Markets In Action

How High Taxes on Savings Hurts Investors and the Economy

Right now, Americans are working to finalize their tax returns in time for the April 15 filing deadline—and discovering just how much they paid to the government over the last year (and for some, how much more they may still owe).

The question is: are you willing to pay an even higher tax bill? Probably not. But that won’t stop some politicians and policymakers from demanding tax hikes on your retirement savings investment income. In this tight budget climate with a staggering $18.1 trillion federal debt and yearly deficits in the hundreds of billions of dollars, taxpayers must keep a watchful eye on irresponsible efforts to raise tax revenue.

A call to raise taxes on capital gains and dividends is in fact a tax increase on savings and investment. In recent years, Congress has enacted a number of federal laws with higher taxes for investors. The 2012 Fiscal Cliff Deal raised taxes on gains and dividends to 20 percent for taxpayers with income over $400,000 (single) and $450,000 (joint filers). The deal also included the Pease limitation on deductions. In addition, the recent health care reform act (Affordable Care Act of 2010) included a 3.8 percent tax increase on investment income above $200,000 (single) and $250,000 (joint filers). For taxpayers subject to both the 20 percent rate, the Pease limitation, and the 3.8 percent increase for health care reform, the combined top rate for capital gains and dividends is about 25 percent, a 2/3rds increase over the maximum rate before 2013.

A recent study published by Ernst & Young, prepared for the Alliance for Savings and Investment (ASI), explains the problem with this type of taxation.

The April 2015 study, “Corporate Dividend and Capital Gains Taxation: A Comparison of the United States to Other Developed Nations,” found that for 2014, the top U.S. integrated tax rate on corporate profits, which combines corporate-level taxation with investor-level taxes on dividends and capital gains, is among the highest in any developed or developing nation.

The top U.S. integrated dividend tax rate is 56.2 percent; for capital gains, it’s 56.3 percent. Those figures, which include federal and state taxes on capital gains and dividends, are significantly higher than the average rate prevailing outside the United States.

Only France— currently experiencing increasing uncertainty related to its economic policy —imposes higher rates, the study notes.

Bad news for economic growth

So why is this a problem? First, as the ASI study indicates, this form of double taxation, which taxes corporate profits first at the corporate level and then when they’re distributed to investors, has a distorting effect on broader economic performance:

• Higher taxes on capital discourage capital investment, which reduces the capital formation needed for a prosperous economy.

• Higher taxes on capital discourage equity financing, pushing companies to take on more debt financing—which can leave companies more vulnerable in an economic downturn.

• Higher taxes on dividends discourage the payment of dividends.

That last point was a key reason cited by Securities Industry and Financial Markets Association (SIFMA) President and CEO Kenneth Bentsen in the industry’s opposition to higher investment taxes proposed by the Obama administration in this year’s State of the Union.

“The United States already has among the highest integrated capital gains and dividends rates in the developed world,” Bentsen said in January. “The president’s proposal would push us further out of step with our economic competitors and would worsen the existing bias for debt over equity financing.”

Tax Foundation economist Kyle Pomerleau explains how higher capital gains taxes discourage saving and create a drag on capital investment.

“As more people prefer consumption today due to the tax bias against saving, there will be less capital available in the future,” he writes. “For investors, this represents less available capital for factories, machines, and other investment opportunities. Additionally, capital gains taxes create a lock-in effect that reduces the mobility of capital. People are less willing to realize capital gains from one investment in order to move to another when they face a tax on their returns. Funds will be slower to move to better investments, further reducing economic growth.”

Bad news for investors

Those high taxes on capital gains and dividends aren’t just bad for the economy. They’re also bad for investors, who see their returns eroded over time by taxes—and it’s not just “the rich” who suffer from those lower returns.

As Manhattan Institute economist Jared Meyer explains in a recent article for the Fiscal Times, higher taxes on investment have serious implications for many investors, who structure their purchases, sales and transfers in hopes of protecting their assets’ values against erosion from taxes. That introduces further distortions into the economy, while failing to even deliver on their goals of supplying more revenue for government priorities.

“Instead of evaluating investments purely on merits, individuals have to plan the timing of their purchases and sales based on tax implications,” Meyer writes. “Some avoid selling assets altogether and pass on assets to heirs, a move that results in no tax going to the Treasury. Others sell assets only when they have a loss in another asset. These tax avoidance methods are legal but time-consuming.”

As a general rule, tax policy should promote and encourage savings and investment—it shouldn’t punish those who save for the future. Yet, increases in taxes on capital gains and dividends are just such a punishment.

The next time you hear lawmakers demand higher taxes on investment income, recognize that they are advocating for reduced incentives to save and invest, which would result in less growth in the overall economy. Closing this “loophole” benefits no one, other than our economic competitors abroad.