Taxing Dividends and Capital Gains Income Fairly: The Tax Rates and Policies on Income from Dividends and Long-Term Capital Gains Lead to Some Unintended Negative Consequences. in Trying to Help Stamp out Fraud in Financial Reporting and Add More Fairness into the Tax System, Closer Examination of These Policies Is Warranted

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Income taxes have long been a divisive issue in the United States--as evidenced recently by the debates and concerns surrounding the fiscal cliff. One area that continues to be a significant source of controversy is whether both dividends and long-term capital gains should receive preferential tax treatment. In recent years, the rates of taxation on capital gains and most dividends have been progressive, perhaps designed to make high-income taxpayers pay their "fair" share. Although fairness in tax policy may undoubtedly exist only in the eye of the observer, several ethical considerations and related negative, unintended consequences of tax policy deserve discussion.

The elimination of any taxation on dividends received by shareowners has been discussed periodically, most recently by President George W. Bush in 2003. Soon thereafter, Congress included some of the cuts Bush requested, reducing the rate at which most dividends were taxed to the same rate as for long-term capital gains. In general, this is 15% for most individual taxpayers. For taxpayers in the two lowest tax brackets, taxation on this income was eliminated in 2009.

The American Taxpayer Relief Act of 2012, which helped postpone the fiscal cliff, increased the rate for most dividends to 20% for taxpayers in the highest tax bracket, but the 15% rate for taxpayers in the middle brackets and the zero rate for taxpayers in the two lowest brackets stayed the same. The Patient Protection and Affordable Care Act of 2010 also increased tax rates in 2013 for upper-bracket taxpayers by 3.8% on investment income, including both dividends and capital gains.

The economics-oriented argument for preferential tax rates on income from dividends and capital gains considers the fact that both involve previously invested capital. Incentives to invest in start-up companies--as well as established ones--are widely believed to help create additional jobs and stimulate growth in the economy. According to Mark Heesen, president of the National Venture Capital Association, "If capital gains rates go up high, venture capitalists will become more conservative."

But empirical research supporting the theory that higher taxes suppress investment or the converse is hard to find. A December 29, 2012, New York Times opinion article titled "Why the Economy Needs Tax Reform" states the opposite, noting that "research shows that the [preferential capital gains] tax breaks do not add to economic growth but do contribute to inequality." The top 1% of taxpayers receives more than 70% of all capital gains, according to the Times.

A more cogent argument for taxing capital gains lightly is because some of the gains are the result of inflation and hence don't represent increases in real wealth. But almost all of the strength of that argument is lost by the fact that the holding period for an asset to be taxed at the preferential long-term capital gains rate is only one year. If long-term capital gains were defined as those resulting from holding assets at least six to eight years, then better recognition of the effects of inflation would be appropriate.

In "The case for raising taxes on capital gains," Ezra Klein states, "It's also hard to find much evidence that cutting taxes on investment income has led to much economic growth. In the 1980s, for instance, Ronald Reagan actually raised taxes on investment income--and the economy did very, very well. George W. Bush's capital gains cuts, however, did not lead to such a strong economy." (The Washington Post's Wonkblog, September 25, 2012)

Klein cites tax expert Len Burman, who has found no correlation between tax rates on capital gains and economic growth. According to Burman, what's clear is that taxing capital gains at a much lower rate than that of ordinary income "incentivizes very complex tax avoidance." Transforming highly taxed compensation into more lightly taxed capital gains has led to a vast industry of lobbyists, attorneys, and accountants. …