The High Burden of State and Federal Capital Gains Tax Rates

 
 
February 11, 2014

Savings in an economy is important. It leads to higher levels of investment, a larger capital stock, increased worker productivity and wages, and faster economic growth. However, the United States currently places a heavy tax bias against saving and investment. One way it does this is through a high top marginal tax rate on capital gains.

Currently, the United States’ top marginal tax rate on long-term capital gains income is 23.8 percent. In addition, taxpayers face state-level capital gains tax rates as low as zero and as high as 13.3 percent. As a result, the average combined top marginal rate in the United States is 28.7 percent. This rate exceeds the average top capital gains tax rate of 18.2 percent faced by taxpayers throughout the industrialized world. Even more, taxpayers in some U.S. states face top rates on capital gains over 30 percent, which is higher than most industrialized countries. In fact, California’s top marginal capital gains tax rate of 33 percent is the third highest in the industrialized world.

Capital Gains Taxes in the United States

The current federal top marginal tax rate on long-term[1] capital gains in the United States is 20 percent plus a 3.8 percent tax on unearned income to fund the Affordable Care Act for a total of 23.8 percent for taxpayers with an adjusted gross income of $200,000 ($250,000 married filing jointly) or more. In addition, states levy taxes on capital gains income,[2] which range from zero percent in states with no individual income tax such as Florida, Texas, South Dakota, and Wyoming to 13.3 percent in California. (See Table 1.)[3]

An individual who has capital gains income is subject to both federal and state capital gains rates. Taking into account the state deductibility of federal taxes and the phase-out of itemized deductions,[4] top marginal tax rates on capital gains range from 25 percent[5] in the nine states that do not levy a tax on personal income to 33 percent in California. The average across the United States is 28.7 percent.[6]

How the United States Compares to the OECD

The United States’ average top marginal tax rate on capital gains of 28.7 percent is the 6th highest rate in the OECD and is more than 10 percentage points higher than the simple average of 18 percent across the 34 countries (Table 2).[7] The highest rate on capital gains is 42 percent in Denmark. Nine OECD countries do not tax capital gains.

It is also worth noting that taxpayers in many U.S. states face much higher marginal tax rates on capital gains than taxpayers in most OECD countries (Table 3). Comparing U.S. states with individual countries in the OECD, U.S. states have six of the top ten capital gains tax rates in the OECD. California, with a top rate of 33 percent, has the third-highest capital gains tax rate in the industrialized world, while even taxpayers in states without taxes on capital gains, such as Florida, Texas, South Dakota, and Wyoming, face top rates higher than the OECD average.

The Impact of a High Tax Burden on Capital Gains

The United States’ high tax burden on capital gains has long-term negative implications for the economy. This non-neutral tax creates a bias against savings, slows economic growth, and harms U.S.’s competitiveness.

Capital Gains Tax is One of Many Taxes on the Same Dollar

Capital gains taxes represent an additional tax on a dollar of income that has already been taxed multiple times. For example, take an individual who earns a wage and decides to save by purchasing stock. First, when he earns his wage, it is taxed once by the federal and state individual income tax. He then purchases stock and lets his investment grow. However, that growth is smaller than it otherwise would have been due to the corporate income tax on the profits of the corporation in which he invested.[8] After ten years, he decides to sell the stock and realize his capital gains. At this point, the gains (the difference between the value of the stock at purchase and the value at sale) are taxed once more by the capital gains tax. Even more, the effective capital gains tax rate could be even higher on your gains due to the fact that a significant difference in the value of the stock is due to inflation and not real gains.[9]

Creates a Bias Against Saving

These multiple layers of taxation encourage present consumption over savings. Suppose someone makes $1,000 and it is first taxed at 20 percent through the income tax. This person now has a choice. He can either spend it all today or save it in stocks or bonds and spend it later. If he spends it today and buys a television, he would pay a state or local sales tax. However, if he decides to save it, delaying consumption, he is subject to the multiple layers of taxation discussed previously plus the sales tax when he eventually purchases the television. This lowers the potential rate of return on an investment, which discourages the savings. As an individual, to avoid the multiple layers of taxation on the same dollar, it makes more sense to spend it all now rather than spend it later and pay multiple taxes.

