ranged up to 79 percent in 1936, the effective maximum tax on very-
long-term gains was reduced to about 24 percent.
In 1938, the tax code was amended again to provide for a 50 percent
exclusion of capital gains income if an asset was held more than 18
months, but in no case would the tax exceed 15 percent on such capital
gains. The maximum rate on capital gains income was raised to 25 per-
cent in 1942, but the holding period was reduced to 6 months. Except for
a 1 percent surtax that raised the maximum rate to 26 percent during the
Korean War, the 25 percent rate held until 1969.
In 1969, the maximum tax rate on capital gains in excess of $50,000
was phased out over a number of years, so ultimately the 50 percent ex-
clusion applied to all tax rates. Since the maximum rate on ordinary in-
come was 70 percent, this meant the maximum tax rate on capital gains
rose to 35 percent by 1973. In 1978, the exclusion was raised to 60 per-
cent, which lowered the effective maximum tax rate on capital gains to
28 percent. When the maximum tax rate on ordinary income was re-
duced to 50 percent in 1982, the maximum tax rate on capital gains was
again reduced to 20 percent.
In 1986, the tax code was extensively altered to reduce and simplify
the tax structure and ultimately eliminate the distinction between capi-
tal gains and ordinary income. By 1988, the maximum tax rates for both
capital gains and ordinary income were identical, at 33 percent. For the
first time since 1922, there was no preference for capital gains income. In
1990, the top rate was lowered to 28 percent on both ordinary and capi-
tal gains income. In 1991, a slight wedge was reopened between capital
gains and ordinary income: the top rate on the latter was raised to 31
percent, while the former remained at 28 percent. In 1993, President
Clinton raised tax rates again, increasing the top rate on ordinary in-
come to 39.6 percent while keeping the capital gains tax unchanged. In
1997, Congress lowered the maximum capital gains tax to 20 percent for
assets held more than 18 months and the following year returned to the
12-month capital gains period. Starting in 2001, investors could take ad-
vantage of a new 18 percent top capital gains rate for assets held at least
5 years.
In 2003 President Bush signed into law legislation that lowered the
top rate on capital gains and qualified dividend income to 15 percent.
Qualified dividend income must come from taxable enterprises, not
“flow through” organizations such as real estate investment trusts or in-
vestment companies.CHAPTER 5 The Impact of Taxes on Stock and Bond Returns 75