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US Congress Studies Capital Gains Tax Reform

The Senate Committee on Finance and the House of Representatives Committee on Ways and Means have held a joint hearing on the taxation of capital gains in the United States in the context of comprehensive tax reform, particularly the treatment of capital gains as compared to ordinary income.

The maximum capital gains tax rate (CGT) currently is 15%, as compared to the maximum individual ordinary income tax rate of 35%. However, as part of the so-called ‘fiscal cliff’, if Congress takes no action beforehand, the maximum statutory CGT will increase to 20% on January 1, 2013, while the maximum individual ordinary income tax rate will increase to 39.6%.

Beginning in 2013, however, an additional 3.8% tax will also be imposed on net investment income earned by individuals with incomes above USD 200,000 (single individuals) and USD250,000 (joint returns) in 2013, where ‘net investment income’ includes capital gains. Furthermore, the 2013 scheduled restoration of the ‘Pease limitation’ on itemized deductions will impose a roughly 1.2% marginal rate on capital gains, bringing the top federal rate on capital gains to 25% in 2013.

A Republican Party bill passed in the House of Representatives would extend the lower tax structure on long-term capital gains for all of 2013, as, in his testimony to the hearing, Dave Camp (R - Michigan), Chairman of the Ways and Means Committee, pointed out that “it is critical that we focus on the total integrated CGT rate, which is nearly 45%, not just the present statutory CGT rate of 15%”.

He said that “the CGT is often a double layer of taxation. For example, in the case of shares of stock, a company’s income is first taxed at the corporate rate. Then, when shareholders of the company later decide to sell their stock, they are subject to CGT on the sale. So, even if we make current low-tax policies permanent, the top integrated rate on capital gains is actually 44.75% – a 35% first layer of tax and a 15% CGT. If we allow current low-tax policies to expire, the top integrated CGT will exceed 50%.”

He also believed that “it is also important to mention that, regardless of what rate we apply to capital gains, we should strive to retain parity between the rates for capital gains and dividends. We should not restore the 'lock-in' effect on domestic corporate earnings that makes it more tax-efficient to retain earnings inside a corporation when it might be more productive to push the cash out to shareholders so they can reinvest it elsewhere in the economy.”

Orrin Hatch (R-Utah), the Ranking Member of the Senate Finance Committee, added that “other important reasons given for preferential treatment for capital gains are that a low CGT savings and investment, counteracts the two levels of taxation of corporate income, and corrects the income tax law’s bias against savings”.

On the other hand, Max Baucus (D- Montana), Chairman of the Senate Finance Committee, stressed that “only a third of capital gains come from sales of corporate stock, (and) the rest have never previously been taxed before reaching individuals,” while “capital gains go disproportionately to high-income taxpayers”.

Furthermore, he continued, “experts tell us that about half the US tax code – more than 20,000 pages – exists solely to deal with capital gains, (and) that complexity, as well as the wide gap between the tax rates on income and capital gains, invites people to use all kinds of shenanigans to game the system”.

In like manner, the Ranking Member of the Ways and Means Committee, Sander Levin (D – Michigan), while demonstrating that the reduced rate on long-term capital gains is one of the largest individual tax expenditures, also noted “by some estimates fully half of the tax code is devoted to defining the difference between capital gains and ordinary income, (while) some 71% of the benefit of the preferential rate on capital gains goes to those making more than USD1m a year, according to the Joint Committee on Taxation.”

Finally, the Senior Policy Director Marc Goldwein of the Committee for a Responsible Federal Budget has written that, in looking at broadening the base of US taxation in order to provide lower tax rates in a revenue-neutral way, “everything must be on the table, and that includes capital gains”.

In taxing capital gains and dividends as ordinary income, Goldwein has argued that, “despite popular opinion, this might not have a serious effect on growth”. He has confirmed that many studies have shown little correlation between the capital gains rate and growth.

“Lowering overall rates and then taxing all income the same could have substantial benefits by allowing businesses and individuals to make investment decisions based on what the market, not the government, thinks is best,” he considered. “Taxpayers would put more of their money into wise long-term investments and hand less to tax accountants and other intermediaries. These efficiencies by themselves are likely to make up for much or all of the potential losses from higher rates on capital gains.”

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