Slows Economic Growth

As people prefer consumption today due to the tax bias against savings, there will be less available capital in the future. For investors, this represents less available capital for factories, machines, and other investment opportunities. Additionally, capital gains taxes create a lock-in effect that reduces the mobility of capital.[10] People are less willing to realize capital gains from one investment in order to move to another when they face a tax on their returns. Funds will be slower to move to better investments, further slowing economic growth.

Harms U.S. Competitiveness, Raises the Cost of Capital

Relatively high capital gains taxes also harm the competitiveness of U.S. corporations by raising the cost of capital. As corporations seek higher returns, corporate investment will move to countries that have lower capital gains tax rates.[11] Following the reduction of capital gains tax rates in the U.S. in 1978 from 39 percent to 20 percent, the ability of firms to raise funds through equity offerings greatly increased. As a result, the daily volume of the New York Stock Exchange increased from 28.6 million shares to 85 million shares in five years.[12] Higher rates also slows down the productivity of workers due to less investment in new machinery and software.

Conclusion

The United States currently places a heavy tax burden on saving and investment with its capital gains tax. Its top marginal tax rate on capital gains, combined with state rates, far exceeds rates faced throughout the industrialized world. Increasing taxes on capital income would further the bias against savings, lead to lower levels investment, and slower economic growth. Lowering taxes on capital would the reverse effect, increasing investment and leading the greater economic growth.

 

Table 1. Top Marginal Tax Rate on Capital Gains, by U.S. States, 2014

 

Rank

State

State Rate

Combined Rate

 

1

California

13.3%

33.0%

 

2

New York*

8.8%

31.5%

 

3

Oregon

9.9%

31.0%

 

4

Minnesota

9.9%

30.9%

 

5

New Jersey

9.0%

30.4%

 

5

Vermont

9.0%

30.4%

 

7

Maryland*

5.8%

30.3%

 

8

Maine

8.0%

29.8%

 

9

Iowa*

9.0%

29.6%

 

10

Idaho

7.4%

29.4%

 

10

Hawaii*

7.3%

29.4%

 

12

Nebraska

6.8%

29.1%

 

13

Connecticut

6.7%

29.0%

 

13

Delaware

6.6%

29.0%

 

15

West Virginia

6.5%

28.9%

 

16

Georgia

6.0%

28.6%

 

16

Kentucky

6.0%

28.6%

 

16

Missouri

6.0%

28.6%

 

16

Rhode Island

6.0%

28.6%

 

20

North Carolina

5.8%

28.5%

 

20

Virginia

5.8%

28.5%

 

22

Ohio*

5.4%

28.3%

 

23

Wisconsin*

7.7%

28.2%

 

23

Oklahoma

5.3%

28.2%

 

25

Massachusetts

5.2%

28.1%

 

26

Illinois

5.0%

28.0%

 

26

Mississippi

5.0%

28.0%

 

26

Utah

5.0%

28.0%

 

29

Arkansas*

7.0%

27.9%

 

29

Montana*

6.9%

27.9%

 

29

Louisiana*

6.0%

27.9%

 

29

Kansas

4.8%

27.9%

 

33

Indiana*

3.4%

27.8%

 

33

Michigan*

4.4%

27.8%

 

33

Colorado

4.6%

27.8%

 

36

Arizona

4.5%

27.7%

 

37

Alabama*

5.0%

27.4%

 

38

South Carolina*

7.0%

27.3%

 

39

Pennsylvania

3.1%

26.8%

 

40

New Mexico*

4.9%

26.5%

 

41

North Dakota*

3.2%

26.3%

 

42

Tennessee

0.0%

25.0%

 

42

New Hampshire

0.0%

25.0%

 

42

Alaska

0.0%

25.0%

 

42

Florida

0.0%

25.0%

 

42

Nevada

0.0%

25.0%

 

42

South Dakota

0.0%

25.0%

 

42

Texas

0.0%

25.0%

 

42

Washington

0.0%

25.0%

 

42

Wyoming

0.0%

25.0%

 

 

D.C.

