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Capital Gains Tax Rates Must Go Up to Lower Income Inequality

January 20, 2015

On the eve of President Obama's 2015 State of the Union address, we have a rare bipartisan consensus on one of the greatest challenges facing the United States. Record-high income equality, President Obama, Jeb Bush and Mitt Romney all agree, presents a threat to the American Dream and American democracy. The ever-widening gap between the rich and everyone else is a disease that puts the future of the middle class at risk.
Now, the parties disagree on their diagnosis and prescriptions for the battling the scourge of income inequality. But no serious plan to counter the dramatic upward redistribution of wealth underway since the early 1980's can ignore one of its most important causes. As it turns out, historically low capital gains tax rates haven't fueled greater investment in the U.S. economy, but instead helped fuel the biggest income gap since 1929.

In September 2011, the Washington Post illustrated how plummeting capital gains and dividend tax rates helped bring that about. As part of the Post's series on the widening chasm between the super-rich and everyone else titled "Breaking Away," the Post concluded that "capital gains tax rates benefiting wealthy feed [the] growing gap between rich and poor." As the Post explained, for the very richest Americans the successive capital gains tax cuts from Presidents Clinton (from 28 to 20 percent in 1998) and Bush (from 20 to 15 percent in 2003) have been "better than any Christmas gift":

While it's true that many middle-class Americans own stocks or bonds, they tend to stash them in tax-sheltered retirement accounts, where the capital gains rate does not apply. By contrast, the richest Americans reap huge benefits. Over the past 20 years, more than 80 percent of the capital gains income realized in the United States has gone to 5 percent of the people; about half of all the capital gains have gone to the wealthiest 0.1 percent.

While the "fiscal cliff" tax deal boosted the top capitals gains tax rate back to 23.8 percent (the Affordable Care Act added a 3.8 percent tax for upper income earners on top of the new 20 percent top rate), the dynamic remains essentially unchanged. Not only are America's wealthy rapidly pulling away from the rest of their countrymen. The stratospherically rich are leaving the merely rich in the dust, too.

The impact of the nation's tax policies on income inequality has hardly been a secret on Capitol Hill. In December 2011, Thomas Hungerford of the Congressional Research Service (CRS) authored an analysis which concluded:

Capital gains and dividends were a larger share of total income in 2006 than in 1996 (especially for high-income taxpayers) and were more unequally distributed in 2006 than in 1996. Changes in capital gains and dividends were the largest contributor to the increase in the overall income inequality. Taxes were less progressive in 2006 than in 1996, and consequently, tax policy also contributed to the increase in income inequality between 1996 and 2006.

In January 2013, the CRS' Hungerford published another study which once again confirmed that historically low capital gains tax rates are "by far the largest contributor" to America's historically high income inequality. As ThinkProgress explained Hungerford's findings, the upward spiral of income inequality (as measured by the Gini coefficient) between 1991 and 2006 is mostly due to federal tax policy that slashed rates on capital gains and dividend income, income which flows almost exclusively to the rich:

By far, the largest contributor to this increase was changes in income from capital gains and dividends. Changes in wages had an equalizing effect over this period as did changes in taxes. Most of the equalizing effect of taxes took place after the 1993 tax hike; most of the equalizing effect, however, was reversed after the 2001 and 2003 Bush-era tax cuts. [...]
The large increase in the contribution of capital gains and dividends to the Gini coefficient, however, is due to the large increase in the share of after-tax income from capital gains and dividends, and to the increase in the correlation of this income source with after-tax income.

Now, these levels of income inequality not seen since the Great Depression might be more tolerable if they served to produce faster economic growth and accelerated job creation. But as Jared Bernstein along with Troy Kravitz and Len Burman of the Urban Institute have shown, lower capitals gains tax rates (contrary to the claims of conservative mythmakers) haven't fueled increased investment in the America economy.

As Bernstein demonstrated with the chart above, there's no evidence to support the persistent GOP claim that a low tax rate on capital spurs more investment in the U.S. economy, and thus benefits all Americans. Bernstein found that that the business cycle, not acts of Congress, drives investment in the U.S.

Hard to see anything in the picture supporting the view that either the level or changes in cap gains taxes play a determinant role in investment decisions.
Remember, the ostensible reason for the favoritism in tax treatment here is to incentivize more investment and faster productivity growth. But that's not in the data and the reason it's not in the data is because investors aren't nearly as elastic to cap gains rates as their lobbyists say they are (more precisely, they'll carefully time their realizations to maximize their gains around rate changes, but that's not real economic activity-that's tax planning).

