Increase Individual Income Tax Rates
CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.
|Billions of Dollars
|Decrease (-) in the Deficit
|Raise all tax rates on ordinary income by 1 percentage point
|Raise tax rates on ordinary income in the four highest brackets by 2 percentage points
|Impose a surtax of 1 percentage point on AGI above the standard deduction and exemption
|Impose a surtax of 2 percentage points on AGI above the sum of the standard deduction, exemptions, and the threshold of the fourth ordinary income tax bracket
As specified in the tax code, an individual income tax is imposed on the wages, salaries, investments, and other forms of income that people earn. The tax code indicates both how to measure income subject to taxation and the tax rates that apply to that income.
Individuals are required to calculate three main measures of income on their tax return: total income, adjusted gross income (AGI), and taxable income. Broader measures of income allow for fewer deductions. The broadest measure of income on an individual tax return is total income, which includes income from all sources not specifically excluded by the tax code. The next-broadest measure is AGI, which is total income minus certain deductions, called statutory adjustments. Those adjustments to income include a portion of the self-employment tax, certain contributions to retirement accounts, and interest on student loans. AGI is typically the measure of income used in the tax code to phase out preferences for higher-income taxpayers. Under current law, no tax rate applies directly to total income or to AGI.
A narrower measure of income—taxable income—is the measure of income that is subject to the individual income tax. Taxable income is AGI minus allowable deductions. Those deductions include personal exemptions (an amount taxpayers can claim on behalf of themselves, their spouses, and their dependents), and either the standard deduction, which is based on filing status, or itemized deductions, which are based on expenses or losses incurred.
The 2017 tax act (Public Law 115-97) temporarily changed the way taxable income is measured by suspending personal exemptions, increasing the value of the standard deduction, and changing limits on itemized deductions. Additionally, a deduction is available to owners of certain pass-through businesses, such as S corporations, partnerships, and sole proprietorships. At the end of calendar year 2025, nearly all provisions of the 2017 tax act that affect individual income taxes are scheduled to expire.
The regular income tax (as opposed to the alternative minimum tax, or AMT, which is described below) is computed using two tax-rate schedules that apply to taxable income. Those schedules depend on the source of the income. The first rate schedule applies to taxable ordinary income, which is taxable income other than qualified dividends and most long-term capital gains. (Qualified dividends include most dividends. Long-term capital gains are those realized on assets held for more than a year.) The second rate schedule applies to taxable income in the form of qualified dividends and long-term capital gains.
The tax code applies different statutory tax rates to different portions of people's taxable ordinary income. Beginning in 2018, the 2017 tax act lowered the tax rates that apply to ordinary income through 2025. Tax brackets—the income ranges to which different rates apply—vary depending on taxpayers' filing status and are adjusted, or indexed, each year to include the effects of inflation (see the table below). Through calendar year 2025, taxable ordinary income earned by most individuals is subject to the following seven statutory rates: 10, 12, 22, 24, 32, 35, and 37 percent. At the end of 2025, the rates will revert to those in effect under pre-2018 tax law. Specifically, beginning in 2026, the rates will be 10, 15, 25, 28, 33, 35, and 39.6 percent.
|Starting Points for Tax Brackets in 2022 (Dollars)
|Statutory Tax Rate on Ordinary Taxable Income (Percent)
A separate rate schedule specified in the tax code applies to taxable income in the form of qualified dividends and most long-term capital gains, with a maximum statutory rate of 20 percent. Investment income received by higher-income taxpayers, which includes income from all capital gains and dividends, is also subject to an additional tax of 3.8 percent.
Certain taxpayers are subject to the AMT. (The AMT works in parallel with the regular income tax; it is similarly structured but has fewer exemptions, deductions, credits, and rates. Households must calculate the amount they owe under both the AMT and the regular income tax and pay the larger of the two amounts.) Those taxpayers face statutory rates of 26 percent and 28 percent on ordinary income; long-term capital gains and dividends are still taxed at a maximum rate of 20 percent. The 2017 tax act significantly limited the reach of the AMT for calendar years 2018 through 2025 by increasing the amount of income that is exempt from the AMT and by limiting the deduction for state and local taxes under the regular income tax.
For tax year 2019, the Internal Revenue Service (IRS) reported $12.1 trillion in total income and $12.0 trillion in AGI on 158 million returns, of which $9.2 trillion was taxable income. Of that taxable income, $8.3 trillion was taxed at ordinary income rates, generating $1.5 trillion in tax liability; a quarter ($2.1 trillion) of ordinary income was taxed at the four highest rates. Of the 158 million returns, 123 million reported taxable ordinary income.
