Capital gain is income from selling an asset for more than its purchase price, or “basis.” Dividends are payments made by a corporation to its shareholders. Realizing capital gains or receiving dividends are two alternative ways in which investors get a return on their investments.
Currently long-term capital gains and dividends are taxed at a lower rate than “ordinary income” (such as wages). For example, a filer in the highest tax bracket faces a tax rate of 39.6 percent on ordinary income, but only 20 percent on income from capital gains and dividends. Taxpayers in the lowest brackets do not pay tax on capital gains, while others pay at the 15 percent rate.
One argument in favor of maintaining the parity between tax rates on capital gains and dividends is that doing so may help level the tax treatment of the two, making taxes more neutral. This could contribute to economic growth.
Proponents of the lower rates on capital income offer several reasons why this policy is beneficial. They argue that the lower rates encourage savings and investments; encourage risk-taking and entrepreneurial activity; prevent a “lock-in” effect, thereby facilitating the most efficient use of capital; avoid the taxation of inflationary gains; and avoid the double taxation of corporate profits.
Evidence and analysis suggest, however, that these problems are small in reality or that the policy does not effectively address the gist of the problems. For example, under the existing definition of capital gains, some of the appreciation reflected in a higher selling price is a result of inflation and therefore does not reflect a true increase in value. Lower capital gains rates do not remedy this problem. Rather, approaches such as indexing for inflation would achieve this goal.
The preferential tax rates for income from capital gains and dividends challenge the equity, efficiency, and simplicity of the income tax code. Indeed, they significantly complicate the tax code. The benefits of lower rates accrue largely to high-income filers. According to the Tax Policy Center estimates, the top 0.1 percent of taxpayers received about 56 percent of the benefit in 2016, while taxpayers in the top 1 percent received nearly four-fifths. At the same time, the policy has a high budgetary cost. The Joint Committee on Taxation estimates that this tax expenditure reduces tax liability by approximately $689.6 billion in 2015–2019.
The differential in tax rates between capital and ordinary income spurs tax avoidance. It induces taxpayers to recharacterize ordinary income as capital gains income. The most affluent are usually in the best position to engage in these strategies.
In recent years this practice was often mentioned in connection with a special compensation mechanism commonly used by hedge-fund or private-equity managers, called “carried interest.” Carried interest refers to the income that the managers earn from their share of fund profits. Currently it is treated as capital income and taxed at the capital gains rates. As a result, these highly-compensated professionals may pay income taxes at lower rates than many middle-income Americans. Proponents of the reformed tax treatment of the carried interest income argue that it should be treated on par with ordinary salaries and wages.
On top of lower rates, capital gains also receive preferential treatment in the form of deferred taxation. Taxes are assessed and paid when the capital gains are realized (i.e., when assets are sold), rather than as gains accrue. As a result investors may time their capital gains realizations to reduce their tax liability.
At least two other related policies were the focus of public attention. First, individuals can exclude from taxable income up to $250,000 of gain ($500,000 for married couples filing a joint return) realized on the sale or exchange of a principal residence. Taxpayers must meet certain requirements to qualify, such as having resided in the house for two years prior to its sale.
The second exception is the treatment of capital income from inherited assets. Under current law, property transferred at a person’s death receives a basis equal to its fair-market value at the time of death (known as a “stepped-up” basis). This means that heirs pay capital gains tax only on the appreciation that occurs after they inherit the asset. This policy may offer a very valuable tax benefit to the heirs.