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Why Capital Gains are taxed at a Lower Rate

5 min readBy: David Block, William McBride

A joint hearing held by the Senate Finance Committee and the House Ways and Means CommitteeThe Committee on Ways and Means, more commonly referred to as the House Ways and Means Committee, is one of 29 U.S. House of Representative committees and is the chief tax-writing committee in the U.S. The House Ways and Means Committee has jurisdiction over all bills relating to taxes and other revenue generation, as well as spending programs like Social Security, Medicare, and unemployment insurance, among others. on June 28 will discuss capital gains taxation in the context of broader 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. reform. A number of proposed changes have been highlighted; The Bowles-Simpson proposal recommends taxing capital gains and dividends at the same rate as labor income, while many congressional Democrats recommend raising the rate, citing concerns about both revenue and inequality. Any proposal focusing on raising the rate will likely fail to raise the predicted revenue, as demonstrated by both economic history and the high burden already placed on American corporations.

The justification for a lower tax rate on capital gains relative to ordinary income is threefold: it is not indexed for inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. , it is a double tax, and it encourages present consumption over future consumption.

First, the tax is not adjusted for inflation, so any appreciation of assets is taxed at the nominal instead of the real value. This means investors must pay tax not only on the real return but also on the inflation created by the Federal Reserve.

Second, 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. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. is merely part of a long line of federal taxation of the same dollar of income. Wages are first taxed by payroll and personal income taxes, then again by the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. if one chooses to invest in corporate equities, and then again when those investments pay off in the form of dividends and capital gains. This puts corporations at a disadvantage relative to pass through business entities, whose owners pay personal income tax on distributed profits, instead of taxes on corporate income, capital gains, and dividends. One way corporations mitigate this excessive taxation is through debt rather than equity financing, since interest is deductible. This creates perverse incentives to over leverage, contributing to the boom and bust cycle.

Finally, a capital gains tax, like nearly all of the federal tax code, is a tax on future consumption. Future personal consumption, in the form of savings, is taxed, while present consumption is not. By favoring present over future consumption, savings are discouraged, which decreases future available capital and lowers long term growth.

Not only has a low capital gains tax rate worked to encourage savings and increase economic growth, a low capital gains rate has historically raised more in tax revenue. At a 2010 talk at the Cato Institute Dr. Daniel J. Mitchell and Dr. Richard W. Rahn argued that the government has actually raised more revenue with a lower long term capital gains tax rate than a higher rate. For example, in 2007 the IRS raised $122 billion with a 15% tax rate as opposed to $7.8 billion in 1977 ($26.7 billion in 2007 dollars) with a 40% tax rate. In fact, when President Bush signed into law a cut in the top rate from 20% to 15%, revenue increased from $51.3 billion in 2003 to $137.1 billion in 2007 (although it fell significantly after the 2008 financial crisis, understandably).

Attempting to use the tax code to address income inequality will likely disappoint those who seek to attack the lower tax rate on high net worth individuals caused by a lower capital gains and dividends rate. Inequalities caused by globalization and differing education levels will not be remedied by destroying future investment; to the contrary those most likely to be hurt the most by lower economic growth are those with lower incomes.

The intensification of international competition for lower corporate tax rates has been highly publicized, but international capital gains taxation has been largely ignored. Capital gains taxation adds another layer of taxation onto American businesses, making them less competitive. The table below shows how the U.S. stacks up in terms of the total taxation of corporate investment. The first column shows the U.S. capital gains rate (federal plus state) is above the OECD average. Thirteen countries in the OECD have no capital gains tax. The second column shows that the U.S. integrated capital gains tax rate (corporate rate plus capital gains) is the 4th highest in the OECD. This burden will rise to the highest in the OECD starting January 1 if the Bush tax cuts are allowed to expire and the Obamacare investment surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. of 3.8% goes into effect.

The combination of history, international competition, and the destructive nature of the capital gains tax suggests any attempts to raise revenue by raising rates are doomed to failure. The focus on June 28th should not be on raising the capital gains rate, but should instead be focused on how to keep the rate low. History shows that this is the most effective way to both raise revenue and promote economic growth.

Capital Gains Taxation by Country (OECD)
Country Top long-term capital gains tax rate (2011) Integrated capital gains tax rate (2011)
Italy 44.5 59.8
Denmark 42 56.5
France 31.3 54.9
United States 19.1 50.8
Sweden 30 48.4
Norway 28 48.2
Germany 25 47.7
Finland 28 46.7
United Kingdom 28 46.7
Australia 22.5 45.8
Japan 10 45.6
Spain 21 44.7
Canada 22.54 43.9
OECD Avg (non-US) 17.8 41.7
Israel 20 39.2
Estonia 21 37.6
Iceland 20 36
Ireland 25 34.4
Poland 19 34.4
Slovak Republic 19 34.4
Belgium 0 34
Chile 20 33.6
Hungary 16 32
Mexico 0 30
Luxembourg 0 28.6
New Zealand 0 28
Portugal 0 26.5
Austria 0 25
Netherlands 0 25
Korea 0 24.2
Switzerland 0 21.2
Greece 0 20
Slovenia 0 20
Turkey 0 20
Czech Republic 0 19
Source: Robert Carroll and Gerald Prante, “Corporate Dividend and Capital Gains Taxation: A comparison of the United States to other developed nations”, Ernst & Young, February 2012.

See Updated Capital Gains Tax Rates in Europe