31 January 2006

Capital Gain and Dividend Tax Cuts For Whom?

Who benefits?

Who benefits from tax cuts for capital gains and qualified dividends (subject to a top rate of 15% compared to 35% for ordinary income like interest and earned income)?

The benefits of these rates cuts are far more skewed to the wealthy than one might expect, because while 50 million households have some stake in the stock market, most households have the bulk of their holdings in retirement accounts and other tax free accounts, which account for about 40% of all household stock market holdings. Corporations don't get a preferrential tax rate for capital gains either. And, the Federal Reserve has found that these tax cuts don't impact overall stock prices (thus, they don't indirectly benefit tax preferrenced account holders).

About 54% of all capital gain and dividend income flows to the top 0.2% of households, those making $1,000,000 a year or more. About 78% of capital gain and dividend income flows to the top 3% of households, those making $200,000 or more per year.

About 11% of all capital gain and dividend income flows to the 86% of households making $100,000 or less. About 4% of capital gain and dividend income flows to the 64% of families making less than $50,000 a year.

For those making less than $100,000, capital gain and dividend income makes up an average of 1.4 percent of total income. For those making over $100,000, this income accounts for 12.2 percent of total income on average; for those making over $1 million, the share rises to an average of 31.4 percent.

Even among elderly taxpayers capital gains and dividend income is highly concentrated:

[M]ore than three-quarters goes to elderly households with incomes over $100,000, which represent 8.5 percent of all elderly households. Moreover 30 percent of this income goes to the 0.2% of elderly households who have incomes over $1 million. In contrast, the 73 percent of elderly households with incomes below $50,000 receive only 8 percent of the capital gain and dividend income that goes to the elderly.

A Tax Preference Even At Ordinary Income Rates.

Moreover, even when taxed at ordinary income tax rates, capital gains already receive a tax preference.

Consider a simple example. Suppose that you have a taxpayer who is already in the 35% tax bracket due to earned income or pension payments. This taxpayer has two choice. Invest $1,000,000 in a corporate bond paying 6% interest each year (which is reinvested each year in corporate bonds paying the same rate), or invest $1,000,000 in the non-dividend paying stock of that same corporation which happens to appreciate at a 6% annualized rate over a five year period and is sold at the end of that five year period. Which choice results in a higher tax bill?

Let's start with the interest (net of 35% income taxes paid each year):

Year 0 $1,000,000
Year 1 $1,039,000
Year 2 $1,079,521
Year 3 $1,121,622
Year 4 $1,165,365
Year 5 $1,210,814

Now, lets consider the capital gains:

Year 0 $1,000,000
Year 1 $1,060,000
Year 2 $1,123,600
Year 3 $1,191,016
Year 4 $1,262,477
Year 5 $1,219,847 (after taxes at a 35% ordinary income tax rate).

Thus, the investment upon which a capital gains tax is paid already comes out $9,033 ahead of the ordinary income investment, even at the same tax rate, over five years. This is a 4% greater profit.

Also, if a capital gain asset is not sold until death, the capital gain is entirely tax free. In the case of capital gains from real estate this is often possible, as gains may be rolled from one parcel of investment real estate into another, using a device called a "1031 exchange", cash flow meanwhile can be obtained by borrowing money from lenders who know that the capital gains asset is there to satisfy the loan, without actually selling the asset and incurring a capital gains tax prior to death (when the tax is forgiven).

An Expensive Perk.

So, how much do these tax preferences cost the public? A lot.

In 2006, the preferrential rates on capital gains is projected to cost (Table 469) the U.S. Treasury about $28.4 billion. The Treasury will lose another $28.8 billion that year due to the fact the capital gains tax accrued at death are not taxed. The Administration has refused to score the dividend tax cut as a tax expenditure at all, claiming essentially, that dividends shouldn't be taxed in an ideal world. But, the cost about $7.2 billion per year more.

Thus, preferrential rates for capital gains and dividends cost the federal goverment about $35.6 billion, and if you add the cost of making capital gains accrued at death tax free, the total cost of these preferences is $64 billion a year. Several billion dollars more per year of capital gains cuts are found in provisions targetted at narrower markets such as investment real estate, gains on small corporations, coal sales, certain agriculture sales, and the like. There is also, of course, the huge tax benefit that comes from the exclusion of capital gains on the sale of a residence.

By comparison, the charitable deduction reduces federal revenues by about $39.9 billion per year, the per child tax credit costs the Treasury about $32.8 billion a year, partially excluding Social Security benefits from taxation costs about $27.6 billion a year, and all of the major education deductions and tax credits combined reduce federal revenues by about $9.8 billion.

What would that money buy? For comparison purposes, in 2005 (Table 462), the Department of Homeland Security's budget is about $33.3 billion, the Energy Department budget is about $22.2 billion, the Interior Department has a $9.4 billion budget, the Commerce Department has a $6.3 billion budget, the Justice Department has a $21.2 billion budget, the State Department has an $11.9 billion budget, the Judiciary has a $5.7 billion budget, and the cost of administering the Social Security System (apart from the actuall checks themselves) is $55.8 billion. The CIA budget was believed to be about a $30 billion in 1998.


The economic case that a capital gains tax cut is beneficial are very weak. The big businesses that are supposedly encouraged to invest by this tax boon don't even receive the tax break and aggregate stock prices (and hence the cost of capital) aren't materially impacted by capital gains and dividend tax rates.

The distributional case against it is very strong. This is one of the main reasons that: "The government imposes taxes in such a way that the distribution of income is more unequal than if the government imposed no taxes at all."

These tax boons for the rich need to be eliminated, and there are cheaper and more economically reasonable ways to address the "double taxation" of corporate profits that preserve the progressive tax system in this country.

No comments: