000 in taxes. In Absolute terms customer B is paying 4 times more than customer A but the same rate. Again, customer B may not think this is “Fair” but customer A may think this is a better definition of “Fair.”
Progressive – Rate Progressive and Amount Progressive In this case, you would pay a progressively higher rate as you made more, and a progressively higher absolute amount. So if customer A made $50,000 in income and paid 20% in taxes they would owe the same $10,000. However, if customer B made $200,000 and they paid 40% in taxes they would owe $80,000. So both the Rate and the Absolute amount are Progressively higher. In this case customer B would be paying twice the rate as customer A and 8 times the Absolute amount. In this case many more customer B’s are less likely to think this is “Fair.”
Fair Share
Rate
Absolute Amount
Apportioned (Equal)
Regressive
Equal
Absolute Amount
Regressive
Progressive
Share of Income
Equal
Progressive
Progressive
Progressive
Progressive
Table 1
Your Perspective on Fair
So as you can see, the interplay of Rates and Absolute Amounts may change a person’s opinions on what is “Fair” and it generally depends on that person’s perspective, which often depends on which end of the Income spectrum they fall. A Taxpayer that is paying significantly above the average in taxes may consider that unfair, but someone in a lower income bracket may assume that people in the higher incomes can and should shoulder larger shares of the overall burden.
What is the Reality?
So, we now understand that there are some choices as to how taxes could be applied and very different lenses in which individuals may view taxes from. However, removing feelings, individual bias, and differing perspectives, what does the data show?
Micro View and Exceptions
Well, the answer is that it is definitely nuanced. In the micro view where you look at individual cases there are reports, including famously from ProPublica, that analyzed the taxes of Wealthy Billionaires that showed extremely low overall tax rates, albeit at substantially higher absolute amounts than most Americans pay.1 While the IRS and no other US government agency releases this type data, so the Tax Project could not confirm it, we do believe it is likely that their anonymous sources, presumably from leaked or hacked IRS data, do show that Billionaires, and those at the the very top of the income brackets pay lower rates (fractions of the Top 1%). Editorial side note: While we applaud the transparency of these types of reports and it is important to understand how our Taxes are constituted, publishing private Individuals data is an ethical line we will not cross at the Tax Project regardless of the Transparency value. This and many other similar reports have been the basis for much of the rhetoric regarding “Fair” share. Again, based on your definition of “Fair” it may change your perspective, but we would venture to guess a larger number of individuals would not think of this as a “Fair” share. While some may or may not think this is “Fair,” often it is legal. Meaning, these individuals were utilizing what the law allowed. The reasons are many as to why this may be the case, but in general wealthy people, especially those with businesses and other assets, have access to more deductions, and may derive much of their money and wealth from non income sources. For example Elon Musk may be wealthy on paper because he owns large portions of Tesla, but he may derive relatively little income and only generates taxable income if he sells shares that generate taxable capital gains which are taxed at lower rates than ordinary income. He could live entirely off of borrowing money from banks against the value of his Telsa assets which would generate NO taxable income whatsoever. Based on this, it is not surprising that they have lower tax rates. Reality though, this is more of a legislative challenge in closing loopholes for deductions, and how and which income streams are taxed, especially when it comes to taxing Wealth and not income. That is a whole different philosophical debate, taxing wealth, which we will not discuss in this article but clearly brings in many more ethical questions on top of the “Fair” share questions we attempt to review here.
Macro View and the True Aggregate Data
On the other side of the coin is the Macro view, and for this we have clear data with the aggregate data of over 150 million returns across every income group from authoritative sources. So rather than the statistical blip of a few leaked Billionaire returns, we have what each income group is actually paying and you can make your own assessments if they are paying their “Fair” share.
