Sept.HW &M, SFC Examine the Tax Treatment of Capital Gains
AT TODAY’S JOINT HEARING ON CAPITAL GAINS, members of the House Ways and Means and Senate Finance Committees discussed the tax treatment of capital gains in the context of tax reform and the potential consequences of an increase in capital gains rates. If Congress is unable to come to an agreement to avert the “fiscal cliff,” the capital gains rate will increase to 23.8 percent from its current maximum rate of 15 percent. The 23.8 percent rate includes the Affordable Healthcare Act’s 3.8 percent tax on investment income earned by certain individuals.
In his opening statement, Rep. Dave Camp (R-Mich.), Chairman of the House Ways and Means Committee, said a potential increase in the capital gains rate “would have a devastating effect on the economy.” Camp noted how critical it is for Congress to focus on the total integrated rate, which is nearly 45 percent – the integrated rate contains the 35 percent corporate rate and an additional 15 percent capital gains tax. “If we allow current low-tax policies to expire, the top integrated rate on capital gains will exceed 50 percent,” Camp warned.
Senate Finance Committee Chairman Max Baucus (D-Mont.) said the treatment of capital gains “is one of the most difficult issues we face,” adding that he is “optimistic” Congress will be able to come together in agreement on the issue. Baucus listed four considerations that must be weighed:
1) Congress needs to consider the capital gains rate compared to the rates on wage income, dividends, and corporate income. “Only a third of capital gains come from sales of corporate stock. The rest have never previously been taxed before reaching individuals,” Baucus said;
2) Congress needs to consider how capital gains rates affect different income brackets since capital gains currently go disproportionally to high-income taxpayers;
3) Congress needs to consider our low savings rate; and
4) Congress must consider complexity, since roughly half the U.S. tax code “exists solely to deal with capital gains,” according to experts.
House Ways and Means Committee Ranking Member Sander Levin (D-Mich.) said the reduced rate on capital gains “is one of the largest tax expenditures” and “it is also a source of considerable complexity.” Reflecting on Baucus’ comments regarding the disproportionate amount of high-income taxpayers who receive the preferential rate, Levin said “there is a real consequence from the preferential rate to the progressivity of our tax system.”
Senate Finance Committee Ranking Member Orrin Hatch (R-Utah) said there are reasons for the preferential treatment, citing the lock-in effect, increased savings and investment from low rates, how the rate counteracts the two levels of taxation of corporate income, and how it corrects the income tax law’s bias against savings. Hatch referred to a recent Organization for Economic Co-operation and Development (OECD) report which found that the U.S. “has the most progressive tax system in the industrialized world.” When the top 10 percent of households “already pay 70 percent of all federal income taxes,” Hatch asked “when is enough progressivity achieved?”
Testimony
In his testimony, David Brockway, Partner, Bingham McCutchen LLP, discussed his experiences during the consideration of the Tax Reform Act of 1986 when he was serving as Chief of Staff of the Joint Committee on Taxation (JCT). Brockway said “it is highly unlikely that you’ll find it possible to have comprehensive tax reform and operate below 30 percent without raising the capital gains rate close to 30 percent….” Brockway added, “if you believe… that it’s fundamental to keep the differential in the rate structure between capital gains and ordinary income I think you have to think seriously about whether you wish to go forward with comprehensive tax reform. On the other hand if you come to the conclusion, like Congress did in 1986, that overall the benefits of comprehensive tax reform outweigh the detriments of raising the tax rate on capital gains, then I think it is sensible to move forward.”
Brockway said raising the capital gains rate in 1986 to 28 percent “was absolutely not an objective in that process,” but that it was the only way the legislation was going to move forward. Brockway noted that the JCT used traditional revenue estimation methods and did not take into account “any potential change in the overall performance of the economy….” However, Brockway said Congress will have a “much tougher time” setting the distributional and revenue targets, especially whether to consider dynamic revenue scoring will be used, which “wasn’t really an issue” back in 1986.