9.0%

30.4%

 

 

U.S. Average

 

28.7%

 

Source: Tax Foundation, Commerce Clearing House, and author's calculations

 
 

*These states either allow a taxpayer to deduct their federal taxes from state taxable income, have local income taxes, or have special tax treatment of capital gains income.

 
 
 
 

 

Table 2. Top Marginal Tax Rate on Capital Gains, by OECD Nation, 2014

 

Rank

Country

Rate

 

1

Denmark

42.0%

 

2

France

38.0%

 

3

Ireland

33.0%

 

4

Finland

32.0%

 

5

Sweden   

30.0%

 

6

United States

28.7%

 

7

Portugal

28.0%

 

7

United Kingdom

28.0%

 

9

Norway

27.0%

 

9

Spain

27.0%

 

11

Austria

25.0%

 

11

Germany

25.0%

 

11

Israel

25.0%

 

11

Slovak Republic

25.0%

 

15

Australia

22.5%

 

15

Canada

22.5%

 

17

Estonia

21.0%

 

18

Chile

20.0%

 

18

Iceland

20.0%

 

18

Italy

20.0%

 

18

Japan

20.0%

 

22

Poland

19.0%

 

23

Hungary

16.0%

 

24

Greece

15.0%

 

25

Mexico

10.0%

 

26

Belgium

0.0%

 

26

Czech Republic

0.0%

 

26

Korea

0.0%

 

26

Luxembourg

0.0%

 

26

Netherlands

0.0%

 

26

New Zealand

0.0%

 

26

Slovenia

0.0%

 

26

Switzerland

0.0%

 

26

Turkey

0.0%

 

 

OECD Simple Average

18.2%

 

 

OECD Weighted Average

22.9%

 

Source: Ernst & Young, Deloitte

 
 

 

Table 3. Top Marginal Tax Rate on Capital Gains, by OECD Nation and U.S. State, 2014

 

Rank

State/Country

Rate

 

1

Denmark

42.0%

 

2

France

38.0%

 

3

California

33.0%

 

3

Ireland

33.0%

 

5

Finland

32.0%

 

6

New York

31.5%

 

7

Oregon

31.0%

 

8

Minnesota

30.9%

 

9

New Jersey

30.4%

 

9

Vermont

30.4%

 

9

D.C.

30.4%

 

12

Maryland

30.3%

 

13

Sweden   

30.0%

 

14

Maine

29.8%

 

15

Iowa

29.6%

 

16

Idaho

29.4%

 

16

Hawaii

29.4%

 

18

Nebraska

29.1%

 

19

Connecticut

29.0%

 

19

Delaware

29.0%

 

21

West Virginia

28.9%

 

22

United States

28.7%

 

23

Georgia

28.6%

 

23

Kentucky

28.6%

 

23

Missouri

28.6%

 

23

Rhode Island

28.6%

 

27

North Carolina

28.5%

 

27

Virginia

28.5%

 

29

Ohio

28.3%

 

30

Wisconsin

28.2%

 

30

Oklahoma

28.2%

 

32

Massachusetts

28.1%

 

33

Portugal

28.0%

 

33

United Kingdom

28.0%

 

33

Illinois

28.0%

 

33

Mississippi

28.0%

 

33

Utah

28.0%

 

38

Arkansas

27.9%

 

38

Montana

27.9%

 

38

Louisiana

27.9%

 

38

Kansas

27.9%

 

42

Indiana

27.8%

 

42

Michigan

27.8%

 

42

Colorado

27.8%

 

45

Arizona

27.7%

 

