Taxation of Certain Forms of Income

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. In addition, they claim that lower rates offset the taxation of inflationary gains and the double taxation of corporate profits. Evidence and analysis suggest that, in reality, these issues are either minor or 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 funds 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.

Social Security benefits
At the federal level, Social Security beneficiaries whose income exceeds certain thresholds must pay income tax on a portion of their benefits. These thresholds—$25,000 for individuals and $32,000 for couples—have not changed since they were first established in 1983. As a result, the proportion of people who owe federal taxes on their Social Security benefits increases every year.

Revenue from the federal taxation of benefits goes into the Social Security trust funds (the Old-Age and Survivors Insurance Trust Fund and the Disability Insurance Trust Fund) and since 1993, Medicare's Hospital Insurance Trust Fund. These monies help sustain both of these important programs.

Most states do not tax Social Security benefits. In recent years, a handful of states that levied the tax either fully eliminated it or limited those subject to it. As a result, in states that have a tax, it only applies to individuals who have income above a certain threshold, are below a certain age, or both. The revenue from these taxes usually goes into the state’s general fund and thus can be used for a variety of purposes.