Capital Gains and Dividends: What is the effect of a lower tax rate?
Throughout most of the existence of the income tax, capital gains have been taxed at lower rates than ordinary income. Some argue that the lower tax rate offsets taxes paid at the corporate level, encourages risk taking and entrepreneurship, offsets the effects of inflation, and prevents "lock-in" (the incentive to hold assets too long for tax purposes). Critics complain that the lower tax rate disproportionately benefits the wealthy and encourages tax sheltering.
- Roughly half of all capital gains represent profits on the sale of corporate stock. However, about half of those profits are never taxed at the corporate level because of various tax breaks that benefit corporations. A lower rate of tax on capital gains appropriately offsets corporate taxes only in a minority of cases.
- Assets that pay returns in the form of capital gains probably are riskier than average, and so a lower capital gains tax rate may in fact encourage risk taking; however, taxing gains while allowing deductions for losses on a symmetric basis reduces the after-tax variance of returns. Although loss deductions are limited in a given year, they may be carried forward: a study published in 1997 found that most losses are deductible either immediately or soon after realization. Under current law in 2011, taxpayers can use capital losses to offset capital gains and up to $3,000 of non-gain taxable income. Taxpayers can carry the remaining capital losses forward to future years.
- It is true that part of almost any nominal capital gain is due simply to inflation. But inflation actually affects the returns on assets that are taxed currently (interest, dividends, rents, and royalties) more than it affects capital gains. And adjusting capital gains for inflation, either directly or through a lower tax rate, creates tax shelter opportunities if expense items (such as interest and depreciation) are not similarly indexed.
- A capital gains tax discourages sales of assets-the so-called lock-in effect-which may be inefficient. However, a 1994 study found that this effect was very small for permanent changes in capital gains tax rates (but not for temporary changes).
- The benefits of low tax rates on capital gains accrue disproportionately to the wealthy. In 2013, an estimated 94 percent of the tax benefit of low rates on capital gains will go to taxpayers with cash incomes over $200,000, and three-fourths of the benefits will accrue to millionaires.
- Low tax rates on capital gains are an important part of many individual income tax shelters, which employ sophisticated financial techniques to convert ordinary income (such as wages and salaries) to capital gains. For top-bracket taxpayers, tax sheltering can save 20 cents per dollar of income sheltered. Tax sheltering is economically inefficient because the resources that go into designing and managing tax shelters could be used instead for productive purposes, and many tax shelter investments pay subpar returns, turning a profit only after considering the tax benefits.
- The low rate on capital gains complicates tax filing. A significant portion of tax law and regulations is devoted to policing the boundary between returns on capital assets and ordinary income. And the alternative schedule for capital gains compounds the complexity: the entire back side of the schedule D is devoted to calculating the alternative rate.
- For most of its history, the U.S. income tax excluded a portion of long-term capital gains from income and taxed the remainder at ordinary rates. This is a much simpler way to convey a preference to capital gains.