09/19/2008 02:28:28 PM EST
The Case for Special Tax Treatment of Qualified Dividends and Long-Term Capital Gains
Over the next several months leading up to the November election, there will be a multitude of rhetoric in regard to the taxation of qualified dividends and long-term capital gains. The fate of the tax status of these items will depend not only on who becomes the next President of the U.S., but also on the composition of the Senate and the House of Representatives.
Currently, individuals who receive qualified dividends and long-term capital gains are taxed at no more than 15%. I believe the tax rate on these items should either stay the same; or perhaps, be lowered.
In general, qualified dividends are dividends that are paid by taxpaying domestic corporations. Any tax on dividends received by shareholders is a “double taxation” since they represent a distribution of corporate earnings that have already been taxed at the corporate level. Indeed, that income may have been taxed at a federal rate as high as 39%. If individuals are required to pay tax on these dividends at ordinary rates, this income may be completely taxed away taking into account both federal and state income taxes at both the corporate and individual level. Can anyone spell “Boston Tea Party?”
In order to fully understand the fairness of the treatment of qualified dividends, it is instructive to understand the mechanics of a dividend. That is, when a dividend is paid, the value of the stock is reduced by the amount of the dividend. So has the taxpayer received anything of value?
In addition to any tax on qualified dividends being confiscatory, a low rate, or a tax-free status of qualified dividends can promote savings and investment in U.S. based corporations. Any investment in stock has some degree of risk to it, and the special treatment of qualified dividends can serve as an incentive to make an investment in the U.S.
Many retirees and “soon-to-be-retirees” may have started saving for retirement prior to the advent of qualified retirement plans such as 401(k) plans and IRAs. Thus, to some extent, dividend income is being used (or, will be used) to provide them with retirement income. For many individuals, a large part of their retirement income is generated from dividend income.
In a similar manner, many accident victims who receive settlements invest the proceeds in dividend paying stocks with the intent that the dividends will be used to pay their bills. Many of these individuals may not be able to return to their jobs, or they will be forced to accept lower paying jobs. Should accident victims also be the victims of “double taxation”?
Another argument favoring the special treatment of qualified dividends has to do with an arbitrage opportunity. That is, many upper income taxpayers who receive qualified dividends are taxed at a relatively low rate on such dividend income, and then when they contribute an amount equal to the dividend, they receive a tax benefit at a higher rate. In this situation, not only are the donor-taxpayers benefited, but also the charity and the constituents that it serves. Making tax rates high on qualified dividends will negate this opportunity, and possibly reduce the amount donated to charities.
An equally strong argument can be made for retaining the special tax treatment given to long –term capital gains. In general, a long-term capital gain is a gain from the sale of an investment that was held for a period of more than 12 months.
Oftentimes, an individual will own a stock for a period of ten years or more before he or she will sell it at a gain. Typically, the nominal gain will be less than the amount of inflation during the period in which the security was held, leaving an individual with a loss on an inflation-adjusted basis. Should we really be taxing an inflation-adjusted loss? Can someone say “Boston Tea Party?”
Typically, a long-term capital gain represents the accumulative appreciation of an investment over a period of several years. Since it is realized in only one year, it can be atypically large. Thus, it’s possible that this gain could push a taxpayer in a higher income tax bracket than would have been the case if the gain was realized proportionately over a period of several years. Individuals should not be punished due to the nature of this type of income coming in large, indivisible chunks.
Part of the rationale for the special tax treatment on long-term capital gains, is to act as an incentive and reward for risking capital. To repeal or diminish this special treatment would serve as a penalty for taking risks.