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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