Suggestions that Republicans should allow the top federal individual tax rate to revert from 37 percent to 39.6 percent have sparked significant debate within the party as negotiations continue over how to fund the renewal of the Tax Cuts and Jobs Act (TCJA). While adjusting tax rates is one way to raise revenue, policymakers should seriously consider alternative methods that avoid the economic risks associated with higher marginal rates.
Indeed, the practical impact of raising the top rate to 39.6 percent may be limited, given that much of the income of the most affluent taxpayers does not face ordinary tax rates at all. Instead, these taxpayers often benefit from lower special rates such as qualified business income (29.6 percent), long-term capital gains and dividends (23.8 percent), or even a 0 percent rate on multiple categories of investment income.
Some of these special rates help prevent double taxation, but others are loopholes and special-interest carve-outs that facilitate legal tax avoidance. Republicans have consistently argued that the most economically sound strategy to increase revenue is broadening the tax base rather than simply raising rates. Before even reaching a debate between 37 percent and 39.6 percent, Congress should take a look at income that escapes taxation entirely.
If policymakers are looking to fund pro-growth and pro-family tax relief, here are four loopholes worth addressing which together raise around $500 billion:
1. "Buy-Borrow-Die"
Wealthy individuals can indefinitely defer capital gains taxes because those taxes only kick in after selling an asset. Even better for high earners, a "step-up in basis" allows heirs to inherit those assets tax-free. Thus, wealthy individuals borrow against assets such as securities, enjoy the proceeds tax-free, and then pass the appreciated assets to heirs without triggering taxes. Congress can tackle this by imposing an 8 percent excise tax on loan withdrawals secured against appreciated securities (and possibly other assets). This would generate roughly $100 billion over ten years.
2. Stock Buybacks
Companies often reward shareholders via stock buybacks instead of dividends due to favorable tax treatment. This distortion encourages buybacks purely for tax reasons. The Inflation Reduction Act implemented a modest 1 percent excise tax on buybacks, but experts suggest a 4.6 percent tax is needed to equalize tax treatment with dividends. Increasing the buyback excise tax to between 2 percent and 4 percent would raise between $88 billion and $246 billion, respectively, and move closer to fair taxation.
3. Qualified Small Business Stock (QSBS)
The QSBS exemption allows investors and startup founders to exclude up to $10 million (or ten times the basis) in gains on certain small-business stock held for at least five years. Intended to encourage investment in start-ups, QSBS now largely benefits wealthy investors for making investments they would have made anyway. Repealing this exclusion entirely would yield around $81 billion.
4. Excess Qualified Business Income Deduction (Section 199A)
This deduction lets pass-through business owners (like partnerships and S-corporations) deduct 20 percent of their business income from regular rates. However, due to its design, many taxpayers receive tax reductions greater than the 20% tax cut intended by Congress. Congress can preserve the intended tax relief for businesses while preventing excessive benefits by adopting a simplified rate structure taxing qualified business income at precisely 80 percent of regular individual rates. This preferred rate structure would save $82 billion relative to a straight extension of the existing deduction.
America’s fiscal situation is deteriorating rapidly. Instead of defaulting to rate hikes alone, policymakers should focus on closing tax loopholes that undermine our tax system’s fairness and integrity. Paying for extensions like the TCJA isn’t easy, but tackling these loopholes would be a smart place to start.