46

Alabama

27.4%

 

47

South Carolina

27.3%

 

48

Norway

27.0%

 

48

Spain

27.0%

 

50

Pennsylvania

26.8%

 

51

New Mexico

26.5%

 

52

North Dakota

26.3%

 

53

Tennessee

25.0%

 

53

New Hampshire

25.0%

 

53

Austria

25.0%

 

53

Germany

25.0%

 

53

Israel

25.0%

 

53

Slovak Republic

25.0%

 

53

Alaska

25.0%

 

53

Florida

25.0%

 

53

Nevada

25.0%

 

53

South Dakota

25.0%

 

53

Texas

25.0%

 

53

Washington

25.0%

 

53

Wyoming

25.0%

 

66

Australia

22.5%

 

66

Canada

22.5%

 

68

Estonia

21.0%

 

69

Chile

20.0%

 

69

Iceland

20.0%

 

69

Italy

20.0%

 

69

Japan

20.0%

 

73

Poland

19.0%

 

74

Hungary

16.0%

 

75

Greece

15.0%

 

76

Mexico

10.0%

 

77

Belgium

0.0%

 

77

Czech Republic

0.0%

 

77

Korea

0.0%

 

77

Luxembourg

0.0%

 

77

Netherlands

0.0%

 

77

New Zealand

0.0%

 

77

Slovenia

0.0%

 

77

Switzerland

0.0%

 

77

Turkey

0.0%

 

 

OECD Simple Average

18.2%

 

Source: Ernst and Young, Deloitte, Tax Foundation, and author's calculations

 
 

 

 

 

 



[1] Assets held for more than one year.

[2] Most states tax capital gains as ordinary income.

[3] Tax Foundation, Facts & Figures 2014: How Does Your State Compare? (forthcoming). See also Commerce Clearing House Intelliconnect database.

[4] The Pease limitation on itemized deductions reduces many deductions by 3 percent for taxpayers with adjusted gross income exceeding $250,000 ($300,000 married filing jointly).

[5] Assuming individuals facing the top marginal rate have itemized deductions against which the Pease limitation is applied.

[6] The U.S. average is the combined federal, state, and local rates on capital gains, taking into account the Pease limitation and state/federal deductibility of income taxes weighted by capital gains income in each state. For capital gains income data, see Internal Revenue Service, Statistics of Income, Historic Table 2, http://www.irs.gov/uac/SOI-Tax-Stats---Historic-Table-2.

[7] Ernst & Young, 2013-2014 The worldwide personal tax guide, http://www.ey.com/GL/en/Services/Tax/The-worldwide-personal-tax-guide---Country-list. See also Deloitte, Deloitte International Tax Source, Country Guides and Highlights, https://www.dits.deloitte.com/Administration/ManageHomePage/Popup.aspx?ChildPage=Country%20Guides%20and%20Highlights.

[8] For an explanation of “integrated tax rates on capital gains,” see Ernst & Young LLP, Robert Carroll & Gerald Prante, Corporate Dividend and Capital Gains Taxation: A comparison of the United States to other developed nations (Feb. 2012), http://images.politico.com/global/2012/02/120208_asidividend.html.

[9] John L. Aldridge & Kyle Pomerleau, Inflation Can Cause an Infinite Effective Tax Rate on Capital Gains, Tax Foundation Fiscal Fact No. 406 (Dec. 17, 2013), http://taxfoundation.org/article/inflation-can-cause-infinite-effective-tax-rate-capital-gains.

[10] Bruce Bartlett, The Case for Ending the Capital Gains Tax, 41 Financial Analysts Journal 22-30 (June-July 1985).

[11] Chris Edwards, Advantages of Low Capital Gains Tax Rates, Cato Institute Tax & Budget Bulletin No. 66 (Dec. 27, 2012), http://www.cato.org/publications/tax-budget-bulletin/advantages-low-capital-gains-tax-rates.

[12] See Bartlett, supra note 10.

 

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