Reason for Different Tax Rates

[kjpliny]

I was discussing various financial strategies with a coworker today and we got into talking about tax free bonds, CD laddering, mutual funds and the bucket approach to investing.

We were trying to figure out how it came to be that interest from CDs and Money Market accounts are taxed at higher levels than investments in stocks and mutual funds. What is the reasoning behind taxing fixed investments at a higher rate than stocks? Doesn't this discourage saving and isn't it unfair to the conservative investor/saver?

 

[Meadbh]

If a government wants to stimulate private enterprise, reducing taxes on capital gains is a good way to encourage investment in stocks. At a different point n the business cycle, after all that private enterprise has stimulated population growth, they will probably need to raise money for infrastructure by debt instruments such as bonds. If the private sector is overheated at the same time, it would be logical for a government to increase taxes on capital gains and to decrease tax rates on fixed income.

 

[clifp]

I have a somewhat more cynical answer.

The majority of people who invest in assets that are taxed at capital gains, are affluent America who are influential and contribute to politicians. Now obviously plenty of Americans own mutual funds and a house, but for the vast majority of them their mutual funds are in IRAs/401Ks.

I suspect there is very little difference in the economic impact of me owning BofA stock and collecting a 5% dividend taxed at 15% and working stiff having a BofA CD paying <5% and paying 25% or 28% on the interest.

 

[ERD50]

Sorry, but when you try to put the word 'reason' and 'taxes' in the same sentence, you are headed down a path of frustration.

Our tax system is not based on reason. It is based on whatever bill some legislator was able to get signed to encourage or inhibit whatever was their hot button (their supporters hot button? Same thing.) at the time. You do not need to look far to find taxes and policies that are diametrically opposed. Yet, they are both on the books. Try to find 'reason' in that.

Frustrating but true.

-ERD50

 

[audreyh1]

What is the reasoning behind taxing fixed investments at a higher rate than stocks? Doesn't this discourage saving and isn't it unfair to the conservative investor/saver?

No. The government is rewarding the more aggressive investors - those willing to put their capital at risk.

Audrey

 

[d]

ERD50 has the correct answer:

when you try to put the word 'reason' and 'taxes' in the same sentence, you are headed down a path of frustration

 

[brewer12345]

Beats the living **** out of me, like much of the tax code. I think the distortions caused by differing tax rates on interest income, qualified dividends and cap gains are a foolish way to structure incentives. But you also might ask why tax rates on wage income are so much higher than on capital gains...

 

[Sandy]

I opt for (e).....

all of the above.

 

[FinanceGeek]

I look at it this way, money can and does move anywhere in the world to seek the highest risk adjusted returns. Therefore the capital market conditions for invested capital (of which taxation policy is a big piece) have to be competitive on an international basis, or money will not flow to US investment opportunities.

Workers, on the other hand, cannot readily pick up and move to another part of the world nearly as readily in search of a "better deal".

An implication of this is that long term the majority of taxation burden is going to have to fall on individuals working for wages, not to businesses or investors. The latter are far more free to move their activities elsewhere.

 

[aenlighten]

Just consider it motivation

for more people to get rich and retire early. It would be next to impossible to do that on fixed income investments.

 

[Gotadimple]

We were trying to figure out how it came to be that interest from CDs and Money Market accounts are taxed at higher levels than investments in stocks and mutual funds. What is the reasoning behind taxing fixed investments at a higher rate than stocks? Doesn't this discourage saving and isn't it unfair to the conservative investor/saver?

As the OP said, it's about risk.

When you purchase a bond or CD (or bond funds/money market funds) you are lending money and for the loan you are repaid a fee (interest). Generally, the quality of the instruments is such that the risk of losing your investment is low. Same of loss of value (other than to inflation) - generally low.

With stocks (or stock mutual funds), there is the opportunity when you invest in the company that the market will add a premium to the value of the company, the company will have good success, etc. At the same time there is also a probability that the market will discount the value of the company or that the company will not do well. So there is greater risk that you could lose your entire investment, or earn more if the company succeeds.

