How Does Federal Income Tax Progressivity Vary by Income Source?

Every year, millions of Americans pay federal income taxes, but not all forms of income receive the same tax treatment. The federal income tax system is generally described as “progressive,” meaning that effective tax rates rise with income. But where does that progressivity come from? Does it apply equally to a paycheck and an investment dividend?

This blog post explores these questions using data from the 2022 Survey of Consumer Finances (SCF), the most recent survey available. We proceed in two steps. First, we estimate the effective tax rates — the percentage of total income paid in federal income taxes — for the surveyed households’ taxpayers and examine how these rates vary across income levels. Second, we compare the composition of income with the estimated tax burden associated with different income sources.Responses in the 2022 SCF pertain to tax year 2021. Our methodology extends the work of William G. Gale and others, published in a January 2022 Tax Policy Center report, by estimating taxes using Version 35 of the National Bureau of Economic Research’s TAXSIM calculator. As in that paper, the unit of analysis is a single tax filing — the primary taxpayer and, if married, a spouse — rather than a household. A tax filing may cover one person or a couple, while a household includes people who live at the same address; these groups often overlap but are not identical.

Tax Progressivity Varies by Income Source

Our analysis reveals a generally progressive overall system, but one whose progressivity varies significantly by income source. The lowest-income group receives refundable credits that exceed its federal income tax liability, resulting in an effective tax rate of -12.4%. At the other end, the highest-income group faces a rate exceeding 25%.

However, this progressivity is not uniform across income sources. Wage income — which contributes the most to net tax burdens across the income distribution — has a distinctly progressive profile for its effective tax rate while investment and other nonwage sources show substantially flatter rates across income levels.

Effective Tax Rates by Income Level

To understand how tax burdens change across income levels, we divided the 2022 SCF household responses into income deciles and calculated each decile’s effective tax rate. We then decomposed each decile’s overall effective tax rate into the contributions associated with four income categories:

• Wage income, which comprises wages earned by the household’s primary taxpayer and spouse
• Investment income, which comprises dividends, interest and short-term and long-term capital gains
• “Social safety net” income, which comprises pensions, Social Security and unemployment insurance
• “Other” income, which comprises a range of business, property and other income“Other” income captures qualified business income, income earned from a specialized service trade or business, income received from involvement in an S-corporation, and income from property and other nonproperty sources, such as nonqualified dividends and alimony.

The first figure below presents the results.

The figure reveals a generally progressive system: Overall, estimated effective tax rates steadily rise from -12.4% in the lowest-income decile to 25.0% in the highest — a difference of about 37 percentage points. The negative rates in the bottom two deciles result from refundable tax credits, particularly the earned income credit (EIC), that exceed these groups’ federal income tax liabilities.Eligibility for the EIC and the size of the credit depend on income, age, number of dependents, and marital status. In other words, the lowest-income groups, on average, receive more through refundable credits than they owe in federal income taxes.

The figure also shows wage income accounts for the largest portion of each decile’s net tax burden. However, the figure alone cannot tell us why wage income plays such a large role. Its contribution could reflect that people receive more income from wages, that the estimated tax rate on wages varies more sharply across income levels, or both. To distinguish between these explanations, we next compared each source’s share of total income with the effective rate associated with that source.

Income Composition and Effective Tax Rates by Source

The following figures separate the roles of income composition and source-specific rate for three representative groups: the lowest-income (first decile), middle-income (fifth decile) and highest-income (10th decile) groups. The horizontal axis shows each source’s share of total income, while the vertical axis shows its estimated effective tax rate. Together, these dimensions show both where income comes from and how the estimated tax burden varies across those sources.

SOURCES FOR THE THREE FIGURES: Survey of Consumer Finances, National Bureau of Economic Research’s TAXSIM calculator and authors’ calculations.

NOTE FOR THE THREE FIGURES: QBI is qualified business income, SSTB is income earned from a specialized service trade or business, and S-Corp is income received from involvement in an S-corporation.

The figures confirm the importance of wages in explaining the results from the first figure. Primary taxpayer wages alone account for about 71% of total income in the lowest decile, about 64% in the middle decile and 52% in the highest. Including spouse wages further increases the role of wage income for the middle- and highest-income groups. Income composition is therefore part of the explanation for why wages account for most of the tax burdens shown in the first figure.

But the estimated effective tax rate on primary taxpayer wages also changes substantially across income levels. For the lowest-income group, primary taxpayer wages have a rate of -12.2%, reflecting the role of refundable credits. The rate is positive but remains in the single digits for the middle-income group, before rising to 22.6% for the highest-income group — a difference of nearly 35 percentage points when compared with the lowest-income group. This sharp increase helps explain the overall progressivity documented in the first figure.

Nonwage Income Sources Have Flatter Tax Rates

Other income sources have flatter tax rate profiles. Consider investment income. When the four investment categories are added, the lowest-income group receives relatively little investment income — 3.3% of total income — and has an estimated effective tax rate near zero on these sources. The highest-income group receives 11.6% of its income from investments, while the rates on the individual investment sources generally range between 10% and 20%, as shown in the fourth figure. The estimated rates on investment income vary by less than 20 percentage points between the lowest- and highest-income groups, compared with a difference of nearly 35 percentage points for primary taxpayer wages.

Several other nonwage income sources show a similarly flat pattern. These differences matter because investment and other nonwage income account for a larger share of income among the highest-income group. As a result, the overall effective tax rate reflects both the sharply rising rate on wages and the flatter rate on nonwage income, which become increasingly important at higher income levels.

What This Means for Tax Progressivity

Our findings offer two related insights into federal income tax progressivity. First, the system is generally progressive overall: Estimated effective tax rates rise from -12.4% for the lowest-income decile to 25.0% for the highest. Refundable credits produce negative net tax liabilities at the bottom of the income distribution, while higher-income groups pay a substantially larger share of their income in federal income taxes.

Second, this progressivity operates unevenly across income sources. The estimated effective tax rate on primary taxpayer wages ranges from less than zero to more than 20% across the income distribution, while the rates on investment and several other nonwage sources have flatter profiles. At the same time, high-income groups receive a larger share of their income from investment and other nonwage sources than low-income groups do.

Taken together, these results show why an overall effective tax rate provides only part of the picture. The federal income tax is progressive, but the degree of progressivity differs substantially by source. Understanding the distribution of federal income tax burdens therefore requires considering both the composition of income and how effective tax rates vary across income sources.

Notes

1. Responses in the 2022 SCF pertain to tax year 2021. Our methodology extends the work of William G. Gale and others, published in a January 2022 Tax Policy Center report, by estimating taxes using Version 35 of the National Bureau of Economic Research’s TAXSIM calculator. As in that paper, the unit of analysis is a single tax filing — the primary taxpayer and, if married, a spouse — rather than a household. A tax filing may cover one person or a couple, while a household includes people who live at the same address; these groups often overlap but are not identical.
2. “Other” income captures qualified business income, income earned from a specialized service trade or business, income received from involvement in an S-corporation, and income from property and other nonproperty sources, such as nonqualified dividends and alimony.
3. Eligibility for the EIC and the size of the credit depend on income, age, number of dependents, and marital status.