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. 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 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 progressivity. 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.

Most of the benefit goes to the wealthiest 1 percent of taxpayers. One example of this is the taxation of carried interest. Carried interest 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 gains 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 revenue. 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 (see also Medicare).

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 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 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.