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Some Taxes Are Sure to Go Up

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By JOHN D. MCKINNON

The outcome of Tuesday's presidential election is still anyone's guess, but here's one good political bet: taxes on investment income are going up no matter who wins, at least for higher-income households.

Here's why. Government budget deficits are driving politicians in both parties to look for ways to raise revenue. And the tax breaks for capital gains, dividends and other types of investment income are an appealing place to start because most of the benefits flow to upper-income households.

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The top tax rate on capital gains and dividends, for example, is 15%, less than half the top rate of 35% on wage and salary income. All these rates are scheduled to rise on Jan. 1, when the Bush-era tax rates expire. The rate on capital gains will return to 20%, while the rates on dividends and wages and salaries will climb to 39.6%, unless the White House and Congress strike a deal to change the law.

Beginning Jan. 1, President Barack Obama's health-care law will add another 3.8% tax on investment income for upper-income households.

Mr. Obama has proposed maintaining the current 15% investment-tax rates for singles with annual income below $200,000 a year and couples earning less than $250,000. But he wants to let the rates rise as scheduled for households earning more.

The president's budget also calls for limiting other tax breaks for higher-income households' earnings from municipal bonds and on their contributions to retirement plans and accounts. All in all, Mr. Obama's budget would raise roughly $500 billion over the next decade by reducing tax breaks on investment and saving by the upper-income set.

Republican presidential candidate Mitt Romney proposes to eliminate investment-income taxes for households earning less than $200,000, while maintaining the current rates on capital gains and dividends for higher-income taxpayers.

But Mr. Romney is open to narrowing or ending some large tax breaks on savings and investment for upper-income households. An aide said last week that it would be "incorrect to assume" that such changes are off the table for Mr. Romney. Among the possibilities he might consider are curbing the tax exemption on the interest from municipal bonds and on life-insurance investments for higher-income households, the aide said.

Mr. Romney would use the extra revenue from curbing tax breaks to help offset the cost of reducing by 20% the rates on wages and salaries, so those rate cuts don't add to the government's budget deficit. Mr. Obama wants to use the added revenue to reduce the deficit.

Other Republicans also have begun to talk up the possibility of raising investment tax rates, as part of an overhaul of the tax system that would lower taxes on wages and salaries.

"I do come down on the side, on net, of bringing [the rates] closer together, on balance raising the capital-gains rate and cutting the tax rate on … other forms of income," Lawrence Lindsey, a former top economic adviser to President George W. Bush, testified recently at a congressional hearing.

Many lawmakers of both parties have lined up behind the idea of a broad tax overhaul that lowers rates on wages and salaries. But to go as low as Republicans want—a 25% top income-tax rate—some increase in capital-gains rates will be needed, some lawmakers say.

A 25% top income tax rate "is impossible without either raising rates on middle-income Americans and/or raising cap gains rates," Sen. Max Baucus (D., Mont.), the chairman of the Senate Finance Committee, said at the hearing on capital gains rates.

For most of its history, the U.S. has had lower rates for capital gains to encourage savings and investment. The preferential rate for investment income has been eliminated just once in modern times, in the big 1986 tax-code rewrite under President Ronald Reagan. The White House and Congress agreed then to lower the top income tax rate to 28% from 50% while raising the capital-gains rate to 28% from 20%.

It will be harder to keep the two rates apart this time because the budget deficit is much bigger.

House Ways and Means Committee Chairman Dave Camp (R., Mich.) appeared to leave the door open to limiting or even scrapping the tax break for capital gains at the recent hearing. He said there are "compelling arguments for providing a preferential tax treatment for capital gains," but also "important trade-offs to be considered."

It still seems unlikely that lawmakers would agree to end the special rates for capital gains and dividends altogether. But a narrowing of the gap between the rates on investment income and on wages and salaries appears increasingly possible.

Write to John D. McKinnon at [e-mail]

A version of this article appeared November 5, 2012, on page A10 in the U.S. edition of The Wall Street Journal, with the headline: Some Taxes Are Sure to Go Up.