Monday, May 5, 2014

Capital Gains and Dividend Taxes: What Would Ronald Reagan Say?

Earlier this year, I was thinking about tax policy as I, like so many others, used software to prepare and file my federal tax return. This exercise reminded me of the significance of the reduction in the tax rates on most dividend income and long-term capital gains to 15 percent championed by and achieved during the Administration of President George W. Bush. Moreover, these rate changes were a radical break from the Tax Reform Act of 1986, which was enacted with the Reagan Administration’s enthusiastic support.
It is currently rarely mentioned by Republicans, many of whom consider President Reagan as their conservative hero, that the 1986 Tax Reform Act generally raised the maximum tax rate on long-term capital gains to 28 percent (in fact, the marginal tax rate on capital gains could be 33 percent for certain taxpayers whose taxable income fell in a phaseout zone of the 15 percent marginal tax rate on lower amounts of income). The Tax Reform Act resulted in the elimination of a separate Schedule D computation for determining the total amount of income tax owed, which has now come back, since the rate on capital gains and ordinary income were the same.

The differential tax rate between long-term capital gains returned during the Administration of George H. W. Bush as the top marginal rate on ordinary income, but not capital gains, was increased. The Schedule D computation of taxes for taxpayers with long-term capital gains returned for tax year 1991, when the top marginal rate on ordinary income was 31 percent. (Actually, the marginal rates were somewhat higher for certain taxpayers because of limits on deductions and a phaseout of personal exemptions based on adjusted gross income, which includes capital gains).
In subsequent years, the top marginal rate on ordinary income increased as did the differential between that rate and the top marginal rate on long-term capital gains. Thus, a central premise of the 1986 Tax Reform Act argued by Treasury officials in the Reagan Administration was undermined by policies advocated by both Republican and Democratic administrations. In brief, the Reagan Treasury argument was that income is income and should be taxed at the same rate. To do otherwise is not consistent with fairness and encourages stratagems which have no real economic purpose other than converting one type of income or loss into another type. For example, when there is a large difference between the tax rates applicable to ordinary income and long-term capital gains, this creates an incentive to attempt to devise strategies that effectively convert ordinary income into long-term capital gains and convert capital losses into ordinary losses.

The Bush tax cuts lowered the top marginal tax rate on long-term capital gains, and, significantly, qualified dividends, to 15 percent. For a taxpayer with a mix of ordinary income and long-term capital gain and qualified dividend income, there are effectively two calculations. The 15% is applied to the long-term capital gain and qualified dividend income and the normal tax rates are applied to the ordinary income. This means that a taxpayer who had significant long-term capital gain and dividend income and a modest amount of ordinary income would be taxed at a relatively low rate, since the modest amount of ordinary income is taxed by the same amount as another taxpayer who had no other income but this modest amount of ordinary income.
During the Obama Administration, very high income taxpayers have seen their tax rates on capital gains and ordinary income creep up because of the Affordable Care Act and other legislation. Nevertheless, investment income is still treated much more favorably than ordinary income under the tax code. Republicans will keep fighting to preserve that preference or increase it, even though it was the Reagan Administration that advocated its elimination

Note: A full analysis of tax changes requires consideration of the Alternative Minimum Tax. The AMT, though, does retain preferential rates for long-term capital gain and qualified dividend income.

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