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 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, or basis. 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 at least a year, and 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, prevent a lock-in effect whereby investors hold on to their investments for fear of triggering a tax bill, avoid the taxation of inflationary gains, and avoid the double taxation of corporate profits. Evidence and analysis suggest, however, that in reality these issues are small or that the policy does not effectively address them.

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 and reduce its progressivity. The vast majority of the benefit goes to the wealthiest 1 percent of taxpayers.

In addition, the differential in tax rates between capital and ordinary income creates broad tax avoidance opportunities, inducing taxpayers to recharacterize ordinary income as capital gains income. 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 Americans with middle incomes. Proponents of reform argue that carried interest income should be treated on par with ordinary salaries and wages.

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 revenue. A portion of the revenue raised by taxing Social Security benefits goes to the Social Security Trust Funds while 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 a half. As a result, the proportion of people who owe taxes on their Social Security increases every year.

The percentage of benefits that are taxed increases steadily for people above these thresholds until it reaches 85 percent of benefits for individuals with modified income above $34,000 and married couples with modified income above $44,000. Modified income is adjusted gross income plus tax-exempt interest plus half of Social Security benefits.

 

TAXATION OF CERTAIN FORMS OF INCOME: Policy

Capital gains and dividends

In this policy: FederalState

Changes in the tax treatment of income from capital gains and dividends should improve neutrality, progressivity, and simplicity in tax filing.

The taxation of capital gains and dividends should be taxed at the same rate.

The taxation of capital gain and dividend income should be progressive.

Exclusions for modest amounts of capital gains and dividends would simplify tax filing.

Policymakers should protect asset holders from taxation on inflationary gains.

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

Taxing Social Security benefits

In this policy: FederalStateTaxation

Policymakers should not increase the taxation of Social Security benefits and should exempt people with low and moderate incomes 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.