Congress’s two tax-writing committees, the House Ways and Means Committee and the Senate Finance Committee, held a joint hearing Thursday to discuss capital gains taxes and how they might be reformed.

Currently capital gains are taxed at a maximum of 15 percent, compared to the top rate of 35 percent on ordinary income. Senate Finance Committee chairman Max Baucus, D-Mont., said the process of reforming the nation’s tax system must include a comprehensive review of the rates on capital gains to find a level that sparks broad-based growth, creates jobs and strengthens the economy.

He added that the reform process needs to consider the capital gains rate in conjunction with those on individual wage income, corporate income and dividends. Baucus also noted that many high-income earners have a lower effective tax rate than middle class families, because the capital gains tax rates are lower than those on wages.

“Our entire tax code—including its treatment of capital gains—needs to be rebuilt for the 21st century economy.  We need a system focused on broad-based economic growth and jobs,” Baucus said. “In order to get tax reform done, we’ll need members of both parties and both chambers willing to tackle the tough issues.”

At Thursday’s hearing, Baucus questioned whether it is feasible to lower wage income tax rates substantially without an increase in the capital gains rate to maintain revenue. He also noted the fact that capital gains taxes are a major driver of the tax code’s complexity. Experts say about half the code—more than 20,000 pages— exists solely to address capital gains. Baucus said because of that complexity, and because the capital gains rate is lower than the standard income tax rate, many people try to skirt their tax responsibilities and game the system. 

“The taxation of capital gains is one of the most widely discussed areas of our individual tax system, and it needs to be reviewed as part of comprehensive tax reform,” said Ways and Means chairman Dave Camp, R-Mich., in a statement. “With both the Ways and Means Committee and the Senate Finance Committee actively pursuing tax reform, it will be critical for Congress’s two tax-writing panels to continue working closely together.”

Rep. Kenny Marchant, R-Texas, noted, "The investors I've talked to, at 15 percent, they do not spend any time or money on tax avoidance, but they say there is a rate at which they will avoid the tax."

"Everyone wants reform as long as it doesn't affect them," said Rep. Charles Rangel, D-N.Y.

Leonard Burman of Syracuse University testified that capital gains ought to be treated much like ordinary income. “How should capital gains be taxed?” he said in his prepared testimony. “Under an income tax, the answer is that capital gains should be taxed in full as they are earned, not when realized. Capital gains are income, not really different in substance from interest, rents, and royalties: other kinds of capital income that are taxed as ordinary income. Under the pure comprehensive income tax, corporate income would be allocated to shareholders and taxed as ordinary income, in the same way that S-corporations and partnerships are taxed.

"Obviously we don't tax capital gains or corporations that way," Burman added. "Capital gains are taxed only when realized, and gains on assets held for at least a year are generally taxed at a lower rate than other income. Capital gains on assets held until death or donated to charity, however, are never subject to income tax. And corporations are subject to a separate tax that is not integrated with the individual income tax. The consequence is that some corporate income may be subject to two layers of tax: the corporate income tax plus the individual income tax on capital gains and dividends.” Burman recommended that Congress should look into the legislation on 1031 exchanges to stop them from being misused.

Dr. Lawrence Lindsey of the Lindsey Group noted the complexity of the issue. “This is a very complicated issue, but in the interest of time, there are three themes that are critical,” he said. “First, the key to escaping the economic and fiscal morass in which we now find ourselves is to make America the best place in the world to invest, start a business, and create jobs. This involves a focus on the overall rate of taxation of both capital and entrepreneurship, and not on the capital gains tax rate in isolation. Second, there is a strong relationship between the rate of taxation and the level of the economic activity being taxed, and therefore on the revenue collected from such a tax. This relationship is not as strong as some believe, but it is far stronger than that implied by static revenue models.

"Moreover, the focus should not be on the revenue-maximizing tax rate, but on the additional economic burden created for each dollar of revenue collected. This means that the optimal rate of taxation is well below the revenue-maximizing level," Lindsey added. "Third, the revenue collected from capital gains taxation depends not only on the capital gains tax rate, but on the tax rate on ordinary income as well. A large differential between these rates skews the design of investment and financing just as the current huge differential between the taxation of debt and equity. These are important issues in designing the taxation of capital.”

David Verrill, chairman of the Angel Capital Association and managing director of Hub Angel Investment Group, noted that taxing capital gains at ordinary income rates could discourage investment in startup companies by angel investors, who would change their behavior if the tax rates changed. “An increase in capital gains rates will reduce angel investment in promising, job-creating companies at the very time our country needs to create jobs,” he said. “It would be like taking our foot off the gas pedal at the very time when we are trying to get our economy moving faster.”

William Stanfill, a general partner at Montegra Capital Income Fund, argued against continuing the capital gains tax rates. “The preferential tax rates for capital gains and dividends are simply a windfall for wealthy investors,” he said. “In my view this special tax treatment is neither fair nor equitable or available to any other professional endeavor. After all, a gifted teacher who is inspiring and challenging our children and enriching human capital gets no such special treatment. Some predict that firms will locate overseas, taking jobs and tax revenue out of the country.

"My firm is too small to play in the international field—the learning curve is too steep and the costs are too high," Stanfill added. "And because we believe in seed investing, we’ve always found sufficient deals in our own backyard. Further, my accountant advises me that if we did move our fund offshore, as a U.S. citizen, I am still subject to U.S. tax on my income.”