This option focuses on different approaches to increasing individual income tax rates.
Key Design Choices
Raising individual income tax rates to increase revenues could be accomplished in several ways. To implement such a change, policymakers would need to consider two key design choices:
- Which measure of income to use for the tax base; and
- Which taxpayers would be affected by the change.
Which Measure of Income to Use for the Tax Base. Increasing the rate of existing taxes on ordinary income could raise revenues without placing an additional administrative burden on taxpayers and the IRS. Using a broader measure of income as the base for income taxes would add some administrative burden but could raise more revenue than a change to ordinary rates. For example, a tax could be levied on AGI or on total income. Imposing a new tax on AGI would limit the value of exemptions and deductions, whereas a tax on total income would limit the value of exemptions, deductions, and statutory adjustments.
Which Taxpayers Would Be Affected by the Change. Individual income taxes are progressive—that is, higher-income households pay a larger share of their income in taxes than lower-income households do. The progressivity of the tax system would increase if a policy change imposed a larger increase in taxes (as a share of income) on households with higher income than on households with lower income. That could occur if rates increased only for people at higher levels of income or only on certain types of income received mostly by higher-income taxpayers. (For example, most capital gains are realized by people with significant wealth and income.) But rate changes also would raise the value of exclusions and deductions used largely by higher-income taxpayers.
This option consists of four alternatives for raising revenues under the individual income tax. Each would go into effect in January 2023.
- Under the first alternative, all statutory tax rates on ordinary income (income subject to the regular rate schedule) would increase by 1 percentage point. For example, in 2023, the top rate of 37 percent would increase to 38 percent, and in 2026, the top rate of 39.6 percent would increase to 40.6 percent.
- Under the second alternative, the statutory tax rates on ordinary income in the four highest brackets (24 percent or more through 2025, and 28 percent or more after 2025) would increase by 2 percentage points. For example, in 2023, the top rate of 37 percent would increase to 39 percent, and in 2026, the top rate of 39.6 percent would increase to 41.6 percent.
- Under the third alternative, a surtax of 1 percentage point would be imposed on adjusted gross income above the sum of the standard deduction and personal exemptions. For example, a single taxpayer with AGI of $1,000,000 in 2023 would pay a 1 percent tax on the $986,150 of his or her AGI above $13,850 (a standard deduction of $13,850 and a personal exemption of zero).
- Under the fourth alternative, a surtax of 2 percentage points would be imposed on adjusted gross income above the sum of the standard deduction, personal exemptions, and the threshold of the fourth ordinary income bracket ($95,375 for single filers and $190,750 for joint filers in 2023). For example, a single taxpayer with AGI of $1,000,000 in 2023 would pay a 2 percent tax on the $890,775 of his or her AGI that was above $109,225 (a standard deduction of $13,850, a personal exemption of zero, and the threshold of the fourth ordinary income bracket for single filers).
Effects on the Budget
The first and second alternatives would modify specific individual income tax rates on ordinary income, whereas the third and fourth alternatives would apply to AGI. Because the third and fourth alternatives would affect a broader measure of income, both would result in a significantly larger reduction in the deficit than the similar percentage-point increase in rates that would be implemented under the first two alternatives.
If implemented, the first alternative—raising all statutory tax rates on ordinary income by 1 percentage point—would reduce the deficit by a total of $1.1 trillion from 2023 to 2032, according to estimates by the staff of the Joint Committee on Taxation (JCT). The second alternative—raising rates only on ordinary income in the four highest brackets by 2 percentage points—would target specific individual income tax rates and thus affect fewer taxpayers but would increase those rates by a larger amount. Such a change would reduce the deficit by $502 billion from 2023 to 2032, according to JCT. The revenues realized by raising rates on ordinary income would be affected by the share of taxpayers subject to the AMT. As more taxpayers became subject to the AMT after 2025, less revenue would be raised from an increase in ordinary income tax rates.
The third alternative—imposing a tax rate of 1 percentage point on AGI above the sum of a taxpayer's standard deduction and personal exemption amounts—would reduce the deficit by $1.3 trillion from 2023 to 2032, according to JCT. The fourth alternative—imposing a tax rate of 2 percentage points on AGI above the sum of a taxpayer's standard deduction, personal exemption, and the starting point of the fourth ordinary income tax bracket—would affect fewer taxpayers than the third alternative. That alternative would reduce the deficit by $774 billion from 2023 to 2032, JCT estimates.
