Raise the Tax Rates on Long-Term Capital Gains and Qualified Dividends by 2 Percentage Points
CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.
|Billions of Dollars||2017||2018||2019||2020||2021||2022||2023||2024||2025||2026||2017-2021||2017-2026|
|Change in Revenues||6.7||-2.8||6.0||6.1||6.4||6.5||6.7||6.9||7.1||7.5||22.4||57.1|
Source: Staff of the Joint Committee on Taxation.
This option would take effect in January 2017.
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 and interest. Since 2003, qualified dividends, which include most dividends, have been taxed at the same rates as long-term capital gains. Generally, qualified dividends are paid by domestic corporations or certain foreign corporations (including, for example, foreign 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 statutory tax rates on long-term capital gains and qualified dividends depend on the statutory tax rates that would apply if they were considered to be ordinary income—that is, all income subject to the individual income tax from sources other than long-term capital gains and qualified dividends. A taxpayer does not pay any taxes on long-term capital gains and qualified dividends that otherwise would be taxed at a rate of 10 percent or 15 percent if those earnings were treated as ordinary income. Long-term capital gains and qualified dividends become taxable when they would be taxed at a rate that ranged from 25 percent through 35 percent if they were treated as ordinary income; those gains and dividends are taxed, instead, at a rate of 15 percent. All other long-term capital gains and qualified dividends are subject to a tax rate of 20 percent—nearly 20 percentage points lower than the rate that would apply if they were considered ordinary income.
- Certain long-term capital gains and qualified dividends are included in net investment income, which is subject to the Net Investment Income Tax (NIIT) of 3.8 percent. Taxpayers are subject to the NIIT if their modified adjusted gross income is greater than $200,000 for unmarried filers and $250,000 for married couples filing joint tax returns. (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. Therefore, for taxpayers subject to the NIIT, the marginal tax rate (that is, the percentage of an additional dollar of income that is paid in taxes) on long-term capital gains and qualified dividends effectively increases from 20 percent to 23.8 percent.
- Other provisions of the tax code—such as those that limit or phase out other tax preferences—may further increase the tax rate on long-term capital gains and dividends. For example, for each dollar by which taxpayers’ AGI exceeds certain high thresholds, the total value of certain itemized deductions is reduced by 3 cents. As a result, the amount of income that is taxable will increase: For example, for taxpayers in the 39.6 percent tax bracket for ordinary income, taxable income will effectively rise by $1.03 for each additional dollar of long-term capital gains. That increase in taxable income will cause their marginal tax rate to rise by more than 1 percentage point (0.396 times 3 percent).
With all of those provisions taken into account, 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 tax-payers accounts for roughly two-thirds of income from dividends and realized long-term capital gains.
This option would raise the statutory tax rates on long-term capital gains and dividends by 2 percentage points. Those 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 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 $57 billion over the 2017–2026 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 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 working. Overall, raising tax rates on long-term capital gains 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 option 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 related to the fact that taxation of capital gains encourages people to defer the sale of their capital assets, sometimes even leading them to never sell some of the assets during their lifetime. In the former case, the taxation of capital gains is postponed; in the latter case, it is avoided altogether because if an individual sells an inherited asset, the capital gain is the difference between the sale price and the fair-market value as of the date of the previous owner’s death. By raising tax rates on long-term capital gains and dividends, this option could further encourage people to hold on to their investments only for tax reasons, which could reduce economic efficiency by preventing some of those assets from being put to more productive uses.