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 some states.

Capital gainsCapital gains occur when an investor sells an asset for more than its purchase price, or "basis." and dividendsDividends are payments made by a corporation to its shareholders.

Capital gainsCapital gains occur when an investor sells an asset for more than its purchase price, or "basis." and dividendsDividends are payments made by a corporation to its shareholders. are two forms of investment income. They may qualify for lower tax rates than ordinary income. Capital gainsCapital gains occur when an investor sells an asset for more than its purchase price, or "basis." occur when an investor sells an asset for more than its purchase price. DividendsDividends are payments made by a corporation to its shareholders. are payments made by a corporation to its shareholders. In general, capital gainsCapital gains occur when an investor sells an asset for more than its purchase price, or "basis." are taxed at a lower rate than ordinary income if the asset was held for at least a year. DividendsDividends are payments made by a corporation to its shareholders. 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 avoid the taxation of inflationary gains, they say, and avoid 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 progressivityIn taxation, a situation in which people with lower income pay a smaller percentage of their income than do people with higher income.. 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 gainsCapital gains occur when an investor sells an asset for more than its purchase price, or "basis." income.

Most of the benefit goes to the wealthiest 1 percent of taxpayers. One example of this is the taxation of carried interestCarried interest refers to the income that the managers earn from their share of fund profits.. Carried interestCarried interest refers to the income that the managers earn from their share of fund profits. refers to the compensation that hedge-fund or private-equity managers earn when the firm’s investments perform well. They can earn it regardless of whether they invested any of their own money. Currently, it is taxed at the capital gainsCapital gains occur when an investor sells an asset for more than its purchase price, or "basis." rates rather than as regular income. As a result, these highly compensated professionals may pay income taxes at lower rates than many Americans with middle incomes.

Social Security benefits

Social Security benefits are either wholly or partially exempt from taxes at the federal level. Some states also provide full or partial tax exemptions for Social Security benefits.

At the federal level, the taxes raised do not go into general revenueRevenue that can be used for any purpose.. Part of the revenue raised by taxing Social Security benefits goes to the Social Security trust funds. The remainder goes to 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. Taxpayers with incomes below these thresholds do not have to include any of their benefits in their taxable income. 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.

 

TAXATION OF CERTAIN FORMS OF INCOME: Policy

TAXATION OF CERTAIN FORMS OF INCOME: Policy

Capital gains and dividends

The way income from capital gainsCapital gains occur when an investor sells an asset for more than its purchase price, or "basis." and dividendsDividends are payments made by a corporation to its shareholders. is taxed should be changed to improve neutrality, progressivityIn taxation, a situation in which people with lower income pay a smaller percentage of their income than do people with higher income., and simplicity in tax filing.

Capital gainsCapital gains occur when an investor sells an asset for more than its purchase price, or "basis." and dividendsDividends are payments made by a corporation to its shareholders. should be taxed at the same rate.

A modest amount of capital gainsCapital gains occur when an investor sells an asset for more than its purchase price, or "basis." and dividendsDividends are payments made by a corporation to its shareholders. should be excluded from taxation to simplify tax filing.

Policymakers should protect asset holders from taxation on inflationary gains.

Carried interestCarried interest refers to the income that the managers earn from their share of fund profits. 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 not increase the taxation of Social Security benefits. People with low and moderate incomes should be exempt from paying tax on their benefits.

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

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