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Taxing Dividends and Capital Gains: Effect on the Super-Rich and Retirees

By Douglas A. Kahn, Paul G. Kauper Professor of Law, and Lawrence W. Waggoner, Lewis M. Simes Professor of Law Emeritus

It is now well understood that, unless the president and Congress soon agree on a different course, the 15 percent tax rate on dividends and capital gains will come to an abrupt end on January 1 and will be replaced by the Fiscal Cliff rates. Dividends will then be taxed as ordinary income at a marginal rate as high as 39.6 percent and capital gains will then be taxed at 20 percent. For high-income taxpayers, a 3.8 percent Medicare surtax will be added to the taxation of dividend income, capital gains, interest, and other investment income, bringing the highest marginal rate to 43.4 percent.

In speech after speech, and on the White House website, President Obama has embraced the so-called Buffett Rule: "As multi-billionaire Warren Buffet has pointed out, his average tax rate is lower than his secretary's. No household making over $1 million annually should pay a smaller share of their total income in taxes than middle-class families." The 15 percent tax rate on dividends and capital gains is the reason why Warren Buffett's tax rate is lower than the tax rate paid by middle-income families (including Buffett's secretary). The income of middle-income families comes mostly in the form of salary and wages, which are taxed as ordinary income.

The Obama Administration's formal tax proposals urge Congress to end the current 15 percent rate on dividends and capital gains and allow the Fiscal Cliff rates on those items to go into effect for taxpayers in the 36 percent and 39.6 percent brackets, i.e., for married taxpayers filing jointly whose adjusted gross income (AGI) is more than $250,000, for head-of-household taxpayers whose AGI is more than $225,000, for single taxpayers whose AGI is more than $200,000, and for married taxpayers filing separately whose AGI is more than $125,000. (The administration's proposals are memorialized in the Middle Class Tax Cut Act passed by the Senate in July.) For simplicity, we treat the administration’s proposal for Fiscal Cliff rates on dividends and capital gains as applying to taxpayers whose AGI is more than $250,000, which is the income figure the president most talks about publicly.

The following table, drawn from IRS data for 2010 (the latest year for which data are available), shows, by percentage, selected sources of income for taxpayers (regardless of marital status) who itemize deductions and whose adjusted gross income is at or above $250,000:

Adjusted Gross Income

Number of Taxpayers

Salary & Wages

Qualified Dividends

Net Capital Gains

$250k to $500k

1,866,973

68%

2%

4%

$500k to $1m

527,916

56%

3%

8%

$1m to $1.5m

123,984

46%

4%

12%

$1.5m to $2m

50,702

42%

4%

14%

$2m to $5m

71,694

37%

5%

19%

$5m to $10m

17,280

32%

6%

25%

$10m & up

11,166

16%

8%

45%

If the Fiscal Cliff rates on dividends and capital gains go into effect, the real winners will be the super-rich (which we count as taxpayers earning $10 million and above). Although their taxes will go up, they, on average, could continue to pay a smaller share of their total income than many middle-income taxpayers. Why? Because 45 percent of their income comes in the form of net capital gains (to be taxed at a still-preferential rate of 20 percent), and only 8 percent comes in the form of qualified dividends (to be taxed as ordinary income). The super-rich, in fact, reported 46 percent of the capital gains ($152.41 billion) reported by all taxpayers ($331.88 billion). Salary and wages account for only 16 percent of the income of the super-rich.