In his testimony, Lawrence Lindsey, President and CEO of The Lindsey Group, said the relationship between the rate of taxation on ordinary income and the capital gains rate “is stronger than many believe.” Lindsey repeated Camp’s discussion on integrated rates, but added that “I do come down on the side, on net, of bringing them closer together. On balance, raising the capital gains rate, while cutting the tax rates on other forms of income,” he said.
Lindsey discussed how a change to the capital gains rate affects the S&P market. In a 2001 study on the effect of a reduced capital gains rate on equity prices, Lindsey said a change would raise the level of the S&P 500 by 8 percent. However, Lindsey said the elimination of the capital gains and dividend tax changes of 2003 as a result of the U.S. falling off the fiscal cliff “would lead to an 19.6 percent reduction in the S&P 500.”
Finally, Lindsey offered three suggestions to Congress. First, Lindsey said the rates need to be moderate, noting that the current effective tax rate on capital income and entrepreneurship, between 38 to 44 percent, “is internationally uncompetitive and raising rates from that level can only be viewed as counterproductive.” Second, capital taxation should be as neutral as possible with regard to financial decisions. Lindsey said limiting the favorable tax treatment of debt relative to equity “will produce a better tax system while also providing revenue gains that can be used to pay for lower and better designed taxation of equity.” Third, Lindsey said the differences between ordinary and capital gains tax rates “should probably be reduced.”
Leonard Burman, Professor of Public Affairs at Syracuse University, said taxing capital gains at a lower rate than ordinary income “can do more harm than good.” He added that the biggest factor in reducing tax shelters under the Tax Reform Act of 1986 was the taxation of capital gains at the same rates as other income. In his testimony, Burman discussed the shift in the kind of assets that generate capital gains over time, and said the lower tax rate on long-term capital gains produces several distortions including: 1) encouraging investment purely for tax purposes, which drains capital away from more productive uses; 2) creating and maintaining tax shelters is a “socially unproductive line of work; and 3) the “enormous tax savings” will lure highly productive people into the private equity business, “drawing them away from other potentially more socially valuable enterprises.”
Burman explained the inequality associated with differing rates and the overall complexity in the tax code as a result. He argued against a list of common reasons why a capital gains tax rate should be separate from ordinary income. Among the options for reform, Burman said Congress should consider corporate tax integration or consider replacing the schedule of alternative tax rates with a partial exclusion, which would simplify compliance.
David Verrill, Chairman of the Angel Capital Association (ACA) and Founder and Managing Director of Hub Angels Investment Group LLC, supported a maximum capital gains rate of 15 percent. Verrill discussed the importance of a lower rate to angel investing and the industry’s contribution to startups and entrepreneurship, and job creation. He strongly encouraged Congress to provide tax incentives and education “to allow and encourage private citizens to risk their own capital to support startups and early-stage businesses.” Verill said the ACA also supports S. 256, The American Opportunity Act¸ which includes angel investment tax credits.
In his testimony, William Stanfill, General Partner at Montegra Capital Income Fund and Founding Partner of TrailHead Ventures, L.P., said “the sky will not fall if the rates go up.” Throughout his professional life, Stanfill said he has seen the capital gains rate decrease and increase and yet witnessed “little impact on investment planning, the ability to attract investors, or any impact on those investments.” He added that the special tax treatment “is neither fair nor equitable or available to any other professional endeavor.”
Question & Answer
Many lawmakers centered their questions on the total integrated rate, what angel investor views are of the potential tax rate changes, overall fairness in the tax code, and whether investors have begun to react to the potential rate changes, including the 3.8 percent tax on investment income.
Camp asked Lindsey whether there should be multiple holding periods for investments in stocks, for instance, with different rates applied depending on the period of time an investor held a stock.
Lindsey said this would create even greater complexity in the tax code while Burman said the tax rate on capital gains “already provides lower effective tax rates on long-held assets… as you basically get to defer the tax which is a valuable benefit.” Verill cautioned against such an approach as angel investors “simply don’t know the term with which we will own these equities.”
Sen. Ron Wyden (D-Ore.) asked the panel whether the idea of a capital gains exclusion could achieve bipartisan support.
Burman said “I think it would be a good idea to restore the exclusion.” Brockway stated his ambivalence toward the exclusion, noting that he was “not sure it would have a significant effect.”
