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Capital Gains Tax Effect On Investment And Economy Finance Essay

The American tax code is extremely complex, almost as complex as the United States economy. When one factor changes in the economy it can cause others effects that are almost unpredictable. When tax rates are increase, as they have been numerous times throughout history the results are generally similar. It can be expected that when tax rates increase prudent individuals will attempt to alter their situation to avoid paying the increase in tax, this strategy can work for some; however, not everyone is able to be as fiscally flexible. When the long term capital gains and qualified dividend tax rates increase as they are scheduled to do at the end of 2010 the effects will range from diminished tax revenue from capital gains tax, increased tax burden on the elderly and a decline in American output and employment.

Capital gains and losses result from the sale of capital assets. Capital assets are not directly defined by the Internal Revenue Service in the Internal Revenue Code. The Internal Revenue Code provides a guide line of what is not a capital asset, primarily a capital asset is an asset that if sold would not provide ordinary income. Ordinary income items include but are not limited to inventory, property held for re-sale, accounts or notes receivable acquires through the ordinary course of business, depreciable property used in business and supplies of used in the ordinary course of business.(26 USC. Sec. 1221. 2009) A gain is determined when the consideration received from selling an asset exceeds the seller’s basis in the asset, the difference is considered income. Capital gains and losses are separated into two types, short term and long term. Short term capital gains result from assets purchased and sold within a year’s time. Long term capital gains result from assets purchased and sold over the time period of a year or greater. This form of income is given favorable tax treatment.

Ordinary dividends are common forms of distributions for corporations; they are paid out of earnings and profits of a corporation and treated as ordinary income to the recipient. Qualified dividends are ordinary dividends paid to an investor that has held the stock for more than 60 days during the 121 day period that begins 60 days before the ex-dividend date. (Hoffman, Maloney, Raabe, Willis, Young, 2009) Qualified dividend income is currently given the same preferable treatment as capital gains.

The tax liability for capital gains and qualified dividends can be computed through the use of a special tax rate application. Currently, if a taxpayer’s ordinary income places them in either the 10% or 15% tax bracket, they do not have to pay taxes on capital gain income or qualified dividends received. If a taxpayer’s ordinary income places them in the 25%, 28%, 33% and 35% tax bracket, they must pay tax of 15% of the gain recognized. (Hoffman, Maloney, Raabe, Willis, Young, 2009)

In 1913 when congress first leveed an income tax capital gains were considered taxable income. The supreme court stated “capital gains did not constitute taxable income because, unlike wages, interest, dividends and other forms of income that accrue entirely within a single tax year, capital gains could accrue over many years. Hence it was wrong to tax as if they had arisen within a single year.” (Grey v. Darlington, 1872) Starting in 1918 the Internal Revenue Service began taxing capital gains even though the precedence of court cases. Over the next few years as the Internal Revenue Service continued to tax capital gains there were more Supreme Court cases that found capital gains did not constitute income. The Internal Revenue Service refused to follow the courts ruling and taxed capital gains at ordinary income rates. In 1921 the courts reversed their decisions about taxing capital gains in Merchants Loan and Trust Co. v. Smietanka, and decided capital gains were to be taxed. The court felt that capital gains needed to be taxed because they feared that the government would be unable to pay off the huge World War I debt, they felt this extra tax revenue would help. (Bartlet, 2001)

Over the past score of years there have been many different rates on capital gains. The highest tax rate on long term capital gains for the highest marginal tax bracket was 28% which was in effect from 1988 to May 6, 1997. The lowest long term capital gains tax rate for the highest marginal tax bracket is 15%, which is the current tax rate. The currently low tax rates on long term capital gains as qualified dividend income is a result of the Economic Growth and Tax Relief Reconciliation Act of 2003. The benefits of this act will expire on December 31, 2010 unless they are extended by congress. If these beneficial tax rates expire the tax on long term capital gains will increase to 10% for taxpayers in the 15% tax bracket and 20% for tax payers in the 28%, 31%, 36% and 39.6% tax brackets. Qualified dividend income will be taxed at ordinary income levels.

