Why is investment income taxed less than wages?

By Stephen Ohlemacher

Associated Press

Published: Friday, Jan. 27 2012 12:00 a.m. MST

House Speaker John Boehner listens as President Barack Obama delivers his State of the Union address in front of a joint session of Congress Tuesday, Jan. 24, 2012, at the Capitol in Washington.

Saul Loeb, Pool, Associated Press

WASHINGTON — Why do Mitt Romney and other wealthy investors pay lower taxes on the income they make from investments than they would if they earned their millions from wages? Because Congress, through the tax code, has long treated investment more favorably than labor, seeing it as an engine for economic growth that benefits everyone.

President Barack Obama and the Occupy Wall Street movement are challenging that value system, raising volatile election-year issues of equity, fairness — and Romney's tax returns.

Romney, who released his 2010 and 2011 tax returns this week, has been forced to defend the fact that he paid a tax rate of about 15 percent on an annual income of $21 million. His tax rate is comparable to the one paid by most middle-income families. His income, however, is 420 times higher than the typical U.S. household.

The Republican presidential candidate's taxes were so low because the vast majority of his income came from investments. The U.S. has long had a progressive income tax, in which people who make more money pay taxes at a higher rate than those who make less. But for almost as long, the U.S. has taxed capital gains — the profit from selling an investment — at a lower rate than wages.

"There are two ways to look at: There is a moral argument and an economic growth argument, and they both point to lower taxes on capital gains," said William McBride, an economist at the conservative Tax Foundation.

McBride says it is unfair to tax income more than once, and capital gains are taxed multiple times. If you got the original investment from wages, that money was taxed. If the stock you own gains value because the company you invested in makes a profit, those profits are taxed through the corporate tax. And if that company issues dividends, those are taxed as well.

Lots of people are double taxed, says Chuck Marr, director of federal tax policy for the liberal Center on Budget and Policy Priorities. "Check out your last pay stub: There's income tax and payroll tax, so you're double taxed, too," Marr said.

And, he noted, when you buy something, you probably pay a sales tax.

Under current law, the top tax rate is 15 percent on qualified dividend and long-term capital gains — the profits from selling assets that have been held for at least a year. The top income tax rate on wages is 35 percent, though that applies only to taxable income above $388,350.

Congress started taxing capital gains at a lower rate than wages following World War I. The concern then was that high taxes on capital gains actually reduced revenue because people would simply hold onto their investments and restrict the flow of capital, according to the Encyclopedia of Taxation and Tax Policy.

At the time, however, the top tax rate on wages was a whopping 73 percent. In 1922, Congress lowered the top capital gains rate to 12.5 percent, a rate that lasted until 1934.

For much of the next 70 years, the top tax rate on long-term capital gains hovered between 20 percent and 30 percent, going as high as 39.9 percent in the 1970s but never falling below 20 percent until 2003, when Congress passed a gradual reduction to the current rate.

The 2003 law also started taxing qualified dividends at the same rate as capital gains.

Liberals and some moderates argue that lower taxes on investments are a giveaway to the rich because they are the ones who get the most benefit. Last year, two-thirds of all capital gains went to people making more than $1 million, according to the nonpartisan Joint Committee on Taxation, the official scorekeeper for Congress.

Only 5 percent of capital gains went to people making less than $100,000, and only 13 percent went to people making less than $200,000.

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