	Introduction

Tax reductions enacted in 2001 through 2004, as well as some under consideration, reduce the effective tax rate on capital income in several different ways. Taxes on capital arise from individual taxes on dividends, interest, capital gains, and income from non-corporate businesses (proprietorships and partnerships). Reductions in marginal tax rates as well as some tax benefits for business reduce these taxes. Taxes on capital income also arise from corporate profits taxes, which are affected not only by rate reductions but also by changes to provisions affecting depreciation, interest deductions, other deductions, and credits. Finally, taxes can be imposed on capital income through the estate and gift tax. Bonus depreciation was deliberately set to be temporary, and expired in 2004. This report addresses these distributional issues, in the context of behavioral responses. Income from unincorporated businesses is not separated into labor and capital income, but the distribution of income of different types can be compared by examining passive capital income sources. Those over $200,000 had 26% of income, 19% of wages, 39% of taxable interest income, 39% of taxable dividends, and 57% of taxable capital gains. Note that there are also significant amounts of capital income that are not subject to tax. Cuts in capital gains tax would most favor higher-income individuals, but in general, all tax cuts on capital income are likely to benefit higher-income individuals. Table 1 does not contain any information about the estate and gift tax. However, the estate tax is highly concentrated among top asset classes, with only 2.1% of decedents paying estate taxes in 2000 (before the recent round of tax cuts). Based on this distributional data, capital income taxes fall on higher-income individuals and contribute to the progressivity of the tax system. Thus, introducing an open economy is not likely to change the conclusion that the ultimate burden of capital income taxes falls on capital in general and therefore falls more heavily on higher-income individuals, even in the limited case of the corporate tax. The Effect of the Savings Response

The burden of a capital income tax could be shifted, in all or in part, to labor, if individuals respond to the reduction in return by reducing savings. Indeed, there is considerable reason to believe that individuals may employ rule-of-thumb guidelines to saving behavior that suggest that taxes on capital either have no effect or increase savings. Ramsey (Infinite Horizon) Model

Because of its infinite horizon, the long run supply of savings is perfectly elastic in this model, which leads to a lot of response to a change in tax rate on capital income. The magnitude and direction of outcomes depend on many factors: how substitutable consumption is over time, whether individuals take into account the effects of behavioral response on future returns, why bequests occur and how they change or do not change with a change in the interest rate, the amount of savings that is for precautionary purposes rather than for retirement, the expected period of retirement relative to the working period, and the pattern of wage growth over the career, and the use of the revenues. Special Issues with the Estate and Gift Tax

Most of the intertemporal models studied have focused on taxes on the return to capital such as individual income taxes and state and local taxes. This assessment is based on the observation of a relatively constant estimated pre-tax return, despite significant variations in the tax rate over the twentieth century. For those who doubt that most individuals possess the sophistication and ability to plan (whether over a finite lifetime or an infinite family dynasty), the rule of thumb approaches that involve targeting or fixed savings rates seem consistent with bounded rationality models and suggest that capital income taxes are more likely to have little effect or increase savings.
Tax reductions enacted in 2001-2004 reduce the effective tax rate on capital income in several different ways. Taxes on capital arise from individual taxes on dividends, interest, capital gains, and income from non-corporate businesses (proprietorships and partnerships). Reductions in marginal tax rates, as well as some tax benefits for business, reduce these taxes. Taxes on capital income also arise from corporate profits taxes, which are affected not only by rate reductions but also by changes to provisions affecting depreciation, interest deductions, other deductions and credits. Finally, taxes can be imposed on capital income through the estate and gift tax.
Tax cuts on capital income through capital gains rate reductions, estate and gift tax reductions, and dividend relief are estimated to cost about $57 billion per year, with about half that amount attributable to the estate and gift tax. Lower ordinary tax rates also affect income from unincorporated businesses. These tax cuts are temporary and proposals to make some or all of them permanent are expected. Bonus depreciation appears less likely to be extended.
While there are many factors used to evaluate the effects of these tax revisions, one of them is the distributional effect. This report addresses those distributional issues, in the context of behavioral responses.
Data suggest that taxes on capital income tend to fall more heavily on high-income individuals. All types of capital income are concentrated in higher-income classes. For example, the top 2.8% of tax returns (with adjusted gross income over $200,000 in 2009) have 26% of income, 19% of wages, 39% of interest, 39% of dividends, and 57% of capital gains. Taking into account a very broad range of capital assets, a 2012 Treasury study found that the top 1% of the population has about 19% of total income and about 12% of labor income, but receives almost half of total capital income. Estate and gift taxes are especially concentrated in the higher incomes: prior to the tax cuts enacted in 2001-2004, only 2% of estates paid the estate tax at all.
If there is a significant reduction in savings in response to capital income taxes, in the long run the tax could be shifted to labor and thus become a regressive tax. Some growth models are consistent with such a view, but generally theory suggests that increases in taxes on capital income could either decrease or increase savings, depending on a variety of model assumptions and particularly depending on the disposition of the revenues. There are also many reasons to be skeptical of these models, which presume a great deal of skill and sophistication on the part of individuals. New models of bounded rationality suggest that taxes on capital income are likely to have no effect or decrease saving, as individuals rely on common rules of thumb such as saving a fixed fraction of income and saving for a target.
Empirical evidence in general does not suggest significant savings responses, as savings rates and pre-tax returns to capital have been relatively constant over long periods of time despite significant changes in tax rate. If capital income taxes do not reduce saving, these taxes fall on capital income and add to the progressivity of the income tax system. This report does not track legislation and will not be updated.