Reflecting on President Obama’s budget, Rep. Wally Herger (R-Calif.) asked how the different rates between capital gains and dividends affect investment.
Lindsey said, in looking back on prior research, especially on what was done in 1986, there is “no question” such a divergence “would lead to a liquidation of dividend paying stocks and a reallocation into capital gains paying stocks.”
Burman said the overall economic effects from the disparity “are smaller than you would think.” In looking back to the dividend rate cuts in 2003, there was a short surge in dividends payments, but the long-term effect of the 2003 rate cuts were “modest” at best. “It is not clear it would have a large overall economic effect.”
Rep. Richard Neal (D-Mass.) turned to the Buffett rule, and specifically referred to an op-ed written by Burman who he advocated for a 30 percent income tax rate to be levied on American taxpayers making over $2 million a year. He asked the panel to elaborate how Congress should address the inequity behind the very wealthy paying a lower rate.
Burman said the solution to this problem would be to push the capital gains rate up to the same rate as ordinary income, or to at least narrow the difference between the two.
Following up, Neal asked Lindsey to further explain his suggestion to eliminate the favorability of debt financed investment versus equity financed investment to produce a better tax system.
Lindsey said “we have reached the end of the road with regard to income as the basis of taxation.” He added that we should get rid of this and move to a cash-flow basis of taxation to solve the current tax treatment of debt and equity.
Rep. John Larson (D-Conn.) turned to Lindsey’s suggestion that revenues should be more cash flow-based, and asked Lindsey to explain further.
Lindsey said the Securities and Exchange Commission (SEC), the Generally Accepted Accounting Principles (GAAP), and the Internal Revenue Service (IRS) all have different definitions of income. “Ultimately, I think, Congress will abandon income taxation and move to value-added base taxation.”
When asked by Larson whether Lindsey would describe cash flow-based taxation as transaction taxes, Lindsey said “I would call it a net transaction tax.”
“Or a broad transaction tax, not a transaction on a specific industry?” Larson added.
“Correct, and where you would pay tax only on the transaction,” Lindsey responded.
For more information on the hearing, please click here.
AT TODAY’S JOINT HEARING ON CAPITAL GAINS, members of the House Ways and Means and Senate Finance Committees discussed the tax treatment of capital gains in the context of tax reform and the potential consequences of an increase in capital gains rates. If Congress is unable to come to an agreement to avert the “fiscal cliff,” the capital gains rate will increase to 23.8 percent from its current maximum rate of 15 percent. The 23.8 percent rate includes the Affordable Healthcare Act’s 3.8 percent tax on investment income earned by certain individuals.
In his opening statement, Rep. Dave Camp (R-Mich.), Chairman of the House Ways and Means Committee, said a potential increase in the capital gains rate “would have a devastating effect on the economy.” Camp noted how critical it is for Congress to focus on the total integrated rate, which is nearly 45 percent – the integrated rate contains the 35 percent corporate rate and an additional 15 percent capital gains tax. “If we allow current low-tax policies to expire, the top integrated rate on capital gains will exceed 50 percent,” Camp warned.
Senate Finance Committee Chairman Max Baucus (D-Mont.) said the treatment of capital gains “is one of the most difficult issues we face,” adding that he is “optimistic” Congress will be able to come together in agreement on the issue. Baucus listed four considerations that must be weighed:
1) Congress needs to consider the capital gains rate compared to the rates on wage income, dividends, and corporate income. “Only a third of capital gains come from sales of corporate stock. The rest have never previously been taxed before reaching individuals,” Baucus said;
2) Congress needs to consider how capital gains rates affect different income brackets since capital gains currently go disproportionally to high-income taxpayers;
3) Congress needs to consider our low savings rate; and
4) Congress must consider complexity, since roughly half the U.S. tax code “exists solely to deal with capital gains,” according to experts.
House Ways and Means Committee Ranking Member Sander Levin (D-Mich.) said the reduced rate on capital gains “is one of the largest tax expenditures” and “it is also a source of considerable complexity.” Reflecting on Baucus’ comments regarding the disproportionate amount of high-income taxpayers who receive the preferential rate, Levin said “there is a real consequence from the preferential rate to the progressivity of our tax system.”
