Why Are Capital Gains Taxed Lower Than Ordinary Income?

The tax system treats different types of income in distinct ways, with capital gains often facing lower rates than ordinary income. This difference has sparked debates over fairness and economic impact, particularly regarding who benefits the most from these policies.

Understanding why capital gains receive preferential tax treatment requires looking at factors like investment incentives, economic growth considerations, and potential double taxation issues.

Distinguishing Capital Gains From Ordinary Income

The tax code separates income into different categories, with capital gains and ordinary income being two of the most significant. Capital gains arise when an asset—such as stocks, real estate, or a business—is sold for more than its purchase price. The profit from this sale is taxed differently than wages, salaries, or business earnings, which fall under ordinary income.

Ordinary income includes earnings from employment, self-employment, interest, and rental income. These sources are taxed at progressive rates, meaning the percentage owed increases as income rises. In 2024, federal tax brackets for ordinary income range from 10% to 37%, depending on total earnings.

Capital gains taxation depends on how long an asset is held before being sold. Unlike wages, which are taxed in the year they are earned, capital gains taxes are deferred until the asset is sold. This delay allows investors to time sales strategically, potentially reducing their tax burden.

Short-Term vs. Long-Term Gains

The length of time an asset is held before being sold determines how it is taxed. Short-term capital gains apply to assets sold within a year of purchase and are taxed at the same rates as ordinary income—ranging from 10% to 37% in 2024. Long-term capital gains, for assets held longer than a year, are taxed at lower rates of 0%, 15%, or 20%, depending on taxable income.

This tax structure encourages long-term investment by making it more financially attractive than frequent trading. Investors who hold assets for extended periods contribute to market stability, as constant buying and selling can lead to sharp price fluctuations. Additionally, long-term investments provide businesses with more consistent funding, supporting growth and expansion.

High-income investors may also be subject to the 3.8% Net Investment Income Tax (NIIT) on capital gains if their modified adjusted gross income exceeds $200,000 ($250,000 for married couples filing jointly). This surtax applies regardless of whether the gain is short- or long-term, but because long-term gains are taxed at lower base rates, the overall tax burden remains lower compared to short-term gains.

Legislative Incentives for Investor Participation

Tax policy is designed to shape economic behavior, and the treatment of capital gains reflects an effort to encourage investment. Lawmakers use tax rates to make long-term asset ownership more attractive, fostering capital formation that supports business expansion and economic growth.

Retirement accounts illustrate this approach. Investment vehicles like 401(k)s and IRAs allow participants to defer taxes on capital gains, dividends, and interest until funds are withdrawn. This deferral amplifies compounding returns, making long-term investing more appealing.

Certain tax provisions further encourage investment. The Qualified Small Business Stock (QSBS) exemption under Section 1202 of the Internal Revenue Code allows eligible investors to exclude up to 100% of capital gains from federal taxes when selling shares in certain startups. This policy promotes entrepreneurship and venture capital funding.

Real estate investment also benefits from specialized tax rules. Section 1031 exchanges let property owners defer capital gains taxes by reinvesting proceeds into similar assets. The capital gains exclusion for primary residences under Section 121 allows homeowners to exclude up to $250,000 ($500,000 for married couples) in gains when selling their home, supporting homeownership and mobility.

Double Taxation Considerations

A key argument for taxing capital gains at lower rates is the issue of double taxation, particularly concerning corporate earnings. When a corporation generates profits, it first pays corporate income tax, which in 2024 stands at a flat 21% federally. Any remaining profits distributed to shareholders as dividends or realized as capital gains when shares are sold have already been taxed at the corporate level. Taxing these gains again at full ordinary income rates would result in a compounded tax burden.

This issue is particularly relevant for equity investors, who bear both corporate and individual tax liabilities. While dividends are taxed upon distribution, capital gains taxation applies only when an asset is sold, allowing investors to defer their tax liability. Without preferential treatment, long-term investors could face significantly higher effective tax rates than those earning wages or salaries, discouraging capital allocation into productive investments.