High & Low Finance: Investment Income Hasn’t Always Had Tax Advantages

Whatever happened to “unearned income”?

That used to be the normal term for income from investments — dividends, interest and capital gains.

For some, that term produced images of “coupon clippers,” another term you don’t hear much anymore. The coupons in question were not the kind that get you 25 cents off on Jell-O at the grocery store. They were the ones that came attached to bonds in a precomputer age. To get your interest payment every six months, you literally had to clip off the coupon and take it to your bank.

More than half a century ago, when President Dwight D. Eisenhower proposed taxing dividends at lower rates than wages, Representative John W. McCormack, a Massachusetts Democrat who later was to become speaker of the House, was outraged.

“The Republican tax bill is indefensible in that portion which gives great benefits to corporations and constitutes a bonanza to stockholders, the larger ones in particular,” he said in 1954. “It is unjust and in my opinion morally wrong to make a person with earned income pay considerably more in taxes than persons with unearned income from dividends.”

That tax fight ended with a benefit for small shareholders, who would escape tax on the first $50 a year of dividends. But annual dividends above that amount remained fully taxable at ordinary income tax rates, which ranged up to 91 percent. Mr. Eisenhower’s proposal to cut the rates on such payouts was rejected.

Not until 2003 were dividend tax rates reduced below ordinary income tax rates. Then they were cut to 15 percent, the same as the capital gains rate.

For most of the history of income taxes in America, long-term capital gains — defined at different times as investments held for minimum periods of as little as six months and as long as 10 years — have been taxed at substantially lower rates than top ordinary income tax rates.

There was, in fact, only one time that capital gains were taxed at the same rates that were paid by people who earned their money by working. That was during the years 1988 to 1990, as a result of the Tax Reform Act of 1986 — a law championed by President Ronald Reagan.

To be sure, he changed his mind about unearned income in 1988. After Vice President George H. W. Bush, then campaigning to succeed Mr. Reagan, endorsed lowering capital gains taxes, the president allowed that might be a good idea. Mr. Bush and the Congress did lower them after he was elected.

These days, the conventional way to look at taxes on investments is to think they should be low to stimulate investment and thus help the economy. It is a view that has much more support in economic theory than in economic history.

Correlation is not causation, of course, but the economy has tended to do the best when taxes on unearned income were high. Economic growth was great during the 1950s, when dividends were taxed at very high levels and capital gains rates were 25 percent, much higher than they are now. Since 2003, tax rates on unearned income have been at their lowest levels ever, and economic growth has been sluggish.

Tax rates are not the reason for that, at least not directly. But it could be argued that low tax receipts now are having a pernicious impact, particularly on state and local governments. Their layoffs have been a drag on the recovery, and the declining quality of infrastructure in many areas has hurt many businesses. If the federal government taxed unearned income anywhere close to historical averages, there could have been a lot more tax money available to help out when the credit crisis hit.

There is no question that tax policy has had a major impact on investment, but its impact probably has been less in the overall level than in the allocation of investments.

Corporate profits, at least theoretically, are taxed twice, once when the company earns them and again when shareholders are taxed on their dividend payments. But interest payments to bondholders are deductible to the corporation, unlike the dividends it pays to shareholders. As a result, there has been an incentive to finance companies with as much debt, and as little equity, as possible. That maximizes return on equity in good times, and allows companies to plausibly claim they will raise profits much more rapidly than sales. But it also makes bankruptcies more likely when the economy falters. The Eisenhower tax policy that outraged Representative McCormack was intended to reduce that incentive a little, by reducing slightly the rates on dividend income. Had it passed, it probably would have had little impact.

Article source: http://feeds.nytimes.com/click.phdo?i=15211d32b2d96fbce8ecbc74fb295833