While ordinary income applies to products and services sold, capital gain applies to income that is earned when an investment asset that was purchased is sold for a higher price. Capital gains are peculiar in three ways:
1. If the asset is held for more than a year, the capital gain is not taxed at the ordinary income tax rate, but at a lower long-term capital gains tax rate. (In 2002, the long-term capital gains tax rate is 15 percent for taxpayers that are in the 25% tax bracket or higher.)
2. Capital losses on the sale of one asset can be used to reduce the taxable capital gain on another sale.
3. The tax obligation occurs only at the time of the realization: if you own a painting that has appreciated by $100,000 each year, you did not have to pay 20% · $100, 000 each year
in taxes. The painting can increase in value to many times its original value, without you ever having to pay a dime in taxes, just as long as you do not sell it. In contrast, $100,00 in income per year will generate immediate tax obligations—and you even will have to pay taxes again if you invest the labor income for further gains.
Dividends, that is, payments made by companies to their stock owners, used to be treated as ordinary income. However, the “Bush 2003 tax cuts” (formally, the Jobs&Growth Tax Relief Reconciliation Act of 2003) reduced the tax rate to between 5% and 15%, the same as long-term capital gains taxes—provided that the paying company itself has paid sufficient corporate income tax. However, this will only be in effect until 2008, when dividends may be taxed at the ordinary income tax level again. There is no guarantee that this will not change every couple of years, so you must learn how to think about dividend taxes, not the current details of dividend taxes.
In the United States, corporations holding shares in other companies are also taxed on dividend proceeds. This makes it relatively inefficient for them to hold cross equity stakes in dividend paying companies. However, in Europe, dividends paid from one corporations to another are often tax-exempted or tax-reduced. This has allowed most European corporations to become organized as pyramids or networks, with cross-holdings and cross-payments everywhere. (In effect, such cross-holdings make it very difficult for shareholders to influence management.)