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Capital Gains: Part Two

Posted by Andrew Quinlan on May 6, 2010

As previously noted, IRET has published a series of three excellent papers on the case for lowering the capital gains tax rate. The second paper is introduced by Stephen J. Entit and written by Paul Evans. Entitled, The Relationship Between Realized Capital Gains And Their Marginal Rate Of Taxation, 1976-2004, it begins as follows:

The tax rates on long-term capital gains (gains on assets held at least one year) are scheduled to rise in 2011. The current top statutory rate of 15% would rise to 20%. President Obama has suggested at various times raising the top rate further, to as much as 28%. How much additional revenue, if any, should the government expect to get from such increases in the tax rate on capital gains? Previous research has indicated that cutting the tax rate to roughly current levels may actually have raised revenue for the Treasury. If so, hiking the rates could reduce revenue, in addition to hurting growth and job creation.

IRET asked Professor Paul D. Evans of Ohio State University to take a fresh look at how taxpayers might respond to an increase in the capital gains rate, using taxpayer data from the most recent available years. His study, The Relationship Between Realized Capital Gains and Their Marginal Rate of Taxation, 1976-2004, is presented below. Evans finds that taxpayers are still sensitive to the tax rate on capital gains, and would report fewer gains if the rate were raised. Based on 2004 data, the revenue maximizing tax rate may be just under 10%. Raising the capital gains tax rate from the current 15% to 20% or more would reduce federal capital gains tax revenue. Additional revenue would be lost from other parts of the income tax and from other federal taxes due to reduced investment, employment, and income. The optimal capital gains tax rate to maximize public welfare, and to help the federal budget, is surely closer to if not zero.

The tax rates on long-term capital gains (gains on assets held at least one year) are scheduled to rise in 2011. They were reduced in the Jobs and Growth Tax Relief Reconciliation Act of 2003, with the cuts effective through 2008. The reductions were extended through 2010 in the Tax Increase Prevention and Reconciliation Act of 2005. (The top tax rate on dividends was also cut to 15% to match the top rate on capital gains. It too will increase in 2011, reverting to ordinary income tax rates.) Before the 2003 reduction, the top tax rate on long term capital gains was 20% for taxpayers in the top four tax brackets and 10% for taxpayers in the 10% and 15% ordinary income brackets. (However, for gains on assets held five years or more, the top rate was only 18% in the top four brackets and 8% in the 10% and 15% brackets.) In 2003, the top rate of 20% (or 18%) was cut to 15% for taxpayers in the top four tax brackets. The capital gains rate for taxpayers in the 10% and 15% brackets was reduced from 10% (or 8%) to 5% through 2007, then to zero for 2008-2010. Under current law, in 2011, the 15% tax rate on long term gains will revert to 20% (or 18% for 5-year holdings) for the top four brackets. The zero rate will revert to 10% (or 8% for gains held 5 years or more) in 2011. The 10% (or 8%) rate will apply to taxpayers in the 15% ordinary income tax bracket. (The 10% tax bracket, which was carved out of the 15% bracket by the Economic Growth and Tax Relief Reconciliation Act of 2001, will expire and be reincorporated in the 15% bracket in 2011). (Note: these rates exclude the effects of the Alternative Minimum Tax. For taxpayers in the phase-out range of the AMT exemption, an additional dollar of capital gains reduces their AMT exemption by $0.25, and subjects that additional amount of wages, salaries, and interest income to additional AMT. The combined effective marginal tax rate due to the additional capital gains is then 21.5% or 22% in the 26% and 28% AMT rate brackets (15% plus a quarter of 26% or 28%). If the capital gains rate were to rise, the new AMT-impacted rates would be 6.5% or 7% above whatever the new rate is set at.)

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