Senate Finance Committee Ranking Member Orrin Hatch (R-Utah) said there are reasons for the preferential treatment, citing the lock-in effect, increased savings and investment from low rates, how the rate counteracts the two levels of taxation of corporate income, and how it corrects the income tax law’s bias against savings. Hatch referred to a recent Organization for Economic Co-operation and Development (OECD) report which found that the U.S. “has the most progressive tax system in the industrialized world.” When the top 10 percent of households “already pay 70 percent of all federal income taxes,” Hatch asked “when is enough progressivity achieved?”
Testimony
In his testimony, David Brockway, Partner, Bingham McCutchen LLP, discussed his experiences during the consideration of the Tax Reform Act of 1986 when he was serving as Chief of Staff of the Joint Committee on Taxation (JCT). Brockway said “it is highly unlikely that you’ll find it possible to have comprehensive tax reform and operate below 30 percent without raising the capital gains rate close to 30 percent….” Brockway added, “if you believe… that it’s fundamental to keep the differential in the rate structure between capital gains and ordinary income I think you have to think seriously about whether you wish to go forward with comprehensive tax reform. On the other hand if you come to the conclusion, like Congress did in 1986, that overall the benefits of comprehensive tax reform outweigh the detriments of raising the tax rate on capital gains, then I think it is sensible to move forward.”
Brockway said raising the capital gains rate in 1986 to 28 percent “was absolutely not an objective in that process,” but that it was the only way the legislation was going to move forward. Brockway noted that the JCT used traditional revenue estimation methods and did not take into account “any potential change in the overall performance of the economy….” However, Brockway said Congress will have a “much tougher time” setting the distributional and revenue targets, especially whether to consider dynamic revenue scoring will be used, which “wasn’t really an issue” back in 1986.
In his testimony, Lawrence Lindsey, President and CEO of The Lindsey Group, said the relationship between the rate of taxation on ordinary income and the capital gains rate “is stronger than many believe.” Lindsey repeated Camp’s discussion on integrated rates, but added that “I do come down on the side, on net, of bringing them closer together. On balance, raising the capital gains rate, while cutting the tax rates on other forms of income,” he said.
Lindsey discussed how a change to the capital gains rate affects the S&P market. In a 2001 study on the effect of a reduced capital gains rate on equity prices, Lindsey said a change would raise the level of the S&P 500 by 8 percent. However, Lindsey said the elimination of the capital gains and dividend tax changes of 2003 as a result of the U.S. falling off the fiscal cliff “would lead to an 19.6 percent reduction in the S&P 500.”
Finally, Lindsey offered three suggestions to Congress. First, Lindsey said the rates need to be moderate, noting that the current effective tax rate on capital income and entrepreneurship, between 38 to 44 percent, “is internationally uncompetitive and raising rates from that level can only be viewed as counterproductive.” Second, capital taxation should be as neutral as possible with regard to financial decisions. Lindsey said limiting the favorable tax treatment of debt relative to equity “will produce a better tax system while also providing revenue gains that can be used to pay for lower and better designed taxation of equity.” Third, Lindsey said the differences between ordinary and capital gains tax rates “should probably be reduced.”
Leonard Burman, Professor of Public Affairs at Syracuse University, said taxing capital gains at a lower rate than ordinary income “can do more harm than good.” He added that the biggest factor in reducing tax shelters under the Tax Reform Act of 1986 was the taxation of capital gains at the same rates as other income. In his testimony, Burman discussed the shift in the kind of assets that generate capital gains over time, and said the lower tax rate on long-term capital gains produces several distortions including: 1) encouraging investment purely for tax purposes, which drains capital away from more productive uses; 2) creating and maintaining tax shelters is a “socially unproductive line of work; and 3) the “enormous tax savings” will lure highly productive people into the private equity business, “drawing them away from other potentially more socially valuable enterprises.”
Burman explained the inequality associated with differing rates and the overall complexity in the tax code as a result. He argued against a list of common reasons why a capital gains tax rate should be separate from ordinary income. Among the options for reform, Burman said Congress should consider corporate tax integration or consider replacing the schedule of alternative tax rates with a partial exclusion, which would simplify compliance.
