Background
When individuals sell an asset for more than the price at which they obtained it, they generally realize a capital gain that is subject to taxation. Most taxable capital gains are realized from the sale of corporate stocks, other financial assets, real estate, and unincorporated businesses. Under current law, long-term capital gains (those realized on assets held for more than a year) are usually taxed at lower rates than other sources of income, such as wages and interest. Since 2003, qualified dividends, which include most dividends, have been taxed at the same rates as long-term capital gains. Generally, qualified dividends are paid by domestic corporations or certain foreign corporations (including, for example, foreign corporations whose stock is traded in one of the major securities markets in the United States).
As specified by the tax code, different statutory tax rates apply to different portions of people's long-term capital gains and qualified dividends, depending on the tax brackets in which each portion lies. (Tax brackets are ranges of total taxable income and vary depending on taxpayers' filing status.) Tax brackets are adjusted, or indexed, each year to include the effects of inflation. The brackets for 2018 are shown in the table below.
| Starting Points for Tax Brackets (2018 dollars) | Statutory Tax Rate on Long-Term Capital Gains and Qualified Dividends (Percent) | |||||
| Single Filers | Joint Filers | 2018 | ||||
| 0 | 0 | 0 | ||||
| 38,600 | 77,200 | 15 | ||||
| 425,800 | 479,000 | 20 | ||||
Consider, for example, a person filing singly in 2018 with taxable income of $40,000, of which $5,000 is long-term capital gains and $35,000 is ordinary income—that is, all income subject to the individual income tax from sources other than long-term capital gains and qualified dividends. Because no tax on long-term capital gains is due on taxable income up to $38,600, such a person would not pay any capital gains tax on the $35,000 in ordinary income and the first $3,600 of his or her gains, but the remaining $1,400 in gains would be taxed at the 15 percent rate.
The 2017 tax act lowered most tax rates on ordinary income and modified the tax brackets that apply to that income but did not change the rates or tax brackets applicable to long-term capital gains and qualified dividends. As a result, the starting points for the 15 percent and the 20 percent brackets shown in the table above do not match the starting points for any of the income brackets used to determine taxes on ordinary income. (See "Increase Individual Income Tax Rates" for a description of those brackets.) However, that is true only through the end of 2025, when the changes to the tax treatment of ordinary income expire. Beginning in 2026, the starting points for the 15 percent and 20 percent rates for capital gains and qualified dividends will match the starting points for tax brackets applicable to ordinary income, as under pre-2018 law. No tax will be payable on capital gains and dividends in the first two tax brackets applicable to ordinary income; the starting point for the 15 percent rate on gains and dividends will match the starting point for the third tax bracket applicable to ordinary income, and the starting point for the 20 percent rate will match the starting point for the top tax bracket applicable to ordinary income.
The marginal tax rate (that is, the percentage of an additional dollar of income that is paid in taxes) on long-term capital gains and qualified dividends may be higher than the statutory rate for some higher-income taxpayers as a result of other provisions of the tax code. First, certain long-term gains and qualified dividends are included in net investment income, which is subject to the Net Investment Income Tax of 3.8 percent. Second, the expiration of certain provisions of the 2017 tax act at the end of 2025 will have implications for the computation of marginal tax rates, even though those expiring provisions do not explicitly refer to capital gains and dividends. For example, a provision that reduced the total value of certain itemized deductions claimed by higher-income taxpayers was temporarily eliminated by the 2017 tax act. When that provision comes back into effect in 2026, it will increase the share of income that is taxed.
In 2015, according to the Internal Revenue Service, about 15 million taxpayers realized net positive capital gains totaling $725 billion. The Congressional Budget Office projects that in 2019, approximately 16 million taxpayers will earn net positive capital gains totaling $955 billion. CBO estimates that those taxpayers will owe about $180 billion in taxes on those gains. Under current law, CBO projects that income from capital gains and dividends will grow more slowly than other sources of income from 2019 through 2028. That slower growth reflects the expectation that income from capital gains and dividends will return to levels consistent with their historical average share of gross domestic product.
Option
This option consists of three alternatives. The first alternative would raise the statutory tax rates on long-term capital gains and dividends by 2 percentage points but would not change the income brackets used to compute those tax rates. Both the second and the third alternative would combine that 2 percentage-point increase with changes to the income brackets that apply to long-term capital gains and qualifying dividends.
The second alternative would set the starting point for the 17 percent rate to be the same as the starting point for the third tax bracket applicable to ordinary income (for 2018, $38,700 for single filers and $77,400 for married couples filing jointly). The starting point for the 22 percent rate would match the starting point for the second-highest tax bracket for ordinary income (for 2018, $200,000 for single filers and $400,000 for joint filers).
