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Wednesday, September 15, 2010

Tax Treatment of Long-Term Capital Gains and Dividends and Related Provisions in the President’s FY2011 Budget Proposal

Maxim Shvedov
Analyst in Public Finance

Pending expiration at the end of 2010 of tax cuts enacted during the presidency of George W. Bush raises important questions about the future of affected tax policies. Tax treatment of long-term capital gains and dividends was one of the key components of the overall tax cut package. Long-term capital gains or losses arise from a sale or exchange of a capital asset, such as shares of stock, held for a year or longer by a taxpayer. Dividends are any distributions made by a corporation to its shareholders. This report discusses their tax treatment under current law and the President's FY2011 Budget Proposal, analyzes economic characteristics of affected taxpayers, and presents some policy alternatives with respect to this element of the tax system. 

Historically capital gains and dividends were often treated differently from ordinary income, such as salaries and wages, and from each other. With the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA, P.L. 108-27), long-term capital gains and qualified dividends were taxed at identical rates. In 2010 the rates are 15% or 0%, the latter if a taxpayer's marginal tax rate on ordinary income is 15% or lower. This treatment compares to the tax rates of 10% to 35% on ordinary income in 2010 (changing to 15% to 39.6% in 2011 under current law). If tax reductions first enacted under JGTRRA are allowed to expire, long-term capital gains would become subject to 20% or 10% rate and dividends would be treated as ordinary income and subject to ordinary tax rates. 

Compared to current law, the President's FY2011 Budget Proposal would reduce the tax rates on capital gains in 2011 and thereafter for taxpayers below certain income thresholds, and on dividends for taxpayers at all income levels. In addition, it would sustain the parity in tax treatment of both types of income. The Administration proposes to retain the 0%/15% rate structure for both capital gains and dividends after 2010 for married taxpayers with income below $250,000 and non-married taxpayers with income under $200,000 (together referred to as FY2011 income threshold). Taxpayers above the threshold would be subject to a 20% rate on both kinds of income. Relative to current law, the President's proposal is estimated to reduce revenues by $238.3 billion over 10 years. 

Economic characteristics of the recipients of these types of income play an important role in analyzing the policy. By value, long-term dividends and particularly capital gains are disproportionately distributed among a relatively small number of higher income returns. By numbers, returns with income below $200,000 represent a majority of recipients for both kinds of income, but a minority within their respective income classes. 

Based on the analysis of IRS data, the largest shares of capital gains and dividends by value would be subject to the 20% rate if President's proposal were enacted. The second largest share would be exempt from tax, due to a 0% rate. Long-term capital gains and qualified dividends subject to a 15% tax would represent the smallest share. Only 5% of the long-term capital gains and 14% of dividends would be subject to the 15% rate. Thus, the third 15% bracket materially affects a modest number of taxpayers, but makes the tax structure more complex for all taxpayers. 

The report concludes with analysis of several legislative options. Besides across-the-board extension or expiration of the tax cuts, some other options may achieve some of the desired distributional goals without adding to the code the complexity of a three-tiered tax rate structure.

Date of Report: September 7, 2010
Number of Pages: 21
Order Number: R41394
Price: $29.95

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