In February, billionaires Warren Buffett and Bill Gates suggested increasing taxes on the wealthy to pay for policies that would help people without market skills keep pace in an increasingly specialized economy. Both have proposed increasing taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. rates for capital gains as one potential way to generate revenue for this purpose.
Long-term capital gains, or appreciation on assets held for more than one year, are taxed at a lower rate than ordinary income when realized. For instance, the top individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. rate for individuals making more than $510,300 in 2019 is 37 percent, while the highest rate at which capital gains are taxed is 23.8 percent. This 23.8 percent top rate comes from the 20 percent rate for individuals with long-term capital gains over $434,550, as well as the 3.8 percent net investment income tax for individuals with modified adjusted gross income over $200,000.
One thing to recognize is that this reduced rate partially compensates taxpayers for double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. . By the time taxpayers invest their income, that income has already been taxed by both the payroll and personal income taxes. The capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. Capital gains taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. then places an additional layer of taxation on any returns in the investment purchased with after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize after-tax income. when taxpayers realize, or sell, their asset with a capital gain.
You shouldn’t look at this double taxation in isolation, because taxpayers who invest in capital gains get the benefit of deferral, making capital gains relatively more attractive from a tax standpoint compared to other investments. As my colleague Kyle Pomerleau points out:
The effective capital gains tax rate is already relatively low compared to the effective tax rate on other sources of capital income such as dividends and interest. This is mainly because individuals can delay realizing their capital gains, which reduces the present value of the tax burden.
This means the double taxation placed on capital gains isn’t mitigated just by the reduced rate, but also by the taxpayer’s ability to choose when they want to pay taxes on the capital gain. Taxpayers would still have this ability to time their capital gains realizations even if the reduced rate were increased.
Eliminating the reduced rate on capital gains would raise revenue, but it would also increase the cost of capital and the marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. on savings and investment—meaning that this might not be the best trade-off for policymakers.
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