Why Should Work Be Taxed More Than Wealth?

Laiba Farshori

“Investing Money” by 401(K) 2012, licensed under CC BY-SA 2.0 via Wikimedia Commons.  

A worker who earns a dollar through a paycheck and an investor who earns a dollar by selling an investment both end up with additional income, but the federal tax code can treat those dollars very differently. Under current law, the federal government taxes long-term capital gains at preferential rates up to 20 percent, while ordinary income can face rates as high as 37 percent. The difference is supposed to encourage investment and economic activity, but it also raises a basic question of fairness. Congress should narrow the gap between taxes on long-term capital gains and wages for high-income taxpayers while preserving the benefits that encourage ordinary Americans to save and invest.  

Capital gains are profits earned when an asset, such as a stock, business, or piece of real estate, is sold for more than its cost. The current system generally taxes gains from assets held for more than one year at lower rates than wages and other ordinary income. This difference matters because investment income is heavily concentrated among high-income households. Tax Policy Center data show that taxpayers earning at least $1 million realized 69 percent of all long-term capital gains in 2021. Preferential treatment of capital gains is not new. When the modern federal income tax began in 1913, capital gains were originally treated as ordinary income. Congress introduced a preferential alternative capital gains rate in 1921, and lawmakers have changed the treatment many times since then. The Tax Reform Act of 1986 temporarily brought the top rates on capital gains and ordinary income together at 28 percent, but later changes reopened the gap. 

There are reasonable arguments for keeping some difference between the two types of income. Supporters of lower capital gains taxes argue that they encourage investment, entrepreneurship, and risk-taking. Preferential rates can also reduce the lock-in effect, where investors avoid selling assets because doing so would trigger a tax bill. These considerations should not be ignored because investment helps businesses obtain capital and gives households an incentive to build savings. The problem is that the current gap may provide a larger benefit than necessary to accomplish those goals.  

The Tax Policy Center finds little evidence that lower capital gains rates from lower capital gains and dividend rates went to taxpayers with incomes above $1 million in 2022. Preferential rates can also encourage taxpayers to find ways to convert ordinary income into more lightly taxed capital gains, making the tax system more complicated. Congress does not need to eliminate preferential capital gains rates for everyone to address this imbalance. A better approach would preserve the current structure for middle-income investors while gradually narrowing the difference for taxpayers with very high incomes. Retirement accounts should remain protected, and ordinary households should not face higher taxes simply because they invested for their future. Reform should focus on taxpayers who receive substantial amounts of income from investments and benefit most from the difference between ordinary and capital gains rates. 

There is a precedent for taking this approach seriously. Congress has changed capital gains rules many times, including reforms aimed at reducing the incentive to turn ordinary income into capital gains. More recent proposals have also considered increasing capital gains taxes specifically for high-income taxpayers rather than applying the same increase to everyone. Any new reform would need to consider investor behavior, tax avoidance, and the possibility that higher rates could cause investors to delay selling assets. The goal should not be to punish investment. Investment is important to economic growth, retirement security, entrepreneurship, and household wealth. The goal should be to create a system in which the method a person uses to earn income does not create an excessive tax advantage, especially at the highest income levels.

Congress should use the next major debate over federal tax policy to narrow the difference between long-term capital gains and ordinary income for high-income taxpayers while protecting retirement savings and smaller investors. More than a century after lawmakers first created preferential treatment for capital gains, policymakers have enough experience to recognize that the choice does not have to be between encouraging investment and taxing income fairly. A tax code should reward productive investment, but it should not make earning money through wealth substantially more valuable than earning it through work.