Taxation of Certain Forms of Income

Background

Currently, some types of income are either taxed at lower rates than ordinary income or are exempt from taxation to some degree. For example, some investment-related income is taxed at lower rates. Social Security benefits are either wholly or partially exempt from taxation at the federal level, as well as in most states. 

Capital Gains and Dividends 

Capital gains and dividends are two forms of investment income. They may qualify for lower tax rates than ordinary income. Capital gains occur when an investor sells an asset for more than its purchase price. Dividends are payments made by a corporation to its shareholders. In general, capital gains are taxed at a lower rate than ordinary income if the asset was held for at least a year. Dividends are taxed at a lower rate if they are from an American corporation and are held for a minimum period of time. 

Proponents of the lower rates on investment income offer several reasons for this policy. They argue that the lower rates encourage savings and investments. They also say that lower rates prevent a lock-in effect, whereby investors hold on to their investments for fear of triggering a tax bill. Also, lower rates offset the taxation of inflationary gains, they say, and the double taxation of corporate profits. Evidence and analysis suggest that, in reality, these issues are small or that the policy does not effectively address them. 

The preferential tax rates on investment income challenge the equity, efficiency, and simplicity of the income tax code. Indeed, they significantly complicate the tax code and reduce its progressivity. Most of the preference's benefit goes to the wealthiest 1 percent of taxpayers. 

In addition, the difference in tax rates between capital and ordinary income creates tax avoidance opportunities. Taxpayers may be tempted to re-characterize ordinary income as capital gains income. One example of this is the taxation of carried interest. Carried interest refers to the compensation that hedge-fund or private-equity firms often use to pay their top managers. The managers pay taxes on their compensation at the preferential capital gain rates, regardless of whether they invested any of their own money. As a result, these highly compensated professionals may pay income taxes at lower rates than many Americans with middle incomes. Provisions limiting or eliminating the practice have been included in many notable proposals, most recently of the 2022 Inflation Reduction Act. But they have not become a part of the law. 

Social Security Benefits 

Social Security benefits are either wholly or partially exempt from taxes at the federal level. Most, but not all, states also provide full or partial tax exemptions for Social Security income. At the federal level, the taxes raised do not go into general revenue. Part of the revenue raised by taxing Social Security benefits goes to the Social Security trust funds and, after 1993, into Medicare's Hospital Insurance Trust Fund. 

Concerns about benefit adequacy for people with lower incomes led to the creation of taxable thresholds: $25,000 for individuals and $32,000 for couples. Since that formula was established, however, inflation has cut the thresholds' real values by more than half. As a result, the proportion of people who owe taxes on their Social Security increases every year. State revenues from taxing Social Security income do not revert back to any of the trust funds and thus do not stave off their expiration. In recent years, many states that levy tax on Social Security income adopted various tax relief measures.

TAXATION OF CERTAIN FORMS OF INCOME: Policy

TAXATION OF CERTAIN FORMS OF INCOME: Policy

Capital gains and dividends

The way income from capital gains and dividends is taxed should be changed to improve neutrality, progressivity, and simplicity in tax filing. 

Capital gains and dividends should be taxed at the same rate. 

A modest amount of capital gains and dividends should be excluded from taxation to simplify tax filing. 

Policymakers should protect asset holders from taxation on inflationary gains. 

Carried interest should be taxed as ordinary income. It should be reported as wages and subject to all applicable taxes, including income and payroll taxes. 

Social Security benefits

Policymakers should limit the increasing number of taxpayers subject to the taxation of Social Security benefits to better protect the benefits of people who have no or limited additional retirement income.  

At the federal level, any changes should maintain adequate financing for the Social Security trust funds (see also Social Security). 

Tax-exempt interest should not be taken into account in determining the amount of taxable Social Security benefits.