David Verrill, Chairman of the Angel Capital Association (ACA) and Founder and Managing Director of Hub Angels Investment Group LLC, supported a maximum capital gains rate of 15 percent. Verrill discussed the importance of a lower rate to angel investing and the industry’s contribution to startups and entrepreneurship, and job creation. He strongly encouraged Congress to provide tax incentives and education “to allow and encourage private citizens to risk their own capital to support startups and early-stage businesses.” Verill said the ACA also supports S. 256, The American Opportunity Act¸ which includes angel investment tax credits.
In his testimony, William Stanfill, General Partner at Montegra Capital Income Fund and Founding Partner of TrailHead Ventures, L.P., said “the sky will not fall if the rates go up.” Throughout his professional life, Stanfill said he has seen the capital gains rate decrease and increase and yet witnessed “little impact on investment planning, the ability to attract investors, or any impact on those investments.” He added that the special tax treatment “is neither fair nor equitable or available to any other professional endeavor.”
Question & Answer
Many lawmakers centered their questions on the total integrated rate, what angel investor views are of the potential tax rate changes, overall fairness in the tax code, and whether investors have begun to react to the potential rate changes, including the 3.8 percent tax on investment income.
Camp asked Lindsey whether there should be multiple holding periods for investments in stocks, for instance, with different rates applied depending on the period of time an investor held a stock.
Lindsey said this would create even greater complexity in the tax code while Burman said the tax rate on capital gains “already provides lower effective tax rates on long-held assets… as you basically get to defer the tax which is a valuable benefit.” Verill cautioned against such an approach as angel investors “simply don’t know the term with which we will own these equities.”
Sen. Ron Wyden (D-Ore.) asked the panel whether the idea of a capital gains exclusion could achieve bipartisan support.
Burman said “I think it would be a good idea to restore the exclusion.” Brockway stated his ambivalence toward the exclusion, noting that he was “not sure it would have a significant effect.”
Reflecting on President Obama’s budget, Rep. Wally Herger (R-Calif.) asked how the different rates between capital gains and dividends affect investment.
Lindsey said, in looking back on prior research, especially on what was done in 1986, there is “no question” such a divergence “would lead to a liquidation of dividend paying stocks and a reallocation into capital gains paying stocks.”
Burman said the overall economic effects from the disparity “are smaller than you would think.” In looking back to the dividend rate cuts in 2003, there was a short surge in dividends payments, but the long-term effect of the 2003 rate cuts were “modest” at best. “It is not clear it would have a large overall economic effect.”
Rep. Richard Neal (D-Mass.) turned to the Buffett rule, and specifically referred to an op-ed written by Burman who he advocated for a 30 percent income tax rate to be levied on American taxpayers making over $2 million a year. He asked the panel to elaborate how Congress should address the inequity behind the very wealthy paying a lower rate.
Burman said the solution to this problem would be to push the capital gains rate up to the same rate as ordinary income, or to at least narrow the difference between the two.
Following up, Neal asked Lindsey to further explain his suggestion to eliminate the favorability of debt financed investment versus equity financed investment to produce a better tax system.
Lindsey said “we have reached the end of the road with regard to income as the basis of taxation.” He added that we should get rid of this and move to a cash-flow basis of taxation to solve the current tax treatment of debt and equity.
Rep. John Larson (D-Conn.) turned to Lindsey’s suggestion that revenues should be more cash flow-based, and asked Lindsey to explain further.
Lindsey said the Securities and Exchange Commission (SEC), the Generally Accepted Accounting Principles (GAAP), and the Internal Revenue Service (IRS) all have different definitions of income. “Ultimately, I think, Congress will abandon income taxation and move to value-added base taxation.”
When asked by Larson whether Lindsey would describe cash flow-based taxation as transaction taxes, Lindsey said “I would call it a net transaction tax.”
“Or a broad transaction tax, not a transaction on a specific industry?” Larson added.
“Correct, and where you would pay tax only on the transaction,” Lindsey responded.
For more information on the hearing, please click here.