A Reprise of ‘Voodoo’ Economics

The economic wisdom of George Bush (from the Sept. 25 presidential debate):

“When you cut capital gains (taxes), you put people to work. . . . It’s going to increase revenues to the federal government, and it’s going to create jobs. . . . Please, let’s learn from history, a capital gains differential will increase jobs, increase risk-taking, increase revenues to the federal government.”

Gimme a break! In 1980, George Bush criticized Ronald Reagan’s supply-side promises as “voodoo economics.” Bush’s current advocacy of proposals to cut the maximum capital gains tax rate to 15% suffers from precisely the same metaphysical fantasies. Several critics have already dubbed it “neo-voodoo economics.” Far from helping promote growth, restoring special tax breaks for capital gains income would do little more than provide a huge windfall for the wealthy. It’s the economy that needs our help, not those who already have far more than they need.

First the background, then the arguments:

The U.S. tax system long provided special treatment for income from capital gains. From 1942 to 1978, half of long-term capital gains income was excluded from taxable income. For much of that period, the tax on capital gains income was also limited to a maximum of 25%.

Never satiated, lobbyists for the wealthy succeeded in pushing through even more favorable treatment in the tax reform legislation of 1978, increasing the excludable portion of capital gains income from half to three-fifths.

But criticism of this favorable treatment began to mount in the early 1980s.

First, it was tending increasingly to distort the tax system by pushing taxpayers toward tax shelters providing capital gains benefits and promoting a pyramid of complicated tax code provisions designed to moderate the most egregious and unproductive examples of such sheltered evasion.

Second, the benefits of the special tax treatment for capital gains flowed almost exclusively to the wealthy.

Third, the general economic benefits from special treatment for capital gains income were not entirely self-evident (more on this below).

These sources of dissatisfaction fed each other. Even the Reagan Administration’s own Treasury Department proposals reflected the determination, according to one recent review of their deliberations, that “the known benefits of (tax system) simplification . . . justified taking the risk (of marginally dampening entrepreneurial initiative).”

Simplification won the day.

The Tax Reform Act of 1986 promoted much simpler and lower rates, particularly at the top, with lost revenue made up by elimination of many shelters and loopholes.

To have maintained the special treatment of capital gains income in the face of all of these other major reforms, it turned out, would have proved politically embarrassing.

“The growing use of tax shelters by wealthy people to reduce or eliminate their tax liabilities was well known,” writes leading public finance expert Joseph A. Pechman. “Without (elimination of special capital gains treatment), the act would have cut the taxes of the wealthy by large amounts and would have been grossly unfair.”

Congress chose not to embarrass itself. In the final 1986 tax reform legislation, income from capital gains was now to be taxed at the same rates as all other taxable income. Many economists applauded. “This change will reduce the incentive to disguise ordinary income as capital gains,” Pechman explains, “and thus make the tax code less complicated and simplify financial planning.”

The dust of this reform had scarcely settled before you could hear the wealthy and their lobbyists muttering, “We wuz robbed.” Led by the American Council for Capital Formation, which helped secure the more favorable treatment in 1978, they have been prowling the legislative corridors seeking a restoration of special capital gains treatment. Early in the primary season, George Bush joined their crusade. And now their pleas for special privilege have made prime time.

Bush and friends stress two putative advantages for the economy as a whole.

First, they insist that lower tax rates on capital gains income would help boost savings and spur enterprise. These claims do not receive warm support from “the lessons of history” to which Bush directs our attention.

The 1981 tax act cut the maximum capital gains tax rate from 28% to 20%. Far from rising, however, the personal savings rate has since plunged to an all-time low. A 1985 Congressional Budget Office study found that capital funds supplied by individual investors had accounted for a very small (and declining) proportion of the increased flow of funds into “venture capital” since the late 1970s--even though it was precisely these loanable funds from individual investors that were supposed to be stimulated and liberated by the favorable provisions of the 1978 and 1981 legislation.

Undaunted, supply-siders also insist that future tax revenue increases will more than recoup the tax revenues lost from the short-term cuts in capital gains tax rates. Advocates for special capital gains treatment point, for example, to an increase after 1978 in federal revenues from capital gains taxes, leading one study (financed by the American Council for Capital Formation) to predict that cutting the capital gains tax rate to 15% now would increase federal revenues by something like $31 billion over the next three years.

But these optimistic conclusions do not follow from the evidence. Studies by the Reagan Administration Treasury Department and by Urban Institute economist Joseph Minarik conclude that, with the minor exception of a brief adjustment to new rates in 1979, increased capital-gains tax revenues in the 1980s are explained by the increase in stock market values, not by lower capital gains tax rates.

In some ways these rebuttals are beside the point, since the supply-siders’ allure builds primarily upon a simple intuitive argument: Doesn’t it make common sense that investment would increase, at least at the margin, if investors were able to realize a higher after-tax return from their investments and their attendant capital gains? How could it not?

Unfortunately for the supply-siders, economic life ain’t so simple. You can lead an investor to water, but you can’t necessarily make the investor take a drink. However much more “attractive” we may make prospective investments, investors won’t respond if they believe that future economic conditions are likely to be worse or more uncertain than present ones.

One major source of hesitation in recent years has come from the clouds of instability gathering over the horizon, clouds seeded by mounting financial fragility, itself stemming in large part from rising public and private indebtedness. We will simply reinforce those hesitations if we further cut taxes and, other things equal, put more pressure on the federal deficit.

Under such conditions, cutting the capital gains tax rate will compound our problems, not resolve them. Instead of investing in productive plant and equipment, which take years to return their initial investments, the wealthy will merely intensify their behavior of the past 10 years, throwing their money after more speculative, short-term paper investments through mergers, commodity speculation, and arbitrage. The storm clouds will continue to darken.

I agree, George: “Please, let’s learn from history.” Former Reagan budget director David Stockman ultimately admitted that the supply-side arguments in 1981 were a scam, “a Trojan horse to bring down the top (tax) rates.” One Trojan horse was enough.