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In the United States, ordinary wage income is taxed at a much higher rate than capital gains. It changes from year to year but in general the maximum bracket is 35% vs 25%.

This is counter intuitive to me: wouldn't the economy be more productive if we made hard work more fruitful than passive capital gains? While investments are important, it makes the reward for earning $5k by buying stocks more than earning $5k at your job.

Holding stocks for longer than a year or investing in qualified dividends lets you convert ordinary income into capital gains. I can understand the incentives behind these rules, but what is the economic reason behind them?

I'm not trying to align with any political side here; I'm genuinely curious why we don't lower the income tax and raise the capital gains tax rate.

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    question may be more appropriate to Personal Finance&Money or Economics sites
    – BobE
    Nov 12 '20 at 3:38
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    Politics.SE generally is where to ask about the "why" of a law, but questions about the specific details are better asked on a specialist site (I recommend Economics, since it's not about personal finance). We can definitely answer "why have taxes" or even "what are the arguments for having different types of tax", but I don't think we have the expertise to address "why is this tax structure better than this other one". It's an interesting question, though, and I'd like to see an answer (on whichever site).
    – Bobson
    Nov 12 '20 at 5:20
  • This doesn't explain it, but it curtails a lot of politically-motivated explanations by showing that it's always been lower: taxpolicycenter.org/sites/default/files/styles/…
    – dandavis
    Nov 12 '20 at 7:52
  • Note that you are comparing maximum rates here and these apply at different levels. If you earn 5k $ (per year) at your job, your income tax would be zero (or close to). Doesn't change the fact that at high incomes, work income is taxed higher than capital gains though.
    – quarague
    Nov 12 '20 at 8:10
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    Isn't the short answer for this Rich people have passive income, poor people have active income and laws, particularly tax laws, are passed by (and for) rich people?
    – Jontia
    Nov 12 '20 at 11:08
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There are several possible justifications for this distinction between capital gains versus ordinary income, and between qualified dividends versus normal dividends.

One is the "double taxation" problem that emerges for equity investments: a corporation may deduct its interest and amortization expenses (so, expenses of debt financing) before paying corporate income tax; but it cannot do the same for dividends it pays to shareholders or stock buybacks. This is inevitable, since if corporations were allowed to deduct everything from their income tax base, the tax would raise no revenue. However, this has the effect that stock returns are subject to double taxation. The dividends are first taxed before the corporation pays them out to shareholders under the corporate income tax, and then they are taxed again once the shareholders receive them under either the personal income tax or the capital gains tax. To see that this is a quantitatively plausible explanation, note that the effective corporate income tax rate paid by Alphabet Inc. in the year 2019 was %13.3, and this pretty much matches the spread between %25 and %35 that you mention in your question.

Another possible reason behind this distinction is the conventional wisdom that taxes are most effective at raising revenue if they are levied on relatively inelastically supplied factors of production. Both common sense and a large body of empirical work supports the conclusion that capital investment is much more elastically supplied than labor, and therefore a tax on capital both has stronger dynamic effects which reduce the amount of revenue raised from the static baseline, and also drives a wedge between saving and investment, which has deleterious economic effects. On the other hand, an increase in payroll taxes, if carried out uniformly at a fixed marginal rate, has little effect both on employment and the number of hours worked per worker.

This is certainly how the low long term capital gains tax rates are advertised by their proponents, but given the double taxation problem mentioned earlier, the correct question to ask might be why the short term capital gains tax rates are as high as they are. The commonly given explanation behind this distinction is that it's meant to separate "speculation" from "long term investment", or "financial" investments from "real" investment for tax purposes. These are fallacious arguments, however, and likely have the effect of depressing investment by reducing market liquidity. If there is a sound reason behind this distinction, I haven't seen it so far. It's likely that sound economic thinking is not the right mode of explanation to understand this (and similar) distinctions drawn in the US tax code.

These are, however, speculations on my part since tax policy in Washington rarely follows any coherent logic and generally doesn't make any sense to outside observers.

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    Capital investment may be more elastic, but in this particular case (stock ownership), it's also mostly unproductive, isn't it? That is, the real economy will do just fine even if nobody is buying stocks?
    – user253751
    Nov 12 '20 at 17:00
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    @user253751 That is about as far from the truth as you can get. Stock ownership is in fact vital for financing all kinds of investments, especially investments with a high risk and high potential return - think venture capital, for instance. Small entrepreneurs also benefit from equity far more than established large corporations who can afford to diversify more easily and have a bigger balance sheet to fall back on in order to finance their investments by debt instead of equity. In this sense, a tax on equity financing is actually somewhat "regressive".
    – Ege Erdil
    Nov 12 '20 at 17:05
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    @user253751 The constant trading is important if you want people who own stocks to have the assurance of being able to sell their stock at any time they want without getting screwed by huge bid-ask spreads. It's also one reason why stocks tend to be more attractive investment vehicles than real estate, since it's much harder to sell a house when you need some cash right now, while it's trivial to sell shares in an ETF - it takes milliseconds to do it in 2020. This means people are willing to hold stocks which return lower than they otherwise would have to - there is a liquidity premium.
    – Ege Erdil
    Nov 12 '20 at 17:34
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    I strongly suspect that startups would still be able to sell stocks if they had a promise of future profitability, even if the stocks were never traded. The stocks would go to wealthy people and banks which have too much money now and want more later, and the more speculative startups would not get funded as much because there would be no "greater fool effect", but the stocks would still exist
    – user253751
    Nov 13 '20 at 14:14
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    in the analogy, you are saying that tax-free alcoholic beverages are absolutely vital for the alcohol industry. And that fact is also obviously BS, because there is an alcohol industry, and it does just fine, despite the taxes.
    – user253751
    Nov 13 '20 at 14:19
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I would say it is all about a political agenda in the US. What can make me elected and what can make me powerful. Can I be elected by promising tax-cuts, or increasing tax on the ultra-rich?

If capital gains was taxed then it could be argued that nobody wants to invest in companies and give a bad snowball effect, whereas tax on income could worst case make people move to another country.

Some of the same can be said for company taxes where there in the recent years has been a movement for taxing big companies in the US (speeches from AOC on Amazon), but tax on companies e.g. in Scandinavia isn't that big a tax, and I think Bill Gates got some valid points about estate-tax and other taxes that would be much more effective in regards to rich people.

Reality isn't that big a thing, but if high taxes becomes law, but there still are loopholes will those loopholes then mean the wrong people will get punished instead.

What I have noticed the last few years around US is that the narrative has changed somewhat and taxes has become less evil than e.g. 20 years ago.

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