Because they would increase marginal tax rates, all of the alternatives would most likely affect taxpayers' behavior. (The marginal tax rate is the percentage of an additional dollar of income that is paid in taxes.) For example, because the first two alternatives would increase marginal tax rates on ordinary income, people might shift income from taxable forms to nontaxable or tax-deferred forms. That could be accomplished in several ways: For instance, they might substitute tax-exempt bonds for other investments, opt for more tax-exempt fringe benefits instead of cash compensation, or spend more on tax-deductible items and less on other items (for instance, by paying more toward their home mortgage interest and spending less on other things). Taxpayers would also have an incentive to mischaracterize or not report the nature of some income. Specifically, increasing rates on ordinary income would increase taxpayers' incentive to mischaracterize labor compensation and profits, which are taxed at ordinary rates, as capital gains. These estimates reflect such behavioral responses.
Imposing a tax on AGI, which would raise the marginal tax rate on both ordinary income and income from capital gains and dividends, would probably result in a smaller set of behavioral responses. Taxpayers would most likely still shift income from taxable forms to nontaxable or tax-deferred forms; but, because AGI is a broader measure of income than ordinary taxable income, there would be fewer ways to do so. Taxpayers could still opt for more fringe benefits that are excluded from AGI or realize fewer capital gains, either by deferring the sale of their capital assets or by not selling some of those assets during their lifetime. However, the incentives to increase spending on tax-deductible items and recharacterize income as capital gains would not exist.
Those behavioral responses would be more pronounced if larger increases in individual income taxes were implemented. As a result, the deficit effects of large rate increases or surtaxes might not be proportional to the estimates shown here.
Uncertainty About the Budgetary Effects
The estimates of the budgetary effects of this option are uncertain for two main reasons. First, they rely on the Congressional Budget Office's 10-year projections of the economy and of individual income under current law, which are inherently uncertain. Second, they rely on estimates of how taxpayers would shift income and change reported income in response to the change in tax rates. Those estimates are based on observed responses to prior changes to tax rates, which might differ from the responses to the changes considered here. The estimates for the alternatives to increase the rates on ordinary income may be more uncertain than the estimates for an AGI surtax because the opportunities for behavioral responses to a surtax on AGI would be more limited.
By increasing rates for all ordinary income brackets by 1 percentage point, the first alternative would increase the amount of federal income taxes paid by all households with ordinary income. By increasing rates only on ordinary income in the four highest tax brackets, the second alternative would increase taxes only for higher-income households. That change would increase the progressivity of the tax system because, without tax increases at the lower end of the income distribution, it would place a relatively larger burden on higher-income households.
The third alternative—imposing a surtax of 1 percentage point on AGI above the personal exemption and standard deduction—would increase the amount of federal income taxes paid by almost all households. But compared with a 1 percentage-point increase in all tax rates on ordinary income, a tax on AGI would have a larger effect on the share of income paid in taxes by higher-income households. The various exclusions, deductions, credits, and preferential tax rates on certain investment income under the individual income tax currently allow some higher-income households, especially those whose income is primarily in the form of capital gains and dividends, to pay a smaller share of their income in taxes than many lower-income households do, especially those whose income is primarily in the form of wages or salaries. By creating a tax on AGI, a measure of income that has limited exclusions, the third alternative would increase the share of income paid in taxes by some higher-income households compared with the first alternative.
The fourth alternative—imposing a surtax of 2 percentage points on AGI above the sum of the personal exemption, standard deduction, and the threshold of the fourth ordinary income tax bracket—would increase the share of income paid in taxes by higher-income households more than the third alternative would. With the larger exemption amount, this surtax would apply only to higher-income households, and with the larger rate increase, the additional amount those households owed would be greater.
In addition to having the behavioral effects reflected in conventional budget estimates, such as the ones shown above, a change to the individual income tax would affect taxpayers' work and saving behavior. All four alternatives would raise the marginal tax rates that some individuals face. Higher tax rates would reduce people's incentives to work and save. By lowering after-tax wages and salaries, all of the alternatives would discourage people from working because other uses of their time would become relatively more attractive. Increases in tax rates can also cause people to work more hours because having less after-tax income requires additional work to maintain the same standard of living. CBO estimates that, on balance, the former effect would be greater than the latter effect. A new tax on AGI, which includes long-term capital gains and qualified dividends, would raise the marginal rate on capital income, thus discouraging saving and investment.
As a way to raise revenues, an increase in ordinary income tax rates would offer some small administrative advantages over other types of tax increases because it would require only minor changes to the current tax system. Because there is no tax on AGI under current law, adding one would reduce the transparency of the tax system, making it more complicated for individuals to understand how their actions would affect their income tax liability.