A quick history of tax rates

Being smart financially invariably involves a big dose of being smart about taxes.

When I first started learning about the tax code in the 1980s there were a couple of main "games" that you had to play in order to be smart about taxes. One of those games was the capital gains vs. dividends game, where dividends (which were taxed at the same rates as ordinary income and which were therefore taxed at the highest tax rate in a person's life), were bad -- very bad -- and capital gains (which were taxed at substantially lower rates, often via a 50% exclusion of the gain from income all together) were good - very good.

That game was as old as the hills. Or at least, as I was soon to learn, as old as The Roaring Twenties.

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Now, as part of honing my skills, I read quite a bit of financial literature. This morning I read a piece (sorry: most financial trade magazines are very far behind technologically, so this article is not available online) that had a chart showing how tax rates on long-term capital gains (a/k/a capital gains rates if you like to talk fast and loose . . . and CGs in here) have evolved. But the table only went back to 1942 and wasn't very informative at all.

That got me wondering and thinking and . . . that got me wandering out into the wild blue yonder, and here's what I found.

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In the early part of the 1900s -- the Dawn of the Internal Revenue Tax Copde -- CGs were taxed as ordinary income, which was taxed at rates up to 70% plus. That changed in the 1920s, when CGs first received favorable tax treatment with a maximum tax rate of 12.5%. So. in the early years, the differences between income tax rates on odinary income and capital gains were quite pronounced,

That was followed by a bump-up on CG rates during the Depression years into the nearly 40% range and then a bump-down during the 1940s to the 25% range. That rate stayed relatively unchanged until the 1960s, at which point there was a surtax to support the Viet Nam war. That surtax, plus other changes, brought CG rates back up close to 40% during much of the 1970s. Then the 1980s saw cuts down into the high-20 and low-30 percent ranges.

And then a few years ago the tax rate on CGs dropped down to 15%, where it stands today. Accroding to many folks' punditry, that is the rate at which it will stay or from or from which it will fall in the next couple of years. Importantly, at the same time CG rates came down, rates on dividend income came down as well, and today also stand at 15%.

(If you'd like to see a pdf with a chart and some intense analysis look here, and if you'd like to just see a pdf table of tax rate changes look here.)

So, historically speaking, insofar as CG rates go we're partying like it's 1929.

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Today's rates are important numbers -- way-important-numbers -- in how you go about being financially smart and how, especially apropos to this time of year, you go about doing end-of-year tax planning.

But, I look around a lot, and nowhere do the financial gurus talk about how the game mentioned above -- the capital gains vs. dividends game -- is now no longer a game because most of the dividends and most of the capital gains that most people receive are taxed at the same 15% maximum rate.

It's as if all the attention that has been paid over the years to fights over CG rates has totally obliterated people's perceptions of this other huge change -- the change of taking tax rates way down on dividends.

So the fact is that, today, in most circumstances there's no difference in tax rates between dividends and CGs. And that's a big deal. The game is gone.

So if one person gets a 3% dividend from, say, owning some GE stock, and another person who has owned GE stock for a spell sells the stock and has a 3% gain on the sale, they are, at the tax level, treated identically.

Now in the esoteric world of tax planning, there might be some reason that someone might prefer to have a capital gain taxed at 15% rather than a dividend taxed at 15%, or vice versa, but, by and large, what they care about is the tax rate, and when the rates for CGs are the same as the rates for dividends, the economically rational person is 100% indifferent as to which it is.

True, the 15% tax on dividend income is an annual, involuntary tax, whereas the 15% tax on capital gain is an intermittent, voluntary tax that only hits when the owner of the capital asset decides to sell. And that's a big difference.

But, hey, in 1945 a rich person would have been taxed at 94% on dividend income and 25% on CGs, whereas today it's 15% for both. So the rich person in 1945 loved loved loved CGs compared to dividends.

And today? Rich person indifferent.

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And what about the tax rate that applies to both CGs and dividends? Well, to many people that tax barely feels like a tax at all because, hey, it's what you tip the waiter at a restaurant for decent service, isn't it?

Of course, here in our little blue bubble there is one exception to this statement: anyone in the Bay Area who just sold a house that they've owned for a good long while, because that person still faces a hefty tax bill of 15% of the gain arising from the sale of a personal residence that is over and above the $250k of personal residence CGs that are exempt from tax .

So the simple fact is that the tax rate on CGs and dividends is less than the tax rate on the wages and the salaries that most of us use to put food on our tables on clothes on our back. Given that, it's pretty hard to conclude anything other than labor is taxed up the wazoo, and capital is not. How does that benefit rural people?

And, to drop a hint of a topic to come, if you want the tax system to avoid double-taxation of dividends, couldn't you just do it by allowing corporations to deduct the dividends they pay out? That way the tax burden on the dividend would be in keeping with the tax status of the person receiving the dividend . . . That seems more fair, doesn't it . . . ?

Hmmm . . ..