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| Tax Notes
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Long-term capital gains have been taxed at lower rates than ordinary income throughout most of the history of the U.S. individual income tax system. As prescribed by section 1(h), the maximum rate on long-term capital gains is 15 percent. Since 2003, qualified dividends have enjoyed the same preferential rate. Starting in 2013, the maximum tax rate on long-term capital gains is slated to rise to 20 percent and qualified dividends are to become subject to ordinary income tax rates.
The capital gains preference has always been controversial, with an astounding variety of arguments offered by its supporters and opponents. In this article, I argue that the preference is a valuable but imperfect feature of today’s tax system.
The capital gains preference lacks a clear conceptual rationale and is not part of an ideal tax system. Nevertheless, it is a useful addition to our imperfect tax system. The preference reduces three important distortions: the lock-in effect, the tax bias against equity-financed investment by C corporations, and the tax penalty on savings. In each case, the preference plays a beneficial role, even though it is not ideally suited to achieving the purpose in question. It therefore would be highly undesirable to remove the capital gains preference while leaving the rest of the tax system unchanged, even though an ideal tax system would replace the preference with other policy instruments.
Lack of Conceptual Rationale
Tax policy principles do not call for capital gains to be treated differently than other types of capital income. Neither a textbook income nor consumption tax would single out capital gains for differential treatment.
It is therefore unsurprising that the current set of tax-preferred capital gains is an artificially constructed category. Section 1221 and reg. section 1.1221 set forth detailed rules to distinguish capital assets that qualify for the preference from ordinary assets that do not. Specific provisions even address the classification of self-created musical works and
copies of the Congressional Record. Also, only gains on capital assets held for longer than one year are eligible for the preference. Section 1258 imposes rules to prevent the conversion of ordinary income into capital gains in an effort to prevent erosion of the thin line that separates the two categories.
Despite its conceptual limitations, the capital gains preference reduces three important distortions in the tax system.
The Lock-In Effect
With a few exceptions, such as securities dealers subject to section 475 and futures contracts subject to section 1256, the U.S. income tax system taxes capital gains only on realization. Taxpayers therefore have an incentive to defer realization of accrued gains by inefficiently retaining assets they would otherwise sell, an outcome commonly referred
to as the lock-in effect. Theory and empirical evidence conclusively demonstrate that changes in capital gains tax rates have a significant short-term effect on the amount of gains realized by taxpayers, although the magnitude of the long-term effect is more uncertain. By lowering the tax rate on realizations, the capital gains preference mitigates the
However, reducing the tax rate on realized gains is generally not the ideal way to address the problem. For liquid assets that can be readily valued and traded, the lock-in effect could be eliminated by taxing gains as they accrue.
The Tax Bias Against Corporate Equity
Unlike debt-financed investment by C corporations and investment by flow-through firms, equity-financed investment by C corporations is subject to corporate income tax. That disparity results in a misallocation of the capital stock. The bias against equity investment can be counteracted in the individual income tax system by taxing capital gains and dividends on C corporation stock at lower rates than interest income and flow-through business income. The capital gains and dividend preferences have that effect.
Again, however, the capital gains preference is not the ideal instrument to address the problem. To begin, the argument supports a preferential rate only for gains on stock in C corporations, not for gains on the full range of capital assets identified by section 1221. More broadly, a preferential rate at the stockholder level is an imperfect corrective for a tax penalty imposed at the firm level. Offsetting a firm-level penalty with a preferential rate that is beneficial only for domestic individuals inefficiently alters portfolio allocation, steering shares in domestic C corporations toward those individuals and away from foreigners and tax-exempt institutions.
The Tax Penalty on Savings
Income taxation inherently imposes higher effective tax rates on those who save for future consumption than on those who consume today, because the returns to savings are taxed. In contrast, consumption taxation at a constant rate imposes equal effective tax rates on current and future consumption. The income tax’s bias against future consumption can be diminished by lowering the effective tax rate on capital income, as is accomplished through the capital gains and dividend preferences.
The capital gains preference is not the ideal way to address that problem, either. Because the taxation of capital gains does not pose any greater savings penalty than the taxation of other capital income, there is no reason to single out capital gains for tax relief. Indeed, the capital gains preference may be ill-designed in one respect: Some investments yield returns in excess of the normal returns generated by marginal investments in the economy and therefore in excess of the return required to motivate additional investment. It is generally desirable to tax those above-normal returns at a relatively high rate because doing so does not impair the incentive to invest. But many above-normal returns are in the form of capital gains and therefore receive the preference.
In view of the beneficial roles played by the capital gains preference, it would be highly undesirable to simply repeal the preference while leaving the rest of the tax system unchanged. Doing so would increase the lock-in effect, the tax penalty on equity-financed investment by C corporations, and the tax penalty on savings. In the context of a sweeping reform, however, other policies could be adopted to address those distortions.
Comprehensive income tax reform could address the first two distortions. The corporate income tax could be abolished, eliminating the penalty on equity-financed investment by C corporations. Capital income would then be taxed only at the individual level. Gains on liquid assets could be taxed as ordinary income on an accrual basis, which
would prevent the sheltering of income at the corporate level.
That approach would remove the lock-in effect and the bias against equity investment without the need for a capital gains preference. If anything, however, the tax penalty on savings would be amplified. Moreover, the use of accrual taxation would pose administrative complications. Those problems could be addressed by a more sweeping
reform — a move to consumption taxation.
Under a personal expenditure tax or consumed-income tax, taxpayers deduct all costs of asset purchases and pay tax on the full proceeds of asset sales. (The treatment under other consumption taxes, such as a sales tax, VAT, Hall-Rabushka flat tax, or Bradford X tax, is economically identical, but administratively different.) For a marginal investment, the upfront deduction for purchase costs offsets, in expected market value, the taxation of sale proceeds. As a result, normal or marginal investment returns escape tax, removing the tax penalty on savings. Above-normal returns, however, are fully taxed. Unlike the capital gains preference, consumption taxation achieves the desired combination of eliminating the tax penalty on the margin while taxing those investors who earn above-normal returns.
Although the capital gains preference does not have a clear conceptual rationale, it reduces three important distortions in the tax system: the lock-in effect, the bias against equity-financed investment by C corporations, and the penalty on savings. In each case, the preference is an imperfect solution to the problem. Nevertheless, it would be a mistake to
remove the preference unless and until more sweeping reforms are adopted to address those distortions.
Alan D. Viard is a resident scholar at AEI.
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