To the extent that you are investing in a business, you benefit from taxation designed to encourage your risk-taking, by taxing gains at a lower rate than when you lend money. Or by allowing you to claim losses if your investment loses value when you've sold it.

Rita

 

[Grizz]

Rich people govern North America.
Rich people make the tax laws to benefit their class.
Rich people don't have hourly jobs.
Rich people make their money from stocks and other capital gains investments.

 

[old woman]

Long term capital gains aren't just in the stock market. If you buy a asset in 1987 and sold it in 2007 you may have a huge profit but it is all in the year sold when it really only kept up with inflation or maybe not even that. The government doesn't want people churning assets but to invest long term. Take houses if you buy a house to use as a rental or a home for yourself you will get tax breaks when you sell but if you buy and sell houses for a living it is just a retail trade like selling bed sheets, so no tax breaks.

 

[kjpliny]

Rich people govern North America.
Rich people make the tax laws to benefit their class.
Rich people don't have hourly jobs.
Rich people make their money from stocks and other capital gains investments.

Shouldn't this change?

 

[Grizz]

Shouldn't this change?

Nope, but the kids in high school should be taught about the system so that they can intelligently choose how and why to invest to achieve minimal tax rates. My kids will know.

 

[ERD50]

Originally Posted by Grizz
Rich people govern North America.
Rich people make the tax laws to benefit their class.
Rich people don't have hourly jobs.
Rich people make their money from stocks and other capital gains investments.

Shouldn't this change?

kjpliny: - Please tell me how you would change this for the better?

Rich people govern North America. Rich people make the tax laws to benefit their class. - Everyone gets a vote. True, rich people and corporations can fund lobbyists - but I don't know how you are going to change that.

Rich people don't have hourly jobs. Hourly Jobs? What do you suggest? We force all rich people to flip burgers, and give salaried positions to people without the skills for those jobs? That's a great reward for some people who worked harder/smarter than average.

Rich people make their money from stocks and other capital gains investments. And poor people don't have the money to invest in companies that can provide products and services. Are you suggesting we do without?

-ERD50

 

[bssc]

Rich people govern North America.
Rich people make the tax laws to benefit their class.
Rich people don't have hourly jobs.
Rich people make their money from stocks and other capital gains investments.

Aren't we the rich people? Aren't we in the top 10%, at least, of our age brackets? The last ER poll I saw, most people here were. Most people have savings and investments so don't these laws benefit the ERs.

My wife has a problem with this, when she starts talking about rich people, I have to remind her that she is one of them.

 

[kcowan]

If I have $100k and I invest it at 5%, I earned $5k every year and pay very little marginal tax on it (assuming no other savings).
If I invest it in a company stock that gains 9% a year and sell it in five years, I get a gain of $53.8k which will attract a larger tax bite on average, so the reduction is partial compensation to discourage me from churning the stock every year.

By managing capital gains on individual stocks in retirement, I have only paid tax in 2 of 5 years.

Mutual funds have distorted this model by distributing results every year.

 

[kjpliny]

kjpliny: - Please tell me how you would change this for the better?

Flat tax? I say abolish the IRS and save some money!

 

[ERD50]

Flat tax? I say abolish the IRS and save some money!

That might be better. I know I just hate all these complex, inter-related, counter-productive tax codes.

Aren't some people against a flat tax because it favors the rich? People want to see a progressive rate on the 'rich'. Though, elimination of 'loopholes' may help to do that.

-ERD50

 

[Grizz]

Flat tax? I say abolish the IRS and save some money!

Where I live, the lower income marginal rate is 25.5%, and the big earners pay 39%. So would the rich pay less, or would the poor pay more, or would it be a bit of both. I admit, a flat tax on wages is probably how things should be done, but no matter where you set the rate, you'd have a political firestorm on your hands.

As far as different investments receiving different tax treatments, I believe that those who are willing to risk their money by investing in those things that are currently taxed as capital gains generally boost the overall economy of the nation more than those who squirrel away money in savings accounts. I'm not sure how it would play out, but the act of taxing both at the same rate would definitely make for some interesting times on Wall Street.