Dividend and capital gains income are taxed at lower rates than regular wage and salary income. That such income is taxed lightly strikes progressives as offensive, but the intent and effects of these lower rates is not to redistribute income to rentiers. Rather, relatively low dividend and capital gains tax rates are in place because they limit double-taxation, minimize taxation of inflationary “gains”, and reward successful risk-taking.

Dividends, and ultimately capital gains, derive from corporate earnings. Corporate income in the U.S. is taxed at the highest rate in the OECD, with a top federal rate of 38% (though the rate drops to 35% above a certain level of earnings). Dividends may or may not be paid to shareholders from corporate income, but if so, they are subsequently taxed again as personal income. If dividends were taxed as regular income to individuals, the combined federal taxes (corporate and individual) on that marginal income in upper brackets would be in excess of 75%. With state corporate and personal income taxes added on, the after-tax dividend received by an individual shareholder from each dollar of pre-tax corporate income could then be less than 10 cents in some states.

The top federal tax rate on dividends is 20%, versus 39.6% for regular income. One reason that dividend income is taxed at lower rates than wage and salary income is recognition of the confiscatory nature of double taxation, as illustrated above. Realized capital gains are taxed at the same rate as dividends for the same reason. A capital gain is the increase in the value of an asset over time. Such gains are taxed only when an asset is sold, when the gain is realized. The low tax rate on gains from the sale of corporate stock also limits double taxation (and even triple taxation).

Stock prices tend to rise along with the expected stream of future after-tax corporate earnings and dividends. A prospective buyer of shares knows they will incur taxes on future dividends, which limits the price they are willing to pay for the shares. So, higher future earnings will be taxed to the corporation when they occur, higher future dividends will be taxed to the buyer of shares when dividends are eventually paid, and the resulting gain in the share price received by the seller today is taxed as a capital gain to the seller. Triple (and anticipatory) taxation! A relatively low tax rate on capital gains at least helps to limit the damage from the awful incentives created by multiple taxation of the same income.

Another important reason for taxing capital gains more lightly than wages and salaries is that the tax, in the presence of inflation, diminishes the real value of an asset. As an example, compare the following situations in which the price level increases by 20% over five years: Worker Joe earns $10 an hour to start with and $12 an hour at the end of year 5; Saver Dev earns $1 dividends per share of the Prophet Corp (which he plans to hold indefinitely) to start with and $1.20 at the end of year 5; Retiree Cap buys one share of Gaines Corp worth $100 at the start and sells it for $120 at the end of year 5. On a pre-tax basis, these three individuals all keep pace with inflation. The real value of their pre-tax earnings, or the share value in Cap’s case, is unchanged after five years. Cap keeps pace by virtue of a $20 capital gain, so the real value of his share is unchanged.

If all three types of income are taxed at the same rate, Joe and Dev both keep pace with inflation on an after-tax basis as well. But what about Cap? After taxes, the proceeds of his stock sale are $115. Cap’s after-tax gain is only 15%, less than the inflation that occurred, so the real value of his investment was diminished by the combination of inflation and the capital gains tax. The same would be true for farmland, artwork, or any other kind of asset. It is one matter to tax flows of income that change with inflation. It is another to tax changes in property value that would otherwise keep pace with inflation. This is truly a form of wealth confiscation, and it provides a further rationale for taxing capital gains more lightly than wage and salary income, or not at all.

There are further complexities that influence the results. For one thing, all three individuals would suffer real losses if inflation pushed them into higher tax brackets. This is why bracket thresholds are indexed for inflation. Another wrinkle is the “stepped-up basis at death”, by which heirs incur taxable gains only on increases in value that occur after the death of their benefactor. This aspect of the tax code was recently discussed on Sacred Cow Chips here.

The third rationale for taxing capital gains more lightly than wage and salary income is an attempt to improve the risk-return tradeoff: larger rewards, ex ante and ex post, are typically available only with acceptance of higher risk of loss or complete failure. This is true for private actors and from a societal point of view. It is hoped that lighter taxes on contingent rewards will encourage savings and their deployment into promising ventures that may entail high risk.

This post was prompted by a article in The Freeman entitled “A Loophole For the Wealthy? Demystifying Capital Gains“, by Dr. Kim Henry. I was somewhat surprised to learn that Dr. Henry is a dentist. His theme is of interest from a public finance perspective, and he provides a good discussion of the advantages of maintaining a low tax rate on capital gains. My only complaint is with the first of these two points:

“[The capital gains tax rate] is lower for two important reasons:
1. Although the gain is realized in one year, it actually took place over more than one year. The wine did not increase in value just in the year it was sold. It took 30 years to achieve its higher price.
2. Capital gains are not indexed to inflation. …”

To be fair, Dr. Henry’s point relative to the time required to achieve a gain probably has more to do with the riskiness of an asset or venture’s returns, rather than the passage of time per se. If an asset’s value increases by 4% per year, the three points raised above (multiple taxation, taxing of inflationary gains, and rewarding successful risk-taking) would be just as valid after year 1 as they are after year 5.

Taxing income from capital is fraught with dangers to healthy investment incentives, which are primary drivers of employment and income growth. Double taxation of corporate income is not helpful. Capital gains taxes suffer from the same defect and others. But capital income is a ripe target for those who wish to score political points by inflaming envy. It’s a dark art.