The Tax Policy Center (Brookings and Urban Institute) has a great project that is the brainchild of prolific author Len Burman--the Tax Policy Briefing Book (authors fully responsible, it notes for content, and not the institutes themselves). This online resource has simple, factual explanations of various aspects of the tax system (e.g., the AMT, defined contribution or defined benefit retirement systems, capital gains) and will be updated online to stay current on proposals and ideas for tax reform.
The posting on the capital gains tax, Capital Gains: What is the effect of a lower tax rate? is well worth a look. It notes the historical trend of taxing capital gains at a lower rate than ordinary income and the arguments for doing so: that lower tax on stock sales (i) offsets the taxes paid at the corporate level, mitigating the so-called double taxation"of corporate income; (ii) encourages entrepreneurs; (iii) offsets effect of inflation, and (iv) prevents the "lock-in" when people hold onto assets longer than economic efficiency suggests they should in order to avoid paying tax.
It then notes some of arguments against the preferential rate. Perhaps the most important is the disproportionate benefit to the wealthy. The distributional effects of the capital gains preference, in a quite clear table showing cash income level, percent of returns getting a benefit and average tax savings. Not surprisingly for anyone familiar with the distribution of capital assets in the US, tax returns with cash income of less than $100,000 show very little average savings from the capital gains preference--%68 for those making more than $75,000 and quickly down from there. But for those making more than 200,000, the average 2007 savings is huge: $2082 for those in the 200-500 thousand range; and $149,315 for those who make more than $1 million in cash income (which of course is only a very small percentage of the returns filed. The wealthy benefit disproportionately from the preference--92 percent of the benefit in 2007 went to taxpayers with income over $200,000 and 72% to those with more than $1 million.
Another argument is the encouragement of inefficient tax sheltering--trying to convert wage income to capital gains to save wealthy individuals 20 cents on the dollar of sheltered income. The hedge fund managers with their carried interest provisions have been notoriously successful at this, and even now that Congress has become clearly aware of the problem, it has not acted.
And preferential capital gains rates are a major complication to the tax laws and regulations.
The article also takes on each of the arguments in favor of a capital gains preference and quickly destroys them. Briefly:
- About half of capital gains are indeed on corporate stock, but only about half of those corporate profits have ever been taxed at the corporate level;
- capital gains assets are probably riskier than other assets, but the ability to deduct the losses evens out the requirement of paying tax on gains (and most losses are used very soon after realization);
- some of the gain is due to inflation, but that is also true for interest and other items that are taxed currently at ordinary rates; adjusting one but not the other for inflation creates tax shelter opportunities;
- at least one study suggests that the lock-in effect is very minimal, except around temporary tax changes;
The article suggests that if the US wants to provide some kind of preference (and it doesn't give much support for doing so), then a better way would be to exclude some portion of capital gains and tax the rest at ordinary rates.
Thanks to Tax Prof for pointing out the new "Tax Policy Book." This is a useful resource, especially for those who don't have a background in tax law because of its easy readibility and straightforward explanations.