The Effect of the Capital Gains Tax Rate on Economic Activity and Total Tax Revenue
The President and the Congress are hoping to raise substantial revenues to pay for social spending programs, including health care. They are relying in part on scheduled increases in tax rates in 2011, when the Bush tax cuts expire. They would extend the tax cuts for people in the bottom four tax brackets (roughly, for couples with $250,000 or less in adjusted gross income), but would let the tax rates rise in the top two tax brackets on income, capital gains, and dividends.
However, taxpayers react to higher tax rates by earning and reporting less income. Higher taxes on capital retard capital formation and reduce wages across the board. The particular tax increases that the Congress and the Administration are most likely to adopt would damage the economy and reduce the tax base. In fact, they are likely to result in lower federal revenues, and larger budget deficits.
Under current law, most of the tax reductions in the 2001 tax act (the Economic Growth and Tax Relief Reconciliation Act of 2001) and the 2003 tax act (the Jobs and Growth Tax Relief
Reconciliation Act of 2003) will expire at the end of 2010. The maximum tax rates on capital gains and dividends were lowered to 15% by the 2003 tax act. In 2011, the capital gains rate will revert to 20%. In 2011, the tax rates on dividends will revert to ordinary income tax rates, with a top rate of 39.6%. (The 2001/2003 acts cut individual marginal tax rates on ordinary income. These cuts will also expire. The top tax rate will rise from 35% to 39.6%, and will apply to dividends.)