Dividend Taxes vs Capital Gains Taxes

One of the elements of the Center for American Progress tax reform plan released today was higher taxes on investment income. CAP would tax investment income (i.e. dividends and capital gains) at lower rates than labor income but higher rates than it’s taxed today. That seems to me to be about in line with the research consensus, but I was a bit puzzled that they want to tax dividends at a different—higher—rate than they tax capital gains.

After I inquired they explained the reason. Capital gains taxes only get paid when actual transactions take place, so when you’re trying to find the short-term revenue-maximizing point there’s a balance between higher rates and lower volumes of transactions. So whatever you think the right tax rate for dividends is, you should put the capital gains rate somewhat lower than that to encourage a bit more transaction churn.

I’ve also heard a separate argument about this from a couple different heterodox thinkers in the business world that supports the same conclusion. This is the idea that relatively high dividend tax rates discourage investors from demanding dividends, which encourages executives to recycle profits into business investments rather than turning them into luxury goods consumption.