The bipartisan deficit-reduction plan gaining momentum in the U.S. Senate would likely require lawmakers to curtail or end the preferential tax treatment of capital gains and dividends.
The proposal from the so-called Gang of Six doesn’t mention capital gains and dividends. The plan’s goals for income tax rates, federal revenue and progressivity would likely require Congress to raise tax rates on investment income, said tax analysts who favor and oppose preferential tax rates on capital gains and dividends.
The proposal, which would lower income tax rates and broaden the tax base, is similar to plans issued over the past year by a bipartisan fiscal commission and the Bipartisan Policy Center in Washington. Those plans suggested taxing capital gains and dividends as ordinary income for the first time since 1990.
“You cut marginal tax rates and you still want to have a progressive tax system, you have to tax capital gains,” said Leonard Burman, a professor of public affairs at Syracuse University in New York who helped write the Bipartisan Policy Center’s report.
Individual and corporate income is taxed at a top rate of 35 percent. Dividends and capital gains on most assets held longer than one year are taxed at 15 percent, under tax laws set to expire at the end of 2012. The 2010 health-care law included a new 3.8 percent tax on capital gains, dividends and other passive income reported by high-income taxpayers, and that extra tax is scheduled to take effect in 2013.
The bipartisan proposal, as outlined in a five-page document obtained by Bloomberg News, would require Senate committees to produce legislation that would reduce spending and raise revenue.
The Senate Finance Committee would be instructed to lower tax rates, eliminate the alternative minimum tax and “reform” tax breaks for health care, charitable giving and homeownership.
The outline calls for three individual income tax brackets with a top rate between 23 percent and 29 percent, and the corporate rate would drop to a single rate of between 23 percent and 29 percent. The tax system would need to retain its current progressivity and keep benefits for low-income workers such as the earned income tax credit.
To make up the revenue and to offset lowering top income tax rates on high earners, lawmakers will look at investment taxation. The congressional Joint Committee on Taxation estimates that preferential tax rates for capital gains and dividends will cost the Treasury $84.2 billion in forgone revenue this year. Eliminating the preference wouldn’t necessarily raise that much money, because capital gains realizations are sensitive to tax rates.
Capital Gains Benefits
More than 90 percent of the benefits of the lower tax rate on capital gains go to the top 20 percent of taxpayers, with almost half of the benefit going to the top 0.1 percent, according to the Tax Policy Center.
“As I read between the lines of the plan, the cap gains and dividend rates are likely to rise,” said Alex Brill, a research fellow at the American Enterprise Institute, a Washington policy center that supports free enterprise. Brill was chief economist at the House Ways and Means Committee under Republican Chairman Bill Thomas.
Equalizing the rates for capital gains and wage income would mirror the result of the last major overhaul of the tax code in 1986. Later increases in the income tax rate and cuts in the capital gains and dividends rates created today’s gap.
Burman said the change would discourage tax shelters that take advantage of the gap between tax rates on wages and investments.
“If you can make wages look like capital gains, you’ve saved a lot of money, and that’s what rich people do,” he said.
Mark Bloomfield, president and chief executive of the American Council for Capital Formation, a Washington group that advocates lower taxes on investments, said the congressional conversation is focused too narrowly on lowering tax rates rather than on what should be taxed.
“Don’t put taxing savings and investment in the same category as special-interest provisions,” he said.
The senators’ proposal also calls for the Finance Committee to create a territorial tax system, under which U.S. multinational companies wouldn’t face taxes on income they earn outside the country. The U.S. Chamber of Commerce and other business groups have been urging Congress to make such a change.
Overall, the senators behind the plan are claiming to raise $1 trillion in new revenue even as they cut taxes by $1.5 trillion by using different yardsticks in the same plan.
Revenue, Tax Cuts
The plan would generate more revenue than the U.S. would collect if Congress were to extend all of the income tax cuts scheduled to expire at the end of 2012. That makes it similar to proposals released over the past year by President Barack Obama and his bipartisan fiscal commission.
At the same time, it would be considered a tax cut under official congressional scoring rules, which assume that the Bush-era tax cuts expire as scheduled.
The numerical and ideological gap over the proper level of revenue may be difficult for Congress to bridge. The House Republican budget sets revenue at a level assuming all of the expiring tax cuts are extended permanently and the health-care law is repealed. That’s about $4.2 trillion less than the Congressional Budget Office baseline over the next decade, and about $2.7 trillion less than the senators’ proposal.
A report from the House Budget Committee and Chairman Paul Ryan said the proposal lacks sufficient detail about how it is measuring savings.
“It does not provide annual spending and revenue totals by category, relying instead on savings relative to three different baselines,” the report said. “So, it is unclear what exactly the spending and tax proposals are.”