Isn't It Time to Reassess the Bush Tax Cuts for Investment Income?

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It was bound to happen. In response to the crisis on Wall Street, some members of the Republican Study Committee in the House of Representatives proposed a familiar solution: tax cuts. In particular, they proposed a suspension of capital gains taxes for both individuals and corporations for two years, after which capital gains would be reduced from their current levels because "assets would be indexed permanently for any inflationary gains." The article from BNA that landed in our inboxes actually said that they proposed this measure "as a way to coax capital back into sluggish lending markets and offset the cost of a proposed government bailout of the U.S. financial system."

If suspending a tax altogether (that is, lowering its rate to zero) can increase revenue and offset the cost of anything, then supply-side economics may have risen above the laws of the known universe entirely into some new, unknown realm beyond our comprehension.

It would be comforting to believe that this thinking is confined to some small fringe group of lawmakers. Actually, the Republican presidential nominee is not far behind. John McCain recently proposed to temporarily slash the capital gains tax rate to a super-low 7.5 percent. (See CTJ's recent paper, "McCain's Proposal to Expand the Loophole for Capital Gains Would Be Unfair and Counterproductive.")

This seems like the ideal time to ask what exactly supply-side tax cuts for investment have accomplished. Bush expanded the tax subsidy for capital gains (lowering the special capital gains tax rate from 20 percent to 15 percent) and created a new one for dividends (which was taxed like any other income but is now taxed at a top rate of 15 percent). We do not know that the Bush tax cuts for investment actually contributed to the financial collapse. But the notion that they contributed to excessively risky investments and helped fuel the calamity is at least as reasonable as the notion that they helped grow the economy, considering our current economic situation.

There are several conceptual reasons why these tax subsidies for investment are simply not sensible policy. For one, it offends most people's idea of basic fairness that someone who earns $42,000 from work can be taxed at a higher rate than someone who receives the same amount of income by collecting dividend checks. Why someone like Paris Hilton, who probably lives off her wealth, should be taxed at a lower rate than someone who actually works has never been adequately explained by the proponents of these tax cuts.

But in addition to that, the subsidy leads to all sorts of shifty tax dodging behavior that makes the economy less efficient, since money is invested in certain activities or properties merely to get a tax break, rather than because it's the most efficient use of capital.

Supply-siders sometimes have their very best luck in convincing the naive to adopt their views when they're talking about the capital gains tax. Part of the reason for this is that capital gains tax revenues fluctuate wildly with economic cycles, rocketing upwards during the good times and crashing during recessions. The charts illustrating capital gains tax revenue have lines that look like rollercoasters, and supply-siders often confuse the unwary into believing that some cut in the capital gains tax rate caused one of the upswings.

For example, as a paper published earlier this year by CTJ explains, capital gains tax revenue crashed during the recession in 2001. This revenue of course climbed back up from that low point, as we would expect. But because this natural upswing coincided with Bush's cut in the capital gains rate from 20 percent to 15 percent, supply-siders (like the editorial board of the Wall Street Journal) argue that the Bush tax cut caused this revenue to increase. What they leave out of the story is the fact that capital gains tax revenue was higher at the end of the Clinton years, when the capital gains rate was higher.

The argument over revenues can seem like an arcane debate full of jargon and charts and tables, but the fairness problem posed by the loopholes for investment income is readily apparent. These loopholes direct a huge amount of money to the rich. Earlier this year, CTJ released a report finding that 70 percent of the benefits of the capital gains and dividends loopholes will go to the richest 1 percent of taxpayers in 2009. Of course recent events on Wall Street will lower the capital gains reported in 2009, but there is no particular reason why the distribution of the benefits from these loopholes would be any different. Unlike the supply-siders, we will resist the temptation to say that the coming change in capital gains tax revenue is a direct result of the Bush administration's policies. (Although the case could be made...)

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