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Studies: Raise Capital Gains Tax Rates to Lower Income Inequality

October 2, 2015

On Monday, Donald Trump became just the latest Republican White House hopeful to propose a Treasury draining, tax cut windfall for the richest Americans. But while Trump calls for slashing the top marginal income tax rates at a time of record income inequality, a new study from the Brookings Institution argues that hiking those same rates will have little impact on the immense income gap in the United States.
That finding from former Obama budget official Peter Orszag and his co-authors William Gale and Melissa Kearney may seem counter-intuitive. But it's not, for the simple reason that Orszag and company focused their attention on the wrong set of tax rates. 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.

Of course, you wouldn't know that from reading Peter Orszag:

We modeled, among other scenarios, raising the top individual income tax rate to 50 percent from its current level of 39.6 percent. That would create significant revenue, no question. For households in the 95th to 99th percentiles of income, taxes would rise by an average of $6,464 a year. For the top 0.1 percent, the average yearly increase would be $568,617. But how much difference would this make for after-tax income inequality?
To answer that, we calculated the Gini coefficient for after-tax income before and after the simulated tax change. (The Gini coefficient is an index that ranges from 0, if everyone has the same earnings, to 1, if a single person has all the earnings and everyone else has none.) Under the current tax schedule, we estimate the after-tax Gini coefficient to be .574. Raising the top marginal tax rate to 50 percent would reduce that only to .571.

While conservatives predictably cheered the findings from Orszag et al, the analysis ignored one of the most important causes of the dramatic upward redistribution of wealth underway since the early 1980's. Simply put, the richest 1 percent of Americans make most of their money from investments. And the tax rates on their gains are now only about half the level when Ronald Reagan first took the oath office.
In September 2011, the Washington Post illustrated how plummeting capital gains and dividend tax rates helped bring about an income gap and wealth concentration not seen since before the Great Depression.
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 2013 "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.

(As University of California economist Emmanuel Saez showed in 2013, the rapid recovery and expansion of the stock market since the lows of the Great Recession allowed the top 1 percent to grow their incomes by 11 percent between 2009 and 2011, while the other 99 percent of American people continued to lose ground.)
Reviewing another study by Saez and co-author Thomas Piketty, Ezra Klein explained the central role of low capital gains taxes in "how the ultra-rich are pulling away from the 'merely' rich." As Klein noted, "If you don't look at capital gains, the top 0.01 percent only captures 3.15 percent of income in the United States," adding "that's about a third smaller a share as when capital gains are included." All told, the top 10 percent account for almost half of total income in the United States, up from just over 30 percent in 1970.

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's 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 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."

That's right. Higher capital gains tax rates haven't scared off investors in the past. But despite their talk about income inequality, Republicans like Mitt Romney and Jeb Bush want to cut capital gains taxes. Marco Rubio wants to eliminate them altogether. The only other reform that could impact intergenerational dynastic wealth as profoundly would be to eliminate the estate tax (and its $25 billion a year in revenue to Uncle Sam), a levy that impacts less than a quarter of one percent of the richest families in America. Unsurprisingly, pretty much all of the 2016 GOP presidential candidates support doing precisely that.

At the end of the day, income tax rates on the well-to-do should go up to help fund the programs Americans of all political stripes say they want, not to reduce income inequality. To do that, Washington will need to address root causes, like The decline of post-World War II American economic dominance, the rise of new international competitors, the withering (and the smothering) of trade unions and accelerating globalization with its seamless transnational flow of capital, investment and automated production, all of factors which have choked off the supply of large numbers of good paying jobs for working Americans. But with the changing nature of the American workforce--and work itself--even that will not be enough to sufficiently narrow the income gap.
That will require raising capital gains tax rates.


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

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