Capital Gains & Dividends
- How does the tax treatment of capital gains and dividends differ from the tax treatment of income from work?
- What are the consequences of the tax-favored treatment of capital gains and dividends?
- Who benefited from the 2003 tax cut for capital gains and dividends?
- Where things stand on the Hill
- Information & resources
How does the tax treatment of capital gains and dividends differ from the tax treatment of income from work?
Under the current tax code, income from work is taxed at higher rates than investment income from capital gains and dividends. Income from work — including wages, salaries, tips, overtime pay, commissions, bonuses, business and farm income — is considered "ordinary income" and taxed at rates up to 35 percent. In addition, income from work is subject to federal employment taxes for Social Security (12.4 percent on earnings up to $106,800 in 2008, including the employer and employee share) and Medicare (2.9 percent on all earnings, including the employer and employee share). Capital gains (profit from the sale of stock and other capital assets) and dividends (share of profits paid by a qualified foreign or domestic corporation) are currently taxed at a maximum rate of 15 percent and not subject to Social Security or Medicare taxes.
What are the consequences of the tax-favored treatment of capital gains and dividends?
Because most of the assets that generate capital gains and dividends income are owned by the very wealthy, the tax-favored treatment of investment income means that the very, very wealthy may pay a lower tax rate on their income than average working Americans. Warren Buffett once observed that he paid a lower tax rate on the $46 million he made than his secretary paid on her $60,000 salary. The lower tax rate on capital gains also creates an incentive for wealthy taxpayers, such as private equity and hedge fund managers, to devise schemes to convert income from work into capital gains.
Who benefited from the 2003 tax cut for capital gains and dividends?
In 1986, under legislation signed by President Ronald Reagan, income from work and capital gains and dividends were taxed at the same rates. In 1997, the maximum tax rate on capital gains was reduced to 20 percent. In 2003, the maximum tax rate on both capital gains and dividends was reduced to 15 percent; the top rate on capital gains and dividends income is now less than half the top rate on income from work.
High-income tax filers account for an overwhelming share of capital gains. In 2009, almost 90 percent of the benefit of low rates went to tax filers with incomes over $200,000 and 68 percent went to those earning over $1 million. The Tax Policy Center projects that in 2009, middle-income families will receive only $20 from the capital gains and dividends tax cuts, while millionaires will receive $32,000.
Middle-income families receive few benefits from the tax cuts for capital gains and dividends, not only because they own much less stock than wealthy households but because most of the corporate shares they own are held in tax-deferred retirement accounts such as IRAs and 401(k)s. Dividends and capital gains earned on shares held in retirement accounts are already tax free. And, when shares held in retirement accounts are sold at retirement, the gain will be taxed as income from work, not capital gains, so there will be no benefit from the lower tax rate for capital gains.
Where things stand on the Hill
The tax cuts for capital gains and dividends expire at the end of 2010. If Congress did nothing, income from dividends would be taxed at the same rate as income from work; the maximum tax rate on capital gains would be restored to 20 percent. A number of lawmakers have introduced bills this year to make permanent the current capital gains and dividends tax rate or to cut it even further as a way to stimulate the economy. Others have argued, and research has confirmed, that cutting the capital gains tax will decrease revenue and provide little economic stimulus.
President Obama’s proposed budget calls for trimming the 2001-03 tax cut for capital gains and dividend income for the very wealthy. Beginning in 2011, for individuals with incomes over $200,000 ($250,000 for couples), the capital gains tax rate would be restored to 20 percent. The maximum tax rate on dividends would be 20 percent – higher than the 15 percent rate under the 2001-03 tax cuts. But dividends for these wealthy households would still be taxed at lower rates than if the 2001-03 tax cuts were allowed to expire. For people with incomes below $200,000 ($250,000 for couples), the maximum rate on dividends and capital gains income would remain at 15 percent.
A similar policy was introduced in Senator Max Baucus’ (D-MT) Taxpayer Certainty and Relief Act (S.722). Under his plan, people in the top two tax brackets would see their capital gains tax rate set at to 20 percent, while the 15 percent rate would be made permanent for those in lower brackets.
Rep. Sander Levin (D-MI) has introduced a bill (H.R. 1935) to address the loophole that allows some private equity managers to classify income from compensation as capital gains and therefore pay only the lower capital gains tax instead of the tax on income from work.
Capital Gains Tax Cut Would Be Poor Stimulus, Center on Budget and Policy Priorities (January 15, 2009).
Distribution of Capital Gains Tax Benefits, Tax Policy Center (October 13, 2008).
Experts Agree that Capital Gains Tax Cuts Lose Revenue, Center on Budget and Policy Priorities (May 7, 2008).
Capital Gains Tax Cuts Slashed Taxes of Top 400, While Their Incomes Soared, Center on Budget and Policy Priorities (March 27, 2008).
Who Pays Capital Gains Tax?, Tax Policy Center (August 4, 2008).
Capital Gains and Dividends Tax Cuts Offer Almost No Benefit to Middle-Income Americans and Add to the Nation’s Fiscal Problems, Citizens for Tax Justice (May 13, 2008).