New Tax Foundation Primer on Investment Income Taxation

July 17, 2007

In a debate of Democratic presidential hopefuls last month, John Edwards put forth the following argument:

People who have done well ought to have more responsibility to pay back to the country. We have a capital-gains rate—15 percent—which is the rate that most pay on their investment income, like Warren Buffett. That’s significantly lower than the tax rate that his secretary pays; that’s not right. There is a moral disconnect.

Edwards echoes the sentiments of other democratic candidates, including Hillary Clinton, who were responding to a call from billionaire Warren Buffet for higher tax rates on investment income. (See debate transcript here.)

We recently released a short primer on capital gains and dividend taxation, explaining why investment income is taxed at a different rate than wage income, and which segments of the population are affected most by the different tax rates. As author Gerald Prante explains, there are three basic reasons investment income is taxed at a different rate:

  • The increased value of any asset is partly due to inflation, but the tax law doesn’t adjust for inflation. The lower tax rate makes up for that but in a very rough, approximate way.
  • Because people can choose when to sell their assets, capital gains are much more sensitive to tax rates than wages. Facing higher wage taxes, people must continue working, but in the face of higher capital gains taxes, people can cling to their assets. This damages the economy and disappoints hopes for higher tax revenue.
  • Because people invest in the stock of specific companies, and because the stock’s gain is reduced by the corporate income tax, tax experts usually add the corporate income tax rate to the capital gains or dividend rate to compute the real tax rate on capital, which adds up to a much higher rate than the tax on wages.

In addition, the primer ranks the states in terms of the amount of capital gains and dividend income per tax return, with Wyoming, Nevada and Connecticut ranking first, second and third, respectively.

View the new Fiscal Fact here. View the data here.

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