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Capital Gains Tax Rates Are Higher Than You Think, and Getting Higher

e21 | January 27, 2012

The President’s State of the Union Address included discussion of the proper level of taxation for investment income. Specifically, the President suggested it was improper for investment income to be taxed at a much lower rate than labor income. This obscures the actual taxation rates faced by investors.

Capital gains are taxed twice, but this isn’t really clear on the typical tax return. This partly explains why the issue of double taxation is often misunderstood. Here is a simplified example to help clarify things:

  • If you invest $1000 in shares of a stock and the company is worth $1 billion, you then own 1/1,000,000 of the company.
  • Then, let’s say the company makes $50,000,000 in pre-tax profit. The company is taxed at 35%, so the after-tax profit is $32,500,000. These new earning make the company more valuable, driving the company’s market value up to $1.0325 billion instead of the previous $1 billion. Your investment is still worth 1/1,000,000 of the company, which means the investment is now worth $1032.50.
  • Once the shares are sold, the capital gain on the sale is $32.50. That money is now your investment income. The investor pays 15% capital gains tax on that $32.50, so you receive $27.625. That 15% tax rate is what’s typically focused on when commentators are discussing the proper or “fair” rates of taxation for investment income. However this simplified example clearly demonstrates how the lower capital gains rate obscures most of the tax incidence on the investment.
  • The total after-tax return for the investor is 2.7625% (instead of 5% without corporate or capital gains tax), and the total tax rate is 0.35 + (1-0.35) * 0.15 = 44.75%. This actual rate is obviously much higher than the nominal tax on the capital gain.

Against this backdrop, the capital gains rate is already set to rise next year according to current law. Donald Marron, Director of the Tax Policy Center, wrote about this scheduled though underappreciated tax increase at TaxVox:

First, the 2001 and 2003 tax cuts are scheduled to expire. If that happens, the regular top rate on capital gains will rise to 20%. In addition, an obscure provision of the tax code, the limitation on itemized deductions, will return in full force. That provision, known as Pease, increases effective tax rates on high-income taxpayers by reducing the value of their itemized deductions. On net, it will add another 1.2 percentage points to the effective capital gains tax rate for high-income taxpayers.

And that’s not all. The health reform legislation enacted in 2010 imposed a new tax on the net investment income of high-income taxpayers, including capital gains. That adds another 3.8 percentage points to the tax rate.

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