In his State of the Union Address, President Obama proposed raising the top tax rate on capital gains and dividends to 28 per cent from the current rate of 24 per cent. This is up from 15 per cent when Obama took office. Part of the increase came from a 3.8 per cent tax on unearned income to help fund the Affordable Care Act.
But America does not need to increase its taxes on investment income in an effort to soak the rich. Rather, there is good reason that investment income is taxed at a lower rate, and lowering the rate further would benefit the economy.
Data from the nonpartisan Tax Foundation show America’s average combined state and federal tax rate on personal dividend income and capital gains are both over 28 per cent. These rates are uncompetitive among the 34 Organisation for Economic Co-operation and Development countries, as the US ranks in the top ten highest tax rates for both capital gains and dividends.
The first reason dividends have a lower tax rate because the corporate earnings which they come from have already been taxed. The company the investment was made in has to pay corporate income tax, which lowers its revenue and the value of the investment. The same logic holds for capital gains.
The statutory federal corporate tax rate is 35 per cent. When the personal dividend and corporate income taxes are combined, the total federal tax rate on dividends can grow to 53 per cent. State and local taxes can bring the tax even higher. When more than half of earnings are lost to taxes, it is no surprise that many US corporations are moving more of their operations and staff overseas.
Capital gains are also taxed at a lower rate because many investments are held for the long-term and much of their gains can be lowered by inflation. It makes little sense to tax gains that came from inflation. Rather than calculating the gain from inflation for each stock, for the sake of simplicity, Congress decided to tax those gains at a lower rate. This is one reason why the tax rate on long-term capital gains, those held longer than a year, is lower than that on short-term capital gains.
Most importantly, capital gains have a lower tax rate to encourage the risk taking inherent in investment. Returns from capital are by no means guaranteed. Investors supply the financial capital essential for investments that spur innovation, improve productivity, and expand capacity. It is beneficial to encourage this risk taking and tax the proceeds of capital at a lower rate.
Higher tax rates on capital gains and income hurt everyone—not just the rich.
When you tax something more, you get less of it. Rather than helping the poor, higher taxes on investment income result in decreased investment—which means less capital available for private companies, innovators, and small firms getting off the ground.
High capital gains rates also decrease investment efficiency. Instead of evaluating investments purely on merits, individuals have to plan the timing of their purchases and sales based on tax implications. This inefficiency makes companies less productive and lowers employee wages. Taxes on US investment are higher than taxes abroad, so some investment capital moves to lower-tax countries.
Taxing investments also hurts retirement funds that individuals—especially retirees—rely on for dividends and capital gains.
People often assume that spending is superior to saving in creating economic growth. However, when money is saved it is not simply hidden under a mattress. Rather, investing allows money to be transferred from people who have little use for it now to those who do. Taxes should not punish this type of behavior. A dollar saved is a dollar spent, just more effectively.
For all these reasons, the United States would be wise cut its top personal dividend income tax rate down to at least the OECD average—not further increase it.
Raising taxes on the rich has a populist ring, but capital is mobile in a global economy, and people respond to decreased incentives to invest. America needs a tax code that is hospitable to investment, and raising taxes on investment income is not the answer. Populist rhetoric might make Americans feel good, but high taxes on capital gains slow economic growth, harming Americans of all incomes.