Figure 1
Review of Macro Data
From the Figure 1 above we can see that the United States has a very Progressive Tax system with the Top 25% of income earners paying more than 89% of income taxes, and the Bottom 50% of income earners paying less than 3% of income taxes. So on a macro basis, clearly the Top 25% of income groups are paying much higher taxes in both percentage rate of income, and overall tax amount. In fact, the rates and amounts go up progressively with each tax group with the exception of the very top of the income brackets where the rate begins to dip. However, we see that the Top 1/10,000 of 1% of tax filings, representing less than 2000 returns of the extremely wealthy, paid 4.7% of income taxes with income shares of 3%. Compared to the Bottom 50%, representing half of the 333 Million Americans (round it to 150 Million Americans) paying 2.3% of income taxes with income shares of 10.4%. While you may not like the income disparity, it is clear the very wealthiest are paying a significant amount of taxes. If we used the Pizza analogy to compare these sub 2000 returns against half of America, the bottom 50% of taxpayers would pay $25 each for their Pizza, and the Top 1/10,000 of 1% would be paying almost $2.5 million each for their Pizza. Is that “Fair?” Again, in the eyes of the beholder, but you can see that as the absolute amount increases at some point those in the higher incomes probably ask at what point is my contribution enough?
Figure 2
From Figure 2 above you can see the amounts paid by each income group in taxes on average. While the Micro view clearly points out there are those in higher income groups reported to be paying very little, however on average the very wealthiest in the Top 1/10,000 of 1% are paying over $66 million each while the Bottom 50% are paying less than $700 each in income taxes. The data points to the fact that the higher income tax brackets are indeed paying significant amounts in taxes at generally higher rates. The income data clearly shows a highly progressive tax system. While this is one view of income taxes, it is also should be noted that there are other sources of government taxes that are more regressive, such as Sales taxes, and in total they tend to burden those in the lower income brackets more, as do all regressive taxes.
Summary
At the Tax Project, we advocate no positions in this area, or any area for that matter. It is clear however, that there is no easy or common definition of “Fair.” We believe that it is important for everyone to start with the same base of information on how our taxes are constituted and who actually pays them. Transparency and not rhetoric, dialogue and not diatribes are our path forward. Healthy discussions on the trade offs in how tax revenue is collected, and what individual contributions and responsibilities should be are all healthy discussions for our Democracy and Society and should be done in the open with full transparency.
The conversation around wealth, particularly the wealth of billionaires or the Top 1%, has intensified. With some pointing to inequality, many ponder whether the ultra-rich hold the key to solving some of the most pressing financial challenges faced by the Nation including the funding of public services through taxation.
Amid discussions on tax reforms and increasing the tax burden on the wealthiest, a crucial question arises: Can Billionaires and their fortunes significantly impact U.S. tax revenue needs if fully utilized?
Assessing the Solution
As of April 2023, there were approximately 2,600 billionaires globally1, with approximately 750 of them residing in the United States. This number is surprisingly low to many people, and the perception from Media may give the impression that many more people live the lifestyle of the rich and famous, like the Kardasians, than actually do. Cryptozoologist Grover Krantz estimated that there were roughly 2000 BigFoot creatures in North America, and if you believe that then you literally have a greater chance of meeting BigFoot than an actual Billionaire in person.2 However, if you did meet them the collective net worth of all U.S. billionaires was estimated at about $4.5 trillion according to Forbes data3.
This is a staggering figure for sure, yet alone for less than 1000 people, the kind of wealth that is hard to comprehend for the average American. However, one’s beliefs and feelings regarding Wealthy individuals and how their wealth should be used and our right to use it is distinct from the elephant in the room: are Billionaires the solution to our Tax problems, and budget shortfalls?
Take it All
To answer this hypothetical question let’s say we appropriated, not just raised their Taxes, but took the entire fortunes of all U.S. billionaires and completely wiped them out, would it cover the U.S. tax needs, and for how long?
For fiscal year 20234, the U.S. federal government spent around $6.2 trillion even though we collected only $4.5 trillion through taxation with the 2024 Federal budget at $6.9 trillion.5 This figure far exceeds the total net worth of U.S. billionaires, and that doesn’t even include State, and Local Taxes which would be over $10 trillion annually spent by our Government as a whole. Thus, even if we theoretically seized and liquidated all billionaire assets, it would only cover a portion of a single year’s federal expenditures, and clearly not be a long term structural solution, what would you do in year 2, year 3?
