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First there was the Congressional hearing last Thursday, then the release of Republican Presidential candidate Mitt Romney’s 2011 tax return on Friday. While one of them was big news and the other not so much, both events highlight the biggest subsidy high-income taxpayers get from the tax system – the preferential rate on capital gains and dividends. While we tax “ordinary” income such as salary and wages at rates up to 35 percent, capital gains and dividends are never taxed higher than 15 percent.
The upshot is that a taxpayer with investment income will pay less than half of the federal income tax that someone with the same amount of regular wage or salary income will pay. This is true at any income level – whether comparing two taxpayers that make $60,000 or two taxpayers that make $60 million. This fundamental unfairness in the tax code is the primary reason why Warren Buffett pays a lower tax rate than his secretary, why Mitt Romney pays a lower tax rate than many middle-income Americans and is the reason behind that feeling most Americans have that the tax code is rigged in favor of the wealthy.
A CTJ review of Romney’s 2011 federal income tax return found that he saved $1.2 million in federal income taxes in 2011 because of the preferential capital gains tax rate. Without that special break, he would have paid total federal income taxes of $3.1 million and his tax rate would have been almost 23 percent.
This benefit of this particular tax subsidy goes overwhelmingly to the richest Americans. A CTJ report released Thursday shows that 83 percent of capital gains and 60 percent of dividends are earned by the richest five percent of taxpayers. As Colorado venture capitalist Bill Stanfill testified in the Senate hearing, this tax break is “simply a windfall for wealthy investors.” He urged lawmakers to eliminate the special treatment.
Also at that rare, joint House Ways and Means and Senate Finance Committee hearing was a panel of experts from across the political continuum who all agreed that addressing the huge discrepancy between the ordinary income and capital gains tax rates will be key to any comprehensive tax reform. Len Burman, a professor at Syracuse and former director of the Tax Policy Center, noted, as did CTJ’s report, that the huge differential in tax rates creates enormous complexity in the tax code – which is exacerbated by more people pushing the limits of the code to structure their income as a capital gain, to which lawmakers respond with even more rules, and so on. (Two of the witnesses guessed that this ridiculousness accounts for about half the pages in the tax code!) David Brockaway, chief of staff of the Joint Committee on Taxation during the tax reform battles of 1986, said the revenue gained from raising the capital gains rate then was essential to pay for the other changes, calling it “a gateway issue.” Even Lawrence Lindsey, former director of the National Economic Council and an architect of the Bush tax cuts, said the ordinary and capital gain tax rates shouldn’t be so far apart.
Mitt Romney’s plan to keep the low capital gains tax rate is the primary reason why his tax proposal will be a huge break for millionaires. Even if all of their other deductions and exclusions are eliminated, taxpayers making over $1 million would get an average federal income tax cut of at least $250,000 and as much as $400,000 under Romney’s plan (to the extent we can know, anyway). For his part, President Obama has proposed to keep the current low capital gains rates for taxpayers with less than $250,000 in income, but to let the rates for taxpayers with higher income revert to the pre-Bush levels of 20 percent – a rate still substantially below the ordinary income rate.
It is clear that the special low rate on capital gains must be completely eliminated to simplify the tax code, end economically-damaging tax shelters, and enable comprehensive tax reform. It would also make the tax system dramatically more fair by taxing income from wealth the same as income from work.