I have never understood the preferential treatment of capital gains and dividends, especially dividends. Back when the top tax bracket was 70% (and, yes, I'm old enough to remember) the capital gains rate was 20%. The wealthy have gotten significant cuts in the tax brackets - the top bracket is now 35%. I see no reason for capital gains to be a maximum of 15%. And if dividends are taxed at 15%, why not interest as well? Both are investment income. Doesn't it penalize conservative savers over risk-takers? Is that what we want to accomplish?
I wrote a lengthy comment, and decided to promote it up to my own blog as a separate entry because (at least at 12:45am) it seemed like a good idea:
The purpose of lower (or zero) tax rates for capital gains is well-known — to encourage investment in businesses, who can use that investment to grow, improving the economy and employing more americans.
If you buy that, including dividends is a rational and actually necessary move. By taxing dividend higher than capital gains, the tax code artificially inflated the value of stock price inflation over return of income via dividends. So rather than pay dividends, business would buy back stock or build up cash, both in an effort to raise the value of their stock. Since paying dividends is a better indication of REAL income (it’s hard to fake income when you have to send real checks), we needed to change the tax code to eliminate this artificial bias toward stock price inflation.
If you wanted to push a lower tax rate on interest, I’d be with you. The argument isn’t as clean, but you could still say we want to encourage savings, and lower taxes on interest would do so. As it is, SOME interest gets special treatment, others don’t — that is why we won’t see this, because it subsidises state and county borrowing (because they are allowed to issue tax-exempt bonds at a lower interest rate).
The tax code as it is makes people do odd things. For example, if you have both normal investment, AND an IRA, you should put all of your INTEREST investments in the IRA, and use your normal investment for risky stock purchases. The reason? Capital gains are taxed at a much lower rate than interest — but ALL earnings in IRAs are taxed as normal income at retirement. So your IRA should have all the non-favored investments.
From a theoretical perspective, a fair tax code would tax investments only on the inflation-adjusted increase. If I buy a stock, and 5 years later it has only increased at the rate of inflation, I haven’t really made ANY money - the sale gives me money that buys the same items I could have bought 5 years earlier. But I can’t imagine how complicate THAT sort of calculation could be.
The lower tax rates for capital gains is a quick-and-dirty way of mimicking the theoretical desire for taxing only REAL gains, while encouraging people to invest for the long term.
What I don’t like is that while gains are fully taxed in the year they occur, losses can only be taken against gains, with only $3,000 loss allowed each year. People like myself, without a lot of money, and with large losses in the stock market, literally can take DECADES to write off all of our losses. If you earn $10,000 in one year, and lose 10,000 the next, it will be 4 years before you get your losses reflected in your taxes — but if you lose 10,000, and gain it the next year, all of the losses are taken care of in that year.
I like the teacher tax deduction — although it signals a problem with local schools providing the tools teachers need.