Challenges with the Solution
Even if you thought this hypothetical situation was a great idea, disregarding the substantial legal and ethical issues taking all of a citizens property create, the challenges and problems it presents make even the thought of using all billionaire wealth as a one time boost would prove even less valuable and daunting on a practical basis. First of all, most ultra Wealthy individuals do not derive most of their networth through income like everyone else which makes their wealth harder to tax and retrieve. They have things like art, equity in companies, stamp collections, Real Estate, and physical capital equipment like Yachts. These things are not cash, they could be assessed at wildly different prices, and at great effort by Federal agencies like the IRS, and much of their wealth may not be easily convertible to Cash. If their cumulative wealth is liquidated, and in this case all at once, it would potentially greatly reduce the value of their assets. I mean, if you took all US Billionaires away, who really is going to buy that $50 million dollar Picasso – how big is that market without Billionaires? If all of the shares they have were sold all at once on the open market, prices of these companies would plummet immediately and drastically, greatly altering their theoretical value and estimated net worth impacting individual investors, mom and pops, retirement plans and pension funds all at the same time.
Bottom line, even if you were successful at capturing their assets they would likely be a small portion of their originally estimated value. All this makes the assumption that you would have access to all their assets, and that they wouldn’t hide their wealth, move it offshore, to another country, someplace outside of US reach. Given that they are likely the ones with the means, and ability to pull this off with armies of lawyers, accountants, foreign officials, and banks in their pocket, it would be hard to imagine all their wealth being exposed. However, if the capital, jobs, and innovation that these individuals put into our country disappeared overnight the economic disaster that would ensue after the impact to many of the worlds largest companies through seizure of billionaires assets (which include privately owned companies) and loss of their intellectual and monetary capital, could and probably would have major impacts on the US economy, and likely have a global impact.
Tax Some, but not all, but clearly more
So now that we understand the challenges and implications of taking it all, we can assess the more practical solution of taking some, but not all, but clearly more than we do today from Billionaires. While this is a more likely scenario, and potentially more sustainable, it too has a number of challenges. First, if taking all their wealth wasn’t enough, how is taking a much smaller percentage going to help? Let’s assume that all the tax loopholes are plugged up, and the rates on millionaires increase, President Biden has proposed a minimum 25% tax on the ultra wealthy.6 Given that more than 2/3rds of the approximate 750 Billionaires in the US have less than $5 Billion in Net Worth, if you were able to generate a very substantial $250 Million per year each from this group would net roughly $150 Billion a year. This scenario still isn’t likely given that many of the challenges and implications previously discussed still apply to this scenario, and taking 5% or more of their net worth per annum may not be sustainable. However, since it’s all theoretical it’s a nice budget filler, although it still doesn’t address our needs with annual budget shortfalls over a Trillion dollars. The Interest line item alone on our National Debt was more than 4 times this amount, and growing rapidly ($659 Billion).7 The Kiel Institute for the World Economy estimates that since February of 2022 the US has sent $75 Billion in aid to Ukraine alone8, and that does not include the $95.3 Billion dollar Ukrainian and Israeli aid package recently passed in the US Senate together more than the budget filler for just these one time aid packages.9
The Answer
A portion of the population may support these routes, though maybe not realizing the challenges and implications, whether it be because of the squeeze of higher taxes and the need/want for more services and the inability of the lower and middle class to pay for these, or the thought that the wealthy don’t pay their fair share (See our article on Fair Share), or that Wealth Inequality is unfair in general and they don’t like it, that the tax system has so many legal loopholes that wealthy individuals can exploit to have lower taxes than the poor, plain simple old fashioned jealousy, or the fact that it’s a lot easier to spend other people’s money. Whatever the reason, the concept is clear: Let the ultra rich cover the burden.
Political Calculus
Sadly, Politicians have already done the math, and they understand that it doesn’t work out. They know that Billionaires aren’t the magic bullet, but it makes for great campaign rhetoric and easy sound bites for those willing to believe it and it’s a lot easier and less politically risky than actual solutions. Unfortunately, there is no easy solution to properly fund the US government without significant “investment” from ordinary taxpayers and more responsible fiscal management by our Government. The solutions are Simple, but not Easy. Just like a family that is spending more than they make, the only two solutions are to spend less, or make more. While simple, those are never easy; cutting spending, government shrinkage, and/or higher taxes across the board don’t sit well with the electorate.