The third alternative would make the same change to the starting point for the 17 percent rate, but the 22 percent rate for long-term capital gains and dividends would share its starting point with the third-highest tax bracket for ordinary income (for 2018, $157,500 for single filers and $315,000 for joint filers). None of the three alternatives would change other provisions of the tax code that affect taxes on capital gains and dividends.
Effects on the Budget
The staff of the Joint Committee on Taxation (JCT) estimates that the first alternative would raise federal revenues by $70 billion from 2019 through 2028. The second and third alternatives would raise revenues by $76 billion and $81 billion, respectively, over the same period, according to JCT's estimates. Those estimates reflect people's responses to the higher rates: The tax base would decline as investors responded to higher tax rates by deferring realizations of accrued gains, and corporations—in response to investors' concerns—would issue smaller dividends.
The second alternative would raise more revenues than the first because some gains and dividends taxable at the rate of 17 percent would instead be taxed at the rate of 22 percent. The third alternative would raise more revenues still because it would shift additional gains and dividends from the 17 percent rate to the 22 percent rate.
JCT's estimates are based on a scenario in which there would be no delay between the active consideration of legislation increasing the tax rates and the effective date of that increase. As a result, taxpayers would have no opportunity to change their behavior in anticipation of the change in the tax rates. If, instead, there was a gap between the consideration and the implementation of the legislation, then some taxpayers would accelerate the sale of various assets to occur before the higher rates were put in place. If this option, with an effective date of January 1, 2019, was changed to include such a gap, then the realization of gains from those accelerated sales would occur in 2018. In that case, compared with the estimates for the option, revenues would be higher in 2019, when tax returns for 2018 would be filed, and would be lower in later years. The magnitude of that shift would vary with the length of time between active consideration and the effective date.
The estimates for the option are uncertain because both the underlying projections of capital gains and dividend income and the estimated responses to the change in the tax rates are uncertain. Projections of capital gains and dividends rely on CBO's projections of economic activity, investment, and the stock market, all of which are inherently uncertain. Those projections are particularly uncertain because they reflect recently enacted changes to the tax system by the 2017 tax act. The estimates are also influenced by predictions of how the increase in tax rates would induce taxpayers to defer the realizations of accrued gains and corporations to reduce their issuance of dividends. Those predictions are based on observed responses to prior changes in tax rates, which might differ from the responses to changes considered here.
Other Effects
One advantage of raising tax rates on long-term capital gains and dividends is that it would reduce taxpayers' incentive to characterize labor compensation and profits as capital gains. Such mischaracterization occurs under current law even though the tax code and regulations governing taxes contain numerous provisions that attempt to limit it. Reducing the incentive to mischaracterize compensation and profits as capital gains would reduce the resources devoted to circumventing the rules.
Another argument for this option is that it would make taxation more progressive. Most capital gains are realized by people with significant wealth and income. Therefore, raising tax rates on long-term capital gains would impose, on average, a larger burden on people with significant financial resources than on people with fewer resources. However, older people, particularly retirees, also realize a substantial amount of capital gains. Although such people have greater wealth and income than younger people, on average, their lifetime income is not necessarily greater.
The second and third alternatives of this option would offer the additional advantage of simplifying the tax code. Under either of those alternatives, the thresholds for the 15 percent and 20 percent tax rates on capital gains would be aligned with the starting points of the brackets for ordinary income immediately, rather than in 2026.
A disadvantage of the option is that the higher tax rates on long-term capital gains and dividends would influence investment decisions by increasing the tax burden on some equity-financed corporate investments. Profits from those investments are taxed twice—once under the corporate income tax and then a second time, either when the profits are paid out as dividends or when they are retained and taxed later as capital gains on the sale of corporate stock. The increased tax burden would discourage investment funded through new issues of corporate stock and would also exacerbate an existing bias that favors debt-financed investment by businesses over equity-financed investments. It would also encourage the formation and expansion of noncorporate businesses, whose profits are taxed only once.
Another argument against implementing the option is related to the fact that, because capital gains are taxed when an asset is sold, taxation encourages people to defer the sale of their capital assets, or, in some instances, to never sell some of the assets during their lifetime. In the former case, the taxation of capital gains is postponed; in the latter case, it is avoided altogether because, if the asset is bequeathed and then sold by the heir, the capital gain is the difference between the sale price and the fair-market value as of the date of the previous owner's death (which is typically much smaller than what it would otherwise be). By raising tax rates on long-term capital gains and dividends, this option could further encourage people to hold on to their investments only for tax reasons, which could reduce economic efficiency by preventing some of those assets from being put to more productive uses.