When the current capital gains and qualified dividend income tax rates expire on December 31, 2010, there will be many economic, fiscal and budgetary effects. Despite heavy opposition and overwhelming evidence for keeping the lower tax rates it does not seem that the Obama administration will heed the advice and warnings of previous rate increases. The general logical thinking provides that higher tax rates will provide higher revenues for the federal government; this is not considered the case in terms of long term capital gains taxes.

With one of the largest federal budget deficits in history and incalculably expensive health care bill looming it may seem necessary to increase federal revenue to help ease these expenses; however, doing so through increasing the long term capital gains tax will not prove to be beneficial despite what an ambiguous report of the Congressional Budget Office has concluded. In “The Budget and Economic Outlook: Fiscal Years 2008 to 2018” the Congressional Budget Office states: “the net effect of an increase in capital gains tax rates is an increase in revenues from that source despite a somewhat lower level of realization”.(Office. C. B, 2008) The Congressional Budget Office feels that there will be short period of time, three or four years, where revenues from capital gains will decrease due to an increase in the long term capital gains rates, but revenues will then begin to rise after that time period. Despite the optimism of the Congressional Budget Office with increasing revenues from increasing long term capital gains tax rates, the Joint Economic Committee published a study over a decade earlier concluding the opposite.

In June of 1997 the Joint Economic Committee published a report titled “The Economic Effects of Capital Gains Taxation” providing evidence that when capital gains taxes rates are lower tax revenues are increases, see Figure 1. From the graph it is clear that at points in time when the capital gains tax rates were reduced the revenue from the capital gains tax increases. Special importance should be noted to the time period of 1968 to 1978. During this period capital gains taxes rose to a high of 35%, during this time, capital gains tax revenue fluctuated but never should any sign of increase. The long term capital gains tax revenue did not begin to increase until tax rates were reduced. After a period of low capital gains tax rates and rising revenue, congress decided to increase capital gains tax rates again. In 1986 tax rates began to increase again. Prior to the increase in capital gains tax rates the Internal Revenue Service reported a year with extremely high capital gains tax revenue, following short period of revenue increases there was a steady decline in revenue received from capital gains taxes.

The Congressional Budget Office feels that after a period of a few years an increase in the capital gains tax will provide an increase in revenue despite the evidence from Figure 1 when from 1967 to 1978 a period of increased capital gains tax rates resulted in a period of relatively unchanged capital gains tax revenue and from 1986 to 1993 there was a steady decline in the amount of revenue received from capital gains tax.

Along with increases in revenue from a low capital gains tax rate an unlocking effect is created, this increases the tax base because realization of gains increase. The unlocking effect reverses a locked-in effect. A locked-in effect occurs when investors are unwilling to sell assets because of tax consequences affecting the return they will receive. Martin Feldstein, former chairman of the Council of Economic Advisors under President Ronald Regan felt that if capital gains taxes were reduced it would allow investors so sell securities that they previously would not sell. The benefit from allowing investors to have a larger realized gain on their investments would result in increased government revenues. (Stiglitz, 2000)

With lower capital gains taxes making investors more willing to sells assets held, the value of investment grade assets will increase. As the demand for investable assets increase the value of assets sold increase and taxes are paid on the higher recognized gains from the sale of those assets.

The value of assets increases for a number of reasons, stocks are believed to be valued based on the present value of future earning, they increase and decrease in price because of demand for the stock based on future expected earnings. Other tangible assets that qualify as capital assets can increase in value for many reasons or no reason at all; however, a major reason for the increase in value of a capital asset, such as land held for investment, is inflation. If an asset held for investment increases in value by 10 percent and inflation increases by 10 percent during the same time period the real capital gain is zero; however, the nominal capital gain is 10 percent, at that is the amount that will be taxed when it is realized at the sale of the land. (Stiglitz, 2000)