“I could end the deficit in five minutes. You just pass a law that says anytime there is a deficit of more than 3% of GDP, all sitting members of Congress are ineligible for re-election.”10
Warren Buffett
Summary
While the wealth of billionaires is vast, it’s a drop in the bucket of our trillion dollar annual budget deficit and $34 trillion dollar national debt challenges, viewing it as a panacea for the U.S.’s fiscal challenges overlooks the complexity of the economy and the nature of wealth. Tax policy is a tool that can influence wealth distribution and revenue generation, but it requires a balanced approach that considers economic growth, fairness, and sustainability. Simply put, there’s no magic bullet when it comes to tax policy and fiscal sustainability. Like a complex puzzle, it demands careful consideration of each piece to create a coherent and effective solution and the will and stomach to handle it. Billionaires may not be the answer, but they can surely be part of the answer, along with a lot of other ordinary people. Our choices as Citizens of how many services we want, how much we want to pay for them, and who should bear the burden are the balancing act that shapes our democracy.
Taxation, often seen as unavoidable, is more an art form than a mere financial obligation. It is a delicate balance between funding government operations and not overburdening the taxpayers.
“The art of taxation is the art of plucking the goose so as to get the most feathers with the least hissing.” Jean-Baptiste Colbert
This concept was famously summed up by Jean-Baptiste Colbert, who knew that taxation was the art of collecting the most taxes while minimizing the complaints over taxation.1 This analogy is more relevant today than ever, especially when considering the U.S. tax system’s complexity and its relationship with citizens.
The challenge lies in the inherent tension between the need for the government to collect taxes to fund public services and the natural desire of individuals and businesses to minimize their tax liabilities. Tax policies must be designed to be fair, efficient, and effective, encouraging compliance while discouraging evasion and avoidance. This balance is precarious, and tipping too far in one direction can lead to dissatisfaction, economic distortion, or both.
The Challenge of Taxation
How to solve Unlimited Wants with Finite Means
Jean-Baptiste Colbert, serving as the Finance Minister under King Louis XIV of France, revolutionized the way we think about taxation.1 His philosophy emphasized the importance of a tax system that is as painless as possible for the taxpayer while still being effective in meeting the needs of the state. His approach underlines today’s tax policies, aiming for a system that extracts necessary resources without stifling economic growth or public contentment.
US Tax Code
The U.S. tax code, a labyrinth of rules and regulations, is a testament to the complexity and intricacy of modern taxation. It is akin to a vast, sprawling metropolis, where every street, building, and alleyway has been meticulously planned, yet can still confound those navigating it without a map. This complexity arises from the need to address a multitude of scenarios, ensuring fairness across diverse economic situations.
Taxation in the U.S. embodies a symbiotic relationship between the government and its citizens. As with the ebb and flow of a river, so goes our taxes. Over various periods of time we have expected our government to provide more or less services and that balance of what the government provides, and what individuals provide creates the basis for the Social Contract (See our article: Social Contract). It is a partnership where individuals and businesses give up some of their freedoms and liberties to live in a society fueled by their taxes that provide the public services everyone relies on, from roads and schools to national defense and social welfare programs. This relationship requires trust and transparency, where taxpayers comply with their obligations, believing in the effective use of their contributions.
The Art of Taxation
The “art” of taxation, therefore, lies in crafting policies that achieve the delicate balance of maximizing revenue without discouraging economic activity or provoking widespread discontent. It is about understanding the psychology of taxpayers, employing strategies that encourage voluntary compliance, and designing a tax system that is perceived by citizens as fair and just.
A Model used by economists called the Laffer Curve2 is a U-shaped curve that shows the relationship between tax rate and tax revenue. If you tax someone nothing and move the tax up to 1% people will continue to work and revenue will rise. As rates on taxes rise, revenue continues to rise until the rates reach a point where rates are too high. The curve begins to bend before plateauing and people begin actively avoiding paying taxes (through legal and illegal means). After it plateaus, revenue begins to drop and people are both actively avoiding taxes, and at a certain point dropping out of the workforce as it is no longer worthwhile. For example, if you were taxed at 100%, would you work? Obviously not, as there would be no reward for your labor, and the model reflects that knowing that people will stop working well before 100%.
The art of taxation is akin to weaving a complex tapestry, where each thread represents a different tax rule or policy, and the goal is to create a harmonious and functional whole. It requires a deep understanding of economics, sociology, and human psychology, like Colbert’s approach centuries ago, proving that while the tools and context may have evolved, the underlying principles of effective taxation remain timeless.
Tax Project Institute is a fiscally sponsored project of MarinLink, a California non-profit corporation exempt from federal tax under section 501(c)(3) of the Internal Revenue Service #20-0879422.
