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.
"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?"
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.
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.
If all scheduled tax increases take place as scheduled in 2013, they will generate $536 billion of revenue in 2013. The increase could net $5 trillion over ten years, the Tax Policy Center states.
"No single policy is enough on its own, but as part of the overall package, it's significant," said Rosenberg. "But perhaps more importantly is who's being affected to the extent that we care about not only the revenue but distribution of taxes."
The change in taxation of capital gains and dividends "overwhelmingly" affects the top of the income distribution. Specifically, if the Bush tax cuts for high-income earners from 2003 for capital gains and dividends expire, then only 1 percent of taxpayers would be affected, all in the top income quintile, according to the center.
Kelly Erb, a tax attorney, said many middle-income taxpayers often carry most of their financial assets, outside of their homes, in mutual funds or retirement accounts such as 401(k)s. Those are often tax-deferred financial vehicles from which account holders withdraw money at retirement age. At that point, they are usually taxed as ordinary income.
For individuals who have stock holdings this year, Erb said most individuals should not necessarily sell their appreciated stock holdings in anticipation of the increase in capital gains and dividends tax rates.
"I don't think you should change your behavior," she said. "I think you should look at the timing of your behavior."
Because the capital gains tax rate applies to assets that have appreciated in price, some investors may benefit from waiting until the New Year if a stock's price is decreasing but hasn't yet led to a net capital loss.
"You may have the opportunity to offset capital losses at a higher rate," she said.
On the other hand, if an investor was planning to sell an asset anyway, it helps to talk with a financial professional or broker about how it has affected your portfolio.
"By December, you know what your gains are for the year usually. That's why they say to get rid of underperformers then," she said.
Erb said the uncertainty for regarding the tax rates is unfair to taxpayers, but particularly to low and middle-income taxpayers who can't afford to pay for professional advice to strategize their financial plans.
Dozens of companies have announced special dividends to shareholders late this year, including Costco Wholesale Corp., to avoid anticipated tax increases.
"I think it's impossible to plan," Erb said for most individuals. "I think people should be angry at Congress for putting us in this predicament."