qualified dividends, such as REITs and other income trusts, in one’s tax-
deferred account to avoid current taxes. However, some risk-averse in-
vestors who are reluctant to hold stocks in their personal accounts
because of short-term volatility find it easier to hold stocks in their re-
tirement accounts where they have a longer-term perspective and may
be better able to tolerate short-term losses.
CONCLUSION
Tax planning is important to maximize returns from financial assets.
Because of favorable dividend and capital gains tax rates and the po-
tential to defer those capital gains taxes, stocks hold a significant tax ad-
vantage over fixed-income assets. These advantages have risen in
recent years as the capital gains and dividend tax has been reduced, in-
flation has remained low, and firms have repurchased shares to increase
capital gains. These favorable developments have increased the after-
tax return of equities by more than 2 percentage points over the average
after-tax return of the past 50 years. As favorable as stocks are over
bonds for long-term investors, the advantage of equities is even greater
for the taxable investor.
APPENDIX: HISTORY OF THE TAX CODE
Federal income tax was first collected under the Revenue Act of 1913,
when the Sixteenth Amendment to the U.S. Constitution was ratified.
Until 1921 there was no tax preference given to capital gains income.
When tax rates were increased sharply during World War I, investors
refrained from realizing gains and complained to Congress about the
tax consequences of selling their assets. Congress was persuaded that
such “frozen portfolios” were detrimental to the efficient allocation of
capital, and so in 1922 a maximum tax rate of 12.5 percent was estab-
lished on capital gains income. This rate became effective when taxable
income reached $30,000, which is equivalent to about $240,000 in
today’s dollars.
In 1934, a new tax code was enacted that, for the first time, excluded
a portion of capital gains from taxable income. This exclusion allowed
middle-income investors, and not just the rich, to enjoy the tax benefits
of capital gains income. The excluded portion of the gain depended on
the length of time that the asset was held; there was no exclusion if the
asset was held 1 year or less, but the exclusion was increased to 70 per-
cent if the asset was held more than 10 years. Since marginal tax rates
74 PART 1 The Verdict of History