Why is investment income taxed less than wages?

WASHINGTON — Why do Mitt Romney and other wealthy investors pay lower taxes on the income they make from investments than they would if they earned their millions from wages? Because Congress, through the tax code, has long treated investment more favorably than labor, seeing it as an engine for economic growth that benefits everyone.

President Barack Obama and the Occupy Wall Street movement are challenging that value system, raising volatile election-year issues of equity, fairness — and Romney’s tax returns.

Romney, who released his 2010 and 2011 tax returns this week, has been forced to defend the fact that he paid a tax rate of about 15 percent on an annual income of $21 million. His tax rate is comparable to the one paid by most middle-income families. His income, however, is 420 times higher than the typical U.S. household.

The Republican presidential candidate’s taxes were so low because the vast majority of his income came from investments. The U.S. has long had a progressive income tax, in which people who make more money pay taxes at a higher rate than those who make less. But for almost as long, the U.S. has taxed capital gains — the profit from selling an investment — at a lower rate than wages.

“There are two ways to look at: There is a moral argument and an economic growth argument, and they both point to lower taxes on capital gains,” said William McBride, an economist at the conservative Tax Foundation.

McBride says it is unfair to tax income more than once, and capital gains are taxed multiple times. If you got the original investment from wages, that money was taxed. If the stock you own gains value because the company you invested in makes a profit, those profits are taxed through the corporate tax. And if that company issues dividends, those are taxed as well.

Lots of people are double taxed, says Chuck Marr, director of federal tax policy for the liberal Center on Budget and Policy Priorities. “Check out your last pay stub: There’s income tax and payroll tax, so you’re double taxed, too,” Marr said.

And, he noted, when you buy something, you probably pay a sales tax.

Under current law, the top tax rate is 15 percent on qualified dividend and long-term capital gains — the profits from selling assets that have been held for at least a year. The top income tax rate on wages is 35 percent, though that applies only to taxable income above $388,350.

Congress started taxing capital gains at a lower rate than wages following World War I. The concern then was that high taxes on capital gains actually reduced revenue because people would simply hold onto their investments and restrict the flow of capital, according to the Encyclopedia of Taxation and Tax Policy.

At the time, however, the top tax rate on wages was a whopping 73 percent. In 1922, Congress lowered the top capital gains rate to 12.5 percent, a rate that lasted until 1934.

For much of the next 70 years, the top tax rate on long-term capital gains hovered between 20 percent and 30 percent, going as high as 39.9 percent in the 1970s but never falling below 20 percent until 2003, when Congress passed a gradual reduction to the current rate.

The 2003 law also started taxing qualified dividends at the same rate as capital gains.

Liberals and some moderates argue that lower taxes on investments are a giveaway to the rich because they are the ones who get the most benefit. Last year, two-thirds of all capital gains went to people making more than $1 million, according to the nonpartisan Joint Committee on Taxation, the official scorekeeper for Congress.

Only 5 percent of capital gains went to people making less than $100,000, and only 13 percent went to people making less than $200,000.

“I’m a liberal person and I believe strongly that the wealthy should pay more than the working poor,” Marr said, regardless of whether the income is from investments or labor.

Obama has taken up this argument, though his budget proposals have called for only small tax increases on capital gains and dividends, to a top rate of 20 percent.

Instead, Obama has developed the “Buffet Rule,” named after billionaire investor Warren Buffet, which says rich people shouldn’t pay taxes at a lower rate than their secretaries. To impose this rule, Obama said at his State of The Union address Tuesday that people making more than $1 million should pay at least 30 percent of their income in taxes.

“Now, you can call this class warfare all you want,” Obama said. “But asking a billionaire to pay at least as much as his secretary in taxes? Most Americans would call that common sense.”

The proposal has little chance of passing a divided Congress this year, and the Obama administration has released few details on how the tax would work.

Conservatives argue that increasing investment taxes would make it harder to for businesses to raise capital, restricting job growth and hurting financial markets, reducing income for people who rely on pension funds and 401(k) accounts as well as billionaires and millionaires.

“In my view the rationale for taxing capital gains and dividends at a lower rate has nothing to do with what an individual pays versus another individual,” said Jim McCrery, who was a senior Republican member of the tax-writing House Ways and Means Committee when the 2003 tax cuts were enacted. “It has everything to do with the creation of jobs in this country.”

McCrery now works for the Alliance for Savings and Investment, a coalition of companies and business groups that want to keep the current tax rates on capital gains and dividends.