How Do High-Income People Avoid Paying Federal Income Tax?

By :: September 5th, 2013

Most of the 43 percent of Americans who the Tax Policy Center projects will pay no federal income tax this year make very little money. Some are middle-income households that qualify for enough tax preferences to zero out their tax bills. But more than 70,000 households with income over $200,000 will pay no federal income tax in 2013. How will they do that?

Some have very high medical expenses but the two biggest reasons are linked to their investments: foreign tax credits and tax-exempt bonds.

 TPC’s hit video explains why the 43 percent pay no federal income tax. But for a closer look at why high-income households pay no income tax, it helps to turn to the IRS’s Statistics of Income (SOI) division.

Each year, SOI focuses on two overlapping groups of returns with income over $200,000: those who pay no income tax to the U.S. and those who pay no tax worldwide.

The first includes people whose U.S. liability is zeroed out by domestic tax preferences combined with foreign tax credits and the exclusion of overseas income taxed abroad. The second includes only those who don’t pay any net income tax at all. The analysis also uses two alternative measures of income to define high-income tax units: adjusted gross income (AGI) and “expanded income,” which adds excluded income such as tax-exempt interest and untaxed Social Security. (The second measure is closer to—but not the same as—the Tax Policy Center’s “expanded cash income.”)

The latest installment of the SOI analysis found that about 3 percent of the 143 million tax returns filed in 2010—4.3 million—had expanded income over $200,000. Almost 33,000 (0.8 percent) paid no tax to the IRS in 2010 and about half of those paid no income taxes worldwide.

Nearly 40 percent of those paying no domestic income tax benefitted most from the foreign tax credit and roughly another third saved most because of tax-exempt interest. Various itemized deductions mattered most for about 15 percent of tax filers.

Among those who had no worldwide tax liability, coupon-clipping was the biggest reason. Fully 60 percent of the 16,000 returns paying no net tax benefited most from tax-exempt bond interest. Extraordinary medical expenses, which are currently deductible to the extent that they exceed 10 percent of AGI, were the main reason why another 11 percent of high-income households paid no tax.

It’s likely that some taxpayers save a lot by using tax avoidance techniques that don’t show up in the SOI data.  Some of the most successful tax shelters simply defer or otherwise mask income so that a well off person can appear to have relatively modest means.

Most of the high-income tax filers who don’t pay income tax hardly get off scot-free. Those who don’t pay the IRS because of foreign tax credits obviously ante up to other countries. Those who benefit from the exclusion of municipal bond interest pay an implicit tax since tax-exempt bonds earn a lower interest rate than taxable bonds. And, of course, high-income households pay many other taxes. But for a small group of lucky duckies, our current system of tax preferences makes it possible to avoid paying any federal income tax.

12Comments

  1. Eugene Patrick Devany  ::  9:54 am on September 5th, 2013:

    Most honest government reports recognize that a worker’s income tax liability includes not just his portion of the payroll tax but also the employer’s portion of the payroll tax – about 15% (combined) plus another 15% or more ordinary income tax on earnings over $17,000. My interest in recognizing the social security and Medicare revenues as a real part of the income tax is reality based and part of a broader effort to make elimination of the “payroll” taxes a part of tax reform.

    The approximately 15% tax on U.S. labor income is a job killer and it could easily be replaced or reduced by a revenue neutral value added tax (VAT). A few years ago Rep. Paul Ryan called for an 8 1/2% VAT to entirely replace the C corporation income tax rate – but there was no plan for the pass-through corporations.
    A 4% VAT for both C corporations and pass through corporations could replace the business portion of the job killing payroll taxes and encourage domestic labor. Reducing the U.S. tax on labor would help businesses to create more jobs in the U.S., pay for benefits like health care, and/or increase wages. A VAT is considered the fairest way to apportion taxes among different types of businesses and across different taxing jurisdictions by every developed country in the world.

    Comprehensive tax reform that includes an “optional” 2% tax on net wealth (excluding $15,000 cash and $500,000 retirement savings) could reduce both the individual and C corporation tax rate to 8% and eliminate all payroll taxes. A higher 26% income tax rate (plus capital gains, gift and estate taxes) could be paid by those who choose to avoid the net wealth tax.

    There is nothing wrong with giving individuals the option of deferring (but not eliminating) their fair share of taxes. While most would choose the 8% income and 2% net wealth tax combination, some very wealthy individuals with a lot of capital appreciation compared to income, might prefer to avoid a net wealth tax and pay a higher 26% income tax rate. The choice would not be an easy one for Warren Buffett. He might even pay the same rates as the poor.

  2. Ralph H  ::  1:52 pm on September 5th, 2013:

    Why not eliminate tax exempt bonds. They only encourage overspending and wasteful practices by states, municipalities and semi government agencies. Also gives a distorted view of income distribution.

  3. Michael Bindner  ::  12:04 am on September 6th, 2013:

    Unless we have a transnational income tax, foreign income will likely continued to be taxed only where the assets earned the money. I don’t see anyone, save myself, yearning for the day when there is OECD wide taxation and governance and a truly international method of electing a chief executive and commander in chief (rather than having the POTUS continue in this role with no non-US electors). As for tax exempt bonds, getting rid of tax exemption would just make bond interest higher and force bond issuers to withhold the taxes. That just increases paperwork and costs for no good reason.

  4. 2014 TAX FREE STATES DELAWARE  ::  11:19 pm on September 6th, 2013:

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  5. AMTbuff  ::  7:51 pm on September 11th, 2013:

    Owners of tax-exempt bonds get less net income than owners of taxable bonds. The interest rates are lower by approximately the amount of tax savings. The benefit of the tax break flows through to the borrowing state or local government agency. Stating flatly that the owners of these bonds pay no tax is highly misleading at best. In economic terms, the assertion is a lie.

    This is only mitigated by the fact that the author essentially retracts the claim in the very last paragraph: “Most of the high-income tax filers who don’t pay income tax hardly get off scot-free. Those who don’t pay the IRS because of foreign tax credits obviously ante up to other countries. Those who benefit from the exclusion of municipal bond interest pay an implicit tax since tax-exempt bonds earn a lower interest rate than taxable bonds.”

    Indeed. The tax is paid, but to a different government. That information should have been at the top of the article, not the bottom. The author should have explained to less informed readers that the implicit tax rate on municipal bonds is not far from the explicit tax rate on taxable bonds. As this article stands, it looks like sensationalism at best and an attempt to misinform at worst.

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