The Simpson-Bowles Commission proposed no preferential treatment for capital gains or dividends. The Commission recommended that ordinary income, including capital gains and dividends, be taxed at marginal rates of 12, 22, and 28 percent. (The Commission proposed these lower marginal rates in conjunction with broadening the tax base by eliminating all itemized deductions and tax expenditures and in conjunction with other reforms.) Although the Commission did not recommend specific tax brackets for each marginal rate, the super-rich’s salary and wages, dividends, capital gains, and other ordinary income would clearly put them in the top bracket (28 percent). The Commission's approach of taxing capital gains as ordinary income would therefore prevent the super-rich from paying a smaller share of their income than middle-income working taxpayers. An important byproduct of the Commission's proposal would also be that capital gains recognized under what are called carried interest arrangements would no longer be taxed at an advantageous flat rate but would be subject to graduated rates. The effect of the Simpson-Bowles recommendations on middle-income retirees, however, is hard to predict, because the tax brackets for each marginal rate remain unspecified. We suspect, though, that most of them would have enough income (including their dividends) to put them in the middle bracket (22 percent). If so, the tax rate on a portion, and maybe a significant portion, of their qualified dividends would rise from 15 to 22 percent.

Back to the Fiscal Cliff rates. Although taxing dividends as ordinary income will have no appreciable effect on the super-rich, it could have a profound effect on middle-income retirees. About 10,000 baby boomers turn 65 every day (3.65 million per year), and most of them then retire. Sadly, many boomers have not saved enough for retirement, but those who have face a dilemma. Their retirement coincides with two other phenomena: the near-zero interest-rate policy of the Federal Open Market Committee and the 15 percent tax rate on qualified dividends. These phenomena have encouraged seniors age 65 and over, especially middle-income retired savers, to reorient their nest eggs away from certificates of deposit, Treasuries, and money market funds to dividend-paying stocks and mutual funds. According to the latest IRS data (again, for 2010), over half of seniors who itemized deductions reported qualified dividends. Those seniors reported $54.34 billion in qualified dividends, which amounts to 46 percent of the qualified dividends reported by all taxpayers.

As the IRS data indicate, retirees will be among those hardest hit by the Fiscal Cliff rates, especially by the higher rates on dividends. Middle-income retired savers are at the point in life when they no longer live on earnings from their human capital. Their income no longer comes in the form of salary and wages. They are also experiencing an increase in longevity and are often in fear of outliving their assets and becoming a financial burden on their families. The steady income stream they expected from dividends may be all they have for supplementing their Social Security benefits and perhaps IRA and 401(k) withdrawals. In all of the discussion about tax reform, scant attention is being paid to how the Fiscal Cliff rates and various tax-reform proposals will affect retirees or those saving for retirement. The Obama administration’s tax proposal would continue the 15 percent rate on dividends and capital gains for married taxpayers earning $250,000 a year or less. Although the president’s proposal does not mention retirees or those saving for retirement, the proposal would extend the 15 percent dividend and capital gain rate for about 96 percent of seniors age 65 or older.

As the Fiscal Cliff approaches, many observers expect the president and Congress to reach a stop-gap agreement before January 1 and to put comprehensive tax reform on hold until next year. In framing comprehensive tax reform, and any stop-gap measure as well, the parties should take the above IRS data into account, i.e., that capital gains go disproportionately to the super-rich and that qualified dividends go disproportionately to seniors seeking income in a near-zero interest rate environment. The conclusion: The super-rich have unduly benefitted from the 15 percent rate on capital gains but middle-income retirees have not unduly benefitted from the 15 percent rate on qualified dividends.

Preventing the super-rich from unduly benefitting from the 15 percent rate on capital gains can take various forms. One obvious form would be to tax capital gains and probably also qualified dividends of high-income taxpayers at a rate in excess of 20 percent or at graduated rates. Another would be to adopt Warren Buffett’s latest proposal and impose a minimum 30 percent tax rate on taxable incomes between $1 million and $10 million and a 35 percent rate on higher amounts. As for middle-income retirees, the preferred course would be to extend the current 15 percent rate on qualified dividends and probably also capital gains for taxpayers whose AGI is $250,000 a year or less, as proposed by the president, or $500,000 a year or less, as preferred by Buffett. It also goes without saying, we hope, that any dollar amounts built into the tax code should be indexed for inflation, unlike the dollar amounts in the current alternative minimum tax.

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