A Tax Policy Primer

As I have mentioned before, I practiced tax law for 25 years.  I moved on to other pursuits over the last decade but I still believe I know more than most about the subject.  When I practiced tax law I always had a very keen interest in tax policy.  In fact, I spent a considerable amount of time in Washington over the years working on tax policy issues for my employer and for industry groups.

The current campaign of President Obama for the so-called "Buffett Rule" requires an understanding of basic tax policy concepts to evaluate the issues intelligently.  President Obama keeps repeating the argument that millionaires are paying a lower tax rate than plumbers or secretaries.  As I have discussed before, this is very misleading.  However,  I also showed how it can occur if almost all of the income of the millionaire is comprised of capital gains and qualified dividends that are taxed at a maximum rate of 15%.

From a tax policy perspective, why have these two classes of income been given a preferential tax rate?  If you listen to President Obama he clearly does not agree with the tax policy behind the lower rate.  Here are the facts.

First, consider the history of the federal income tax.  John Steele Gordon provides "A Short History of the Income Tax" in today's Wall Street Journal.

Steele explains that the corporate income tax (profits tax) was originally enacted as a stop-gap measure while the 16th Amendment (which granted the federal government the authority to enact an individual income tax) worked its way through the ratification process in the states.  The 16th Amendment was ultimately ratified in 1913 just as President William Howard Taft was leaving office.

The new president, Woodrow Wilson, and the strongly Democratic Congress promptly passed a personal income tax. It kicked in at 1% on incomes above $3,000 (a comfortable upper middle-class income at the time) and reached 7% on incomes over $500,000. But there were many deductions, bringing the effective tax rates down sharply from the marginal ones—a feature of the tax system ever since. 

Unfortunately the corporate income tax, originally intended as only a stopgap measure, was left in place unchanged. As a result, for the last 98 years we have had two completely separate and uncoordinated income taxes. It's a bit as if corporations were owned by Martians, otherwise untaxed, instead of by their very earthly—and taxed—stockholders.

This has had two deeply pernicious effects. One, it allowed the very rich to avoid taxes by playing the two systems against each other. When the top personal income tax rate soared to 75% in World War I, for instance, thousands of the rich simply incorporated their holdings in order to pay the much lower corporate tax rate.

Therefore, profits of a corporation are taxed once at the corporate level and are taxed again when these profits (dividends) are distributed to the individual shareholders.   Therefore, a dollar of corporate profit first bears a 35% corporate tax and is potentially subject to being taxed as high as another 35% at the individual level.  That is a total tax of 70% on a dollar of profit.  It is effectively double taxation.

The 15% qualified dividend rate is in place from a tax policy perspective to limit the overall tax rate to 50% rather than 70%.  Many tax policy experts argue that dividends should not be taxed at all since the source of the income has already been taxed at the corporate level.   Alternatively, the corporation should be provided a deduction for dividends paid as it is allowed for interest expense.

When the individual income tax was originally enacted there was no capital gains rate.  It was not believed to be necessary with the top tax rate of only 7%.  However, the top rate was increased to 15% by 1916 (incomes over $2 million) and was 73% by 1919 (incomes over $1 million).   In 1922 the preferential capital gains rate was first introduced at 12.5% as part of an overall tax cut that also reduced the top rate to 58% on individual income on income over $200,000.  The lower rate was only allowed for assets held more than 2 years.

The holding period of a capital asset is the important distinction to consider here from a tax policy standpoint in the preferential rate.  When you receive wages for your labor there is usually a small gap in time.  A week or two for most people.  However, when you make an investment in a capital asset it can be years before you are rewarded.  If you bought a stock in 1991 and sell it in 2011 how much is your real gain?  If you paid $10,000 for the stock and you sell it for $20,000 20 years later should this be taxed the same as your wage income?  Nominally, you have a $10,000 gain but about 70% of that gain is just inflation.  It is a phantom gain.  Should that income be taxed the same as your wages? The input and reward are close in time with your wages and do not involve much risk?   The same is not true when you are putting your money down on a capital investment.  Why should government receive an inflation windfall?

In a perfect tax policy world, the taxpayer should be able to remove the inflation effect on these long lived assets.  Without some protection from this perverse impact it is easy to see why someone would not want to part with their hard earned money and invest it for any long term purpose.  There is a risk element that is not present with ordinary income.  The lower capital gains rate is designed to protect against this disincentive.

A few common sense thoughts from a tax policy standpoint.

• If the ordinary income tax rate is reduced there is less need for a preferential capital gains rate.  History has shown that as the top ordinary rate goes up it becomes necessary to establish a lower capital gains rate.  In fact, when the top tax rate was 28% under President Reagan the capital gains rate was eliminated.  It was re-established when ordinary rates went up under President Bush (41) and President Clinton.
• President Obama is going in the wrong direction on both counts.  He wants to raise both the ordinary income and capital gains rates at the same time.
• Allow an inflation deduction for capital assets and you have a stronger argument for treating capital gains the same as ordinary income.
• If the corporate income tax rate is reduced there is not as strong an argument for the preferential dividend rate.  It is the total tax of the combined total that should be considered.  If the corporate income tax was eliminated there would be no argument at all for a lower dividend rate.