Investment Tax Structure

19 November 2013

Theoretical Paper Final Copy

In the United States, dividends and capital gains are taxed differently than traditional income. For the purpose of this report, unless stated otherwise, assume that all statements are made in respect to the United States tax laws. A capital gain (loss) is defined as the net increase (decrease) in wealth realized upon the sale of an investment (investopedia). Dividends, for the purpose of this report, are the redistribution of a company’s cash to its owners (normally shareholders). These types of income are considered passive income in that they do not require significant effort to maintain. In the United States, capital gains are taxed in two ways. Short-term capital gains are taxed at the marginal income tax rate while long-term capital gains are taxed at a lower rate of anywhere from zero to fifteen percent (irs.gov). Long-term gains are classified as any gain on the sale of an investment held for over a year. Dividends are also taxed in two ways. If a dividend meets certain qualifications, it is classified as a qualified dividend and is taxed at the applicable capital gains tax rate. If a dividend does not meet the standards of a qualified dividend, it is taxed at the ordinary income tax rate. Both of these taxes are progressive in themselves, but regressive to an individual’s overall tax rate. That is, as qualified dividends or capital gains increase, an individual’s overall effective tax rate decreases. The following report will describe the intention behind the taxation of investments, arguments for a lower capital gain and dividend tax rate, arguments against a lower capital gain and dividend tax rate, the way other countries treat investment gains and losses, which method of taxing investment income is most consistent with desired behavior, and a final conclusion on the topic.

The tax code can be written to encourage or discourage certain behaviors. The best method for achieving these behaviors is highly...