What the Average American Should Know About the Capital Gains Tax

PHOTO: Rick Schottenfeld, Chairman and CEO of Schottenfeld Group Holdings, said he is in favor of raising the tax on capital gains to help plug the budget deficit.

Editor's Note: This is the latest in an ongoing series about the building blocks that lawmakers could put on the table as they search for a deal to avert the fiscal cliff.

One of the most contentious issues in the debate over how to increase revenue may be a difference of almost 8 percentage points, but it has encouraged over a hundred companies to scramble to issue special dividend payments to shareholders ahead of the New Year. It's called the capital gains tax and it's the tax paid on the difference between the sale price of an investment asset, like a stock, and the cost.

The long-term capital gains tax rate on most investment assets is generally 15 percent now. Compensating highly-paid employees through capital gains, such as stock holdings, is often favored among the wealthy because it is lower than the top statutory rate on ordinary income, which is 35 percent. But President Obama has proposed to increase the top capital gains tax rate to 23.8 percent. There are exemptions such as with the sale of a home.

Related: Can the mortgage deduction survive the fiscal cliff?

The highest rate for dividends, period payments that some companies distribute to shareholders, could increase to 43.4 percent from 15 percent.

The compensation of Rick Schottenfeld, chairman and CEO of Schottenfeld Group Holdings, based in New York City, is a mix of long-term and short-term capital gains, depending on how "successful" his investments are, he said.

A registered Republican, Schottenfeld has been vocal about raising the capital gains tax despite the fact that doing so will lower his income.

Schottenfeld is a member of the Patriotic Millionaires, a group of over 200 Americans with incomes over $1 million a year who are petitioning lawmakers to increase taxes for the wealthy to help plug the budget deficit, which has topped $1 trillion over the last four years.

Related: Fiscal Cliff Negotiators search for cuts without sacrifice

"This whole process of lowering taxes to create jobs has led to bigger deficits, and made it so we can't afford to pay for things we need," he said. "There's obviously a need for spending cuts. It's an arithmetic problem that needs to be met in the middle. We've overshot on capital gains."

While many executives or employees who are able to negotiate their salaries often have a decision to get paid in stock holdings, people with middle or lower incomes usually do not.

"They really aren't given the opportunities like that to convert your income," he said. "How many teachers have big long-term capital gains to take advantage of?"

Related: Why changing Medicare is so controversial

One of the arguments in favor of keeping the capital gains tax low is that it will be a tradeoff if the general income tax rate for high-income households increases to 39.6 percent from 35 percent, as President Obama has proposed. Households above a specific threshold, $250,000 for married couples and $200,000 for others, will pay an additional 0.9 percent tax on their earnings to finance new healthcare provisions.

Many mainstream economists argue for taxing capital at a lower rate than ordinary income to create an incentive to save or re-invest, said Joseph Rosenberg, research associate with Urban-Brookings Tax Policy Center.

"A high capital income tax would sort of discourage saving and consuming out of your current income, so less capital is available in the economy and for investment," he said.

Related: Meet a 'small business' at center of 'fiscal cliff' debate

The Treasury Department reported in its budget for the 2013 fiscal year that increasing the capital gains tax rate to 20 percent would bring in about $36 billion in tax revenue over 10 years. Taxing dividends as ordinary income would bring in an even larger piece of the pie: $200 billion over 10 years.

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