At the end of December 31, 2010 capital gains and qualified dividend income tax rates will increase causing many taxpayers to have a larger tax burden and resulting in lower income for many people. It has been a common miss conception that investors and people affected by changes in capital gains tax rates and receive dividend income are only affluent members of society, this notion is not true anymore. With the use of online trading and the popularity of employment provided retirement plans almost half of the adult population of the United States owns stock. Of the proportion owning stock over half of them are under the age of 55, and half of the stock owners did not graduate from college. (The Economic Effects of Capital Gains Taxation, 1997) According to the Internal Revenue service 26.4 % of tax returns filed contained dividend income. Of the tax payers claiming dividend income more than 60% of them had wages and salaries earned less than $50,000. (Hodge, 2003) Of tax payers claiming capital gain income 76% earned less than$100,000 in salaries and wages. (Hodge, 2005)

The receipt of dividends has been a controversial topic for as long as dividends have been taxed. The issue with taxing dividends arises because dividends are paid by a corporation with after tax dollars. Those after tax dollars are then taxed when received by the owner of the stock. The current maximum tax rate is 15% but will increase to ordinary income tax rates in 2011. When a large corporation, taxable income over 18 million dollars, has income it is taxed a 35%, the earnings left after paying taxes are then able to be distributed to the owners of the company in the form of dividends. When the corporation earns one dollar, thirty-five cents of it is paid in federal corporation taxes, the remaining sixty-five cents is available for distribution to shareholders. When a share holder receives that remainder as a qualified dividend they currently have to pay a maximum tax of 15% on the sixty-five cents or 9.75 cents. After these taxes the share holder is left with just 55.25 cents. With current qualified dividend tax rates share holders can only receive a maximum of 55.25% of every dollar earned by a corporation. If the qualified dividend tax rates are eliminated and all dividend income is taxed as ordinary income, a shareholder in the 39.6% tax bracket will only keep 33.37% of every dollar earned and declared as dividends. (Hoffman, Maloney, Raabe, Willis, Young, 2009) The class most affected by the increase in dividend taxation is the elderly population.

The elderly are clearly more dependent on income from capital gains and dividend income due to the nature that as you retire you become dependent on money you have saved and invested for the future. Currently over half of the population over 65 is reliant on dividend income. This percentage in expected only to increase in time. The current groups of retirees age 65 and over also rely on pensions from employers. Pension programs have been almost phased out in favor of less costly defined contribution plans. With the use of the contribution plans, dividend producing assets are purchased along with capital appreciating assets. When dividends are paid or these assets are sold for a gain, taxes must be paid. The current maximum rate favorable to the senior population; however, an increase in the tax rate could cause added strain to fixed income individuals. (Hodge, 2005)

With an increase in capital gains and dividend tax rates the reduction in income on senior citizens could place more stress on the economy by decreasing their dependency and increasing their dependency on government funding. The American economy can be described at best as being in a frail state. President Obama is quoted as saying “Tax increases would not take effect until January 1, 2011, when the economy would likely be in the midst of a sustainable recovery.” Although it is not yet 2011 and there is no crystal ball to see the future, it does not seem that in seven months the economy will be in any shape to bear any more stress. (Dickson, 2009)

There is a constant imbalance between the need for tax revenue and economic growth and jobs. It is estimated that the increase in taxes beginning in 2011 will reduce the total output of the economy by 0.04%. This reduction is felt to negate any revenue gain incurred by the increase in taxes. Along with at best marginal gains in federal revenue there is expected to be an increase in unemployment with the increase in the tax rates. In a 2009 debate president Obama expressed that losses in wages and jobs are acceptable in order to advance the ideology of tax fairness. In an economy with unemployment near 10% it does not seem prudent to preach tax fairness. (Foster, 2010)

When midnight arrives on December 31, 2010 an era of favorable tax rates for investors will come to an end if the Economic Growth and Tax Relief Reconciliation Act of 2001 is not extended. The expiration of such favorable tax rates will continue the trend of roller coaster like tax rates in the United States, with the most dramatic affects being on long term capital gains and qualified dividend income. In an economy already under ample stress it seems irresponsible to willingly add to the stress; however, with increasing the tax burden on a majority of Americans that is the unfortunate case. The effect of increasing taxes on long term capital gains and dividend income will have a reverberating effect through the economy that could cause unexpected results in today’s unpredictable economy.

Figure Source: Joint Economic Committee


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