November 13, 2013

RevenuesOption 3

Raise the Tax Rates on Long-Term Capital Gains and Dividends by 2 Percentage Points

(Billions of dollars) 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2014-2018 2014-2023
Change in Revenues 1.2 4.6 5.0 5.3 5.6 5.9 6.1 6.4 6.6 6.8 21.7 53.4

Source: Staff of the Joint Committee on Taxation.

Note: This option would take effect in January 2014.

When individuals sell an asset for more than the price at which they obtained it, they generally realize a capital gain that is subject to taxation. Most taxable capital gains are realized from the sale of corporate stocks, other financial assets, real estate, and unincorporated businesses. Since the adoption of the individual income tax in 1913, long-term gains (those realized on assets held for more than a year) have usually been taxed at lower rates than other sources of income, such as wages, interest, and dividends. However, starting in 2003, the tax rates on qualified dividends were lowered to match those of long-term capital gains. Qualified dividends are generally paid by domestic corporations or certain foreign corporations (including, for example, corporations whose stock is traded in one of the major securities markets in the United States).

The current tax rates on long-term capital gains and qualified dividends depend on several features of the tax code:

  • The basic tax rates on those forms of income depend on the statutory tax rates that would be applicable to taxpayers’ ordinary income—that is, income from sources other than long-term capital gains and qualified dividends. A taxpayer in the 10 percent or 15 percent tax bracket for ordinary income does not pay any taxes on long-term capital gains and qualified dividends. A taxpayer in the brackets for ordinary income that range from 25 percent through 35 percent faces a basic tax rate on long-term capital gains and dividends of 15 percent. For a taxpayer in the top bracket for ordinary income—39.6 percent—that rate increases to 20 percent.
  • Beginning in 2013, certain income from long-term capital gains and dividends, along with certain other types of investment income, is also subject to an additional tax of 3.8 percent under provisions of the Affordable Care Act. Married taxpayers who file joint returns are subject to that additional tax if their modified adjusted gross income is greater than $250,000; that threshold drops to $200,000 for taxpayers who are not married. (Adjusted gross income, or AGI, includes income from all sources not specifically excluded by the tax code, minus certain deductions. Modified AGI includes foreign income that is normally excluded from AGI.) The additional tax is applied to the smaller of two amounts: net investment income or the amount by which modified AGI exceeds the thresholds.
  • Other provisions of the tax code—including those that limit or phase out other tax preferences—effectively increase taxes on long-term capital gains and dividends. For example, the total value of certain itemized deductions is reduced if a taxpayer’s AGI is above a specified threshold. As a result, most taxpayers in the 39.6 percent tax bracket for ordinary income lose 3 cents of itemized deductions for each dollar of additional long-term gains, causing their tax rate to increase by more than a percentage point.

Taking all of those provisions together, the tax rate on long-term capital gains and dividends is nearly 25 percent for most people in the top income tax bracket. Although that bracket applies to less than 1 percent of all taxpayers, the income of those taxpayers accounts for roughly two-thirds of income from dividends and realized long-term capital gains.

This option would raise the basic tax rates on long-term capital gains and dividends by 2 percentage points. Those basic rates would then be 2 percent for taxpayers in the 10 percent and 15 percent brackets for ordinary income, 17 percent for taxpayers in the brackets ranging from 25 percent through 35 percent, and 22 percent for taxpayers in the top bracket. The option would not change the other provisions of the tax code that also affect taxes on capital gains and dividends. The staff of the Joint Committee on Taxation estimates that this option would raise federal revenues by $53 billion over the 2014–2023 period.

One advantage of raising tax rates on long-term capital gains and dividends, rather than raising tax rates on ordinary income, is that it would reduce the incentive for taxpayers to try to mischaracterize labor compensation and profits as capital gains. Such strategizing occurs under current law even though the tax code and regulations governing taxes contain numerous provisions that attempt to limit it. Reducing the incentive to mischaracterize compensation and profits as capital gains would reduce the resources devoted to circumventing the rules.

Another rationale for raising revenue through this option is that it would be progressive with respect to people’s wealth and income. Most taxable dividends and capital gains are received by people with significant wealth and income, although some are received by retirees who have greater wealth but less income than some younger people who are still in the labor force. Therefore, raising tax rates on long-term capital gains and dividends would impose, on average, a larger burden on people with significant financial resources than on people with fewer resources.

A disadvantage of the option is that raising tax rates on long-term capital gains and dividends would influence investment decisions by increasing the tax burden on investment income. By lowering the after-tax return on investments, the increased tax rates would reduce the incentive to invest in businesses. Another disadvantage is that the proposal would exacerbate an existing bias that favors debt-financed investment by businesses over equity-financed investment. That bias is greatest for investors in firms that pay the corporate income tax because corporate profits are taxed once under the corporate income tax and a second time when those profits are paid out as dividends or reinvested and taxed later as capital gains on the sale of corporate stock. In contrast, profits of unincorporated businesses, rents, and interest are taxed only once. That difference distorts investment decisions by discouraging investment funded through new issues of corporate stock and encouraging, instead, either borrowing to fund corporate investments or the formation and expansion of noncorporate businesses. The bias against equity funding of corporate investments would not expand if the option exempted dividends and capital gains on corporate stock—limiting the tax increase to capital gains on those assets that are not taxed under both the corporate and the individual income taxes. That modification, however, would also reduce the revenue gains from the option.

Another argument against implementing the option is that, by taxing long-term capital gains and dividends at higher rates, certain undertakings—such as starting a new business or investing in a new technology—might be less profitable, and investors might therefore undervalue their benefits to the economy. The option could also encourage people to hold on to investments longer than they would prefer so as to postpone the capital gains tax, although taxpayer responses would vary over time and depend on the type of investment. If assets are held until death, the tax is avoided entirely. Postponing the sale of assets, however, means that people could not modify their holdings to suit their current needs.