Why is interest from savings accounts taxed at ordinary income rates instead of capital gains?

This is actually a fascinating question that touches on both tax policy and economic incentives. The different tax treatment between interest income and long-term capital gains has existed for quite a while and does have some economic reasoning behind it. Interest income is considered "ordinary income" because it's generated without any risk to your principal - the bank guarantees both your original deposit and the interest. That guaranteed return is why it's taxed like wages or other regular income. Capital gains, on the other hand, come with significant risk - you could lose part or all of your investment, so the tax code provides a lower rate as a way to encourage that risk-taking. The policy also encourages long-term investment in businesses (through stocks) which helps fund company growth, job creation, and economic expansion. While it might seem unfair to those who can't afford to invest, the theory is that everyone ultimately benefits from a growing economy with more jobs and opportunities. The fact that interest rates have been historically low until recently has made this disparity less noticeable for many years, but with today's higher interest rates, more people are seeing the tax implications of significant interest income.

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The historical perspective is interesting here. Prior to the Tax Reform Act of 1986, the gap between ordinary income tax and capital gains tax was even wider than it is today. In the 1970s, the top ordinary income rate was 70% while long-term capital gains were capped at 25%. Interest on savings accounts has pretty much always been taxed as ordinary income in the modern tax era. One economic theory suggests this creates a natural balance where higher-risk investments get preferential tax treatment to encourage capital formation, while guaranteed-return investments get standard tax treatment. Of course, this doesn't necessarily make it "fair" - but tax policy is rarely about fairness alone. It's usually a complex mix of revenue needs, economic incentives, and political compromises.

I might be in the minority, but I actually think the current system makes some economic sense. Interest is basically guaranteed income - you're not taking any real risk with your principal. Capital gains require taking actual risk - your investment could go down in value. The tax code incentivizes risk-taking that can lead to economic growth. When you buy stocks, you're providing capital to businesses that can use it to expand, create jobs, and innovate. Bank deposits, while useful for liquidity in the banking system, don't have the same direct effect on economic productivity. That said, I do think there should be some consideration for small savers, maybe some kind of interest income exemption for the first few thousand dollars.

The tax treatment difference really comes down to risk and economic policy goals. Interest income is essentially "rental income" for your money - the bank pays you a guaranteed rate to use your funds, similar to how a tenant pays rent to use your property. There's virtually no risk of loss, so it's treated like regular income. Capital gains represent appreciation from risk-taking in productive assets. The preferential rate exists partly because: 1) It encourages long-term investment in businesses 2) It accounts for inflation eroding real returns over time 3) It compensates for the liquidity risk of locking up capital However, I do think the system could be more nuanced. Many countries have tiered systems where smaller amounts of interest income get preferential treatment, recognizing that basic savers shouldn't be penalized. A first $1,000-2,000 of annual interest income taxed at capital gains rates might balance the competing policy goals while helping typical savers. The current system works well for encouraging investment, but it does create some unfair outcomes for people who legitimately need safe, liquid savings for short-term goals.