Reviewing other analyses in 2012, Brad Plumer of the Washington Post concurred with that assessment that low capital gains taxes don't necessarily jump-start investment in the economy:

The top tax rate on investment income has bounced up and down over the past 80 years--from as high as 39.9 percent in 1977 to just 15 percent today--yet investment just appears to grow with the cycle, seemingly unaffected. ...
Meanwhile, Troy Kravitz and Len Burman of the Urban Institute have shown that, over the past 50 years, there's no correlation between the top capital gains tax rate and U.S. economic growth--even if you allow for a lag of up to five years.

Billionaire Warren Buffett, the inspiration for the "Buffett Rule" advocated by President Obama and his Democratic allies, couldn't agree more. As he told the New York Times in 2011:

"I have worked with investors for 60 years and I have yet to see anyone--not even when capital gains rates were 39.9 percent in 1976-77--shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off."

For years, Republicans have similarly claimed that higher marginal income tax rates would scare off the "job creators" House Speaker John Boehner once described as "the top one percent of wage earners in the United States ... the very people that we expect to reinvest in our economy." If so, those expectations were sadly unmet under George W. Bush. After all, the last time the top tax rate was 39.6 percent during the Clinton administration, the United States enjoyed rising incomes, 23 million new jobs and budget surpluses. Under Bush? Not so much.
That dismal performance prompted the Times' Leonhardt to ask in November 2010, "Why should we believe that extending the Bush tax cuts will provide a big lift to growth?" His answer was unambiguous:

Those tax cuts passed in 2001 amid big promises about what they would do for the economy. What followed? The decade with the slowest average annual growth since World War II. Amazingly, that statement is true even if you forget about the Great Recession and simply look at 2001-7 ...
Is there good evidence the tax cuts persuaded more people to join the work force (because they would be able to keep more of their income)? Not really. The labor-force participation rate fell in the years after 2001 and has never again approached its record in the year 2000.
Is there evidence that the tax cuts led to a lot of entrepreneurship and innovation? Again, no. The rate at which start-up businesses created jobs fell during the past decade.

The data is clear: lower taxes for America's so-called job-creators don't mean either faster economic growth or more jobs for Americans.

The American experience since the Great Depression suggests that high income inequality does not correlate to faster economic growth. But as Jared Bernstein, Ezra Klein and Paul Krugman have been quick to explain, lower income inequality doesn't necessarily "cause" higher GDP. As Brad Plumer summed up a recent paper by Bernstein:

His conclusion: There are compelling reasons to believe that inequality can harm growth, but it's surprisingly difficult to prove this is happening...
In his paper, Bernstein ultimately concludes that there still "is not enough concrete proof to lead objective observers to unequivocally conclude that inequality has held back growth," although he also notes that much of the research is "relatively new" -- and there's a lot more work that could be done.

That said, one thing is certain. Low capital gains tax rates, along with reduced estate tax levies and multiplying tax breaks for the wealth, deny Uncle Sam the revenue need to invest in the American people.

That's why, for President Obama and his Democratic allies at least, the outlines of what must be done are clear. With ever-increasing global competition in the information age economy, the U.S. must ramp up its investments in workforce skills and education. But currently, as a percentage of the U.S. economy, nondefense discretionary spending--everything outside of military, Social Security, Medicare, Medicaid, debt interest--is plunging to its lowest level since 1950. And while studies show that the top 1 percent of earners in America captured all of the income gains since the Great Recession "ended" in mid-2009, workers have yet to see rising wages despite accelerating economic growth and dropping unemployment. Providing tax relief to middle income families, funding community college education, boosting the minimum wage and expanding overtime pay eligibility are just some of the measures that could help reverse the diminished prospects for the American middle class.
But you simply can't pay for that and slow the rapid rise of multigenerational dynastic wealth unless you raise capital gains tax rates. And you don't have to be Thomas Piketty or Barack Obama to do the math about returning capital gains tax rates to their Reagan-era level. Jeb Bush and Mitt Romney, those born-again crusaders against income inequality, know it, too.


About

Jon Perr
Jon Perr is a technology marketing consultant and product strategist who writes about American politics and public policy.

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