Stop special tax treatment of capital gains and dividends
April 16, 2015
The income/wealth gap between the rich and the rest of us in the U.S. is huge and growing. One thing we can do about it is change tax laws that favor the rich. One of them is the special treatment of capital gains and dividends.
Starting with the 2013 tax year, the top rate for capital gains and dividends is 20% while the top rate on ordinary income remains 39.6%. Here are the rates for capital gains and dividends (source):
However, with a new "net investment income tax" imposed in 2013 on singles earning over $200k and couples earning over $250k (source), the top effective rate on capital gains and dividends is 23.8%. (source)
Here are the rates for ordinary income (source):
I propose doing away with the special rates on capital gains and dividends and taxing all income as ordinary income. Since "carried interest," the earnings of private equity and hedge fund managers, is illogically classified as capital gains (source), the special rates would end for them, also. The tax rate on capital gains, dividends and carried interest in excess of $406,751 would go from 23.8% to 39.6%. Take that, you one-percenters! (Actually, more than half of the tax benefit on investment income goes to people in the top one-tenth of 1 percent, according to Roberton Williams of the Tax Policy Center.)
Along with that, I would do away with the corporate income tax.
There are two reasons for eliminating the corporate income tax. One is that defenders of the lower tax rate on dividends and capital gains use it as justification for those special rates. The other is that it is counter productive. To the corporation, it is just another business expense. Instead of hitting wealthy stockholders, it gets passed on to everyone else - mostly, corporate customers. In effect, we are taxing ourselves rather than the corporation. A May 2013 GAO report put it this way (page 9):
This is not the only harm done by the corporate income tax. Our tax rate on corporations is among the highest for developed nations, giving foreign corporations a competitive advantage. It encourages "tax inversion," a tax-avoidance tactic where a "U.S. company reincorporates overseas after merging with a foreign business." (source). Generic drug maker Perrigo of Allegan did it in 2013. Bloomberg had a good explanation of the practice in February.
The idea of not taxing corporations might horrify some liberals, but the second part of my proposal should ease their fears: Every penny of corporate profit will be taxed at the individual stockholder level, and sooner rather than later. This is where my plan differs from those proposed by others for eliminating the corporate tax. (See other proposals here.) Not only would I tax capital gains and dividends at the same rate as ordinary income, I would force corporations to distribute all profits. And I would require corporations to withhold tax on those distributions, just as employers withhold tax from workers' paychecks.
Of course, corporations are going to be horrified by the idea of having to distribute all profits. How are they going to raise money for new equipment, research and expansion? Answer: The old fashioned way, by issuing bonds, selling stock or borrowing from the bank. Maybe the increased demand for funding would cause interest rates to go up. That would please investors. And for the corporation, interest is a tax-deductible business expense.
Going out and finding funding might be inconvenient for the corporation, but it is no excuse for letting stockholders off the hook on taxes. Corporate profit is income, and the owners of that income should pay the tax on it just as wage earners pay tax on wages. They shouldn't be allowed to avoid the tax just because they are allowing the corporation to hold the income for them.
One way the corporation could raise money to replace those distributed profits is to invite stockholders to reinvest the after-tax dividends right back into the corporation.
But what about the effect on the federal budget?
First, let's add up the revenue from the current system:
Next, we add up the revenue from my plan:
So my scheme brings in $139.3 billion more than the current system. That is 30% of the $468 billion federal deficit expected for 2015.
There is, however, one possible problem that could cut by two-thirds my estimated revenue from taxes on dividends. Laurence Kotlikoff, an economist who has proposed eliminating the corporate income tax, had an article on the PBS Newshour website in which he presented responses to his earlier article on the subject in the New York Times. One was from Robert McIntyre, director of Citizens for Tax Justice. McIntyre says "when corporate profits are paid out (as stock dividends), only a third are paid to individuals rather than to tax-exempt entities not subject to the personal income tax." I hope he is wrong.
In any case, federal tax revenue should receive a boost from the increased economic activity generated by eliminating the corporate income tax. In Kotlikoff's New York Times op-ed, he says that "Fully eliminating the corporate income tax . . . leads to a huge short-run inflow of capital, raising the United Statesí capital stock (machines and buildings) by 23 percent, output by 8 percent and the real wages of unskilled and skilled workers by 12 percent." And William McBride of the Tax Foundation says "eliminating the corporate income tax would boost GDP and personal incomes about 2 percent, and since most federal tax revenue is from taxing wages and personal income, such a change would actually increase total federal tax revenue by about $18 billion.
While there may be some doubt about the net effect on federal revenue, state and local governments will certainly see a revenue increase. Many state and local governments have income taxes based on federal adjusted gross income (AGI), and requiring corporations to distribute all profits will increase individual incomes by $920.5 billion (the amount of currently undistributed corporate profits). Left out of this windfall will be states that rely on the sales tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.
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