Why should Mitt Romney and the fabled “one-percent” pay only a 15% marginal tax on investment income … half the rate charged to a dentist or auto mechanic on wages earned from work? This was not the case until recent Republican Congresses slashed taxes on passive, unearned dividends and capital gains.
The rationale for that immense tax cut for (mostly) rich investors was simple and alluring – that super-low rates would entice more of the rich to invest in companies within the U.S., helping them to increase their productive capacity and hire more workers. Moreover, the resulting boom in economic activity would then result in so much new tax revenue, even at low rates, that deficits would disappear.
Let’s put this in context with a term you may have heard. “Supply side” economic theory maintained that this flow of investment capital would pump up the factory end of things, increasing the supply of goods and services, offering them cheaper, thus stimulating demand.
In contrast, the standard Keynsian “demand side” model was to fight recession by ensuring that poor and middle class folks had enough cash (“high-velocity” money) in their pockets to buy – or “demand” – goods and services. Whereupon producers would be drawn into greater production.
For a more detailed description of the differences between these two economic models, see my earlier missive A Primer on Supply-Side vs Demand-Side Economics. (It really is one of the top issues of our day and an informed citizen should know about it.) Here in this place, I’ll try to be brief.
Once upon a time…
Who was right? Blatantly, the Keynsian approach worked in the 1940s, when massive government spending on WWII resulted in a boom that ended the Great Depression. A boom that then continued for 30 years, till Vietnam crushed it against a wall. Throughout that period, high tax rates and stimulative spending seemed to work, whenever the economy needed a little help. Moreover, during that era, a very flat social structure – (CEOs earned only a few times what factory workers did) – combined with the most rapid growth of the middle class and the most vibrant era of startup capitalism in human history.
That does not make Keynsianism perfect! Critics like Friedrich Hayek, have indeed exposed some faults and blunders that later Keynsians, like Paul Krugman, openly admit and have striven to correct. Still, the Demand Side approach can point to many clearcut successes.
In particular, it is plain that during recessions, when economic activity lags and deflation looms, what you want is “high velocity” money in circulation – money that will pass from buyer to seller and then to another seller and so on. Not money that just sits.
Does Supply Side have a similar track record? Not even remotely. Not even once. Simple charts – and hard conclusions from the Congressional Research Service - show that the Supply Side assertion was… and is… utter mythology. None of its predicted effects ever happened. And let me reiterate. Not ever, even once.
Specifically, cuts in tax rates for dividends and capital gains have never had any long-term effects upon capital investment, since records were kept in the United States. (See this cogent article putting the myth to rest, once and for all. Also my article: A Primer on Supply-Side vs. Demand-Side Economics.)