My best guess is that the top tax rate on capital gains and dividends in 2013 will be almost 24 percent—a significant increase over today’s 15 percent rate. As a result, the decade-long tax holiday for investors is coming to a gradual end.
At the moment, the fate of all of these tax rates is a bit uncertain. But here is the recipe for big tax increases on investments: Take the tax hikes included in the newly-enacted health law. Combine with other tax changes President Obama has proposed in his 2011 budget. Add huge deficits and the scheduled expiration of the Bush tax cuts in less than nine months. The result is likely to be a big increase in taxes on capital, at least for the wealthiest investors.
Here are the numbers: The top rate on gains and dividends today is 15 percent. If Congress does not act between now and Dec. 31, the maximum rate on capital gains will rise to 20 percent, what it was back in 2001. The top rate on dividends will soar to 39.6 percent, its level prior to those 2001 Bush tax cuts.
Obama has proposed a 2011 tax on investment of 20 percent for both dividends and gains. But remember, the new health law includes an extra Medicare tax of 3.8 percent on investment income starting in 2013. The two changes combined would raise rates on investments to nearly 24 percent, at least for couples making more than about $250,000 and singles earning about $200,000.
Btw, even at 23.8 percent, capital gains rates would still be lower than the post-war average, which my colleague Eric Toder figures has been about 25.5 percent. And initially, the top rate on investment income would apply to only about 2 percent of taxpayers, although because the income triggers are not indexed for inflation, the higher rate gradually would hit increasing numbers of taxpayers.
Even as Obama raises investment taxes, he’d also boost rates on ordinary income--back to 36 percent and 39.6 percent for those in the top two brackets. He’d also restore the phase-outs of the standard deduction and the personal exemption for high-earners (another reversal of the Bush tax cuts). These changes would increase their marginal rates by another percentage point or so. As a result, the difference between rates on investments versus ordinary income will shrink somehwat for top-bracket taxpayers.
Obama could scale back these rate hikes on investments, but he has given no signs that he is planning to do so. For the past couple of weeks, I’ve been trying to get Administration officials to clarify what their preferred rate would be on gains and dividends, but they’ve been unusually silent on the topic. So in the absence of a response, I’m going to assume Obama still favors his own budget proposal.
What will be the impact of all this? First, keep in mind that when it comes to capital gains, timing is everything. Unlike, say, wage income, it is easy for investors to decide when to sell stock or other assets. So taxpayers close to the income triggers for these higher rates will accelerate gains into this year to take advantage of the last days of low rates. They may do the same thing in 2012, just before the next rate hikes take effect. Once the higher rates kick in, they may try to defer income in an effort to stay below the high tax thresholds.
Timing aside, higher rates on investment income may increase the cost of capital for businesses (a bad thing) and limit the attractiveness of tax shelters (a good thing).
Will these tax hikes come to pass? As I’ve written recently, it is very hard to predict what tax rates will be in three years. But we’re getting a pretty good idea of what the administration would like them to look like. And, for wealthy investors, it is not a pretty sight.
