It’s the Capital of the Rich That Gains : Tax Break for Wealthy Posits Fictitious Investment Results

Some congressional Democrats, daunted by the GOP’s political success with tax cuts, are ready to join President Bush in the conservative quest for lower capital-gains taxes.

They should stick to their convictions. This time they have economic logic and equity on their side. The evidence shows that cutting capital-gains rates would make the rich richer without providing any real relief for ordinary Americans--and without generating the investment that the economy needs to compete and grow.

Everyone agrees that there would be more business investment, and thus more economic growth, if the cost of borrowing capital were to fall. But rather than cutting the federal deficit, which would directly increase the capital available for private investment, the President wants more of the supply-side nostrums that brought us that deficit. This time he promises that Americans will jump at the chance to save and invest more, and so bring down the cost of business capital, if only Congress would tax an investor’s capital gains at a lower rate than the income everyone else earns by working.

The hitch is that people do not behave the way that supply-siders imagine. Most Americans will not defer buying a new washer or sofa so that they can purchase shares of General Motors because the tax rate on some future and as yet unknown return on the stock has declined. Rather, most people save or invest what’s left over after they finish consuming to achieve a life style they think is consistent with their incomes and wealth.

And that’s not an untested hypothesis. There were four successive cuts in capital gains rates from 1978 to 1986, and both the personal savings rate and the growth rate for new business investment fell. The cuts didn’t work because most Americans were spending whatever they earned, trying to meet rising housing and education costs in the face of stagnating incomes.

While a lower capital-gains rate won’t much affect how much Americans save and invest, it will influence what we invest in. Cut capital-gains taxes and people will move out of money-market accounts and certificates of deposit, which would still be taxed at the old rate, and into those GM shares or other instruments that would be taxed less. That’s good for stockbrokers. But moving capital around won’t affect its total supply, and so it can’t help business investment.

Strip away the supply-siders’ faith and the case for cutting capital-gains taxes looks like the trickle-down economics that Democrats have properly fought for so long. Cutting capital-gains taxes is the way to boost investment, so it goes, precisely because it makes the rich richer. That’s because the rich are supposed to have the economic sense to invest their additional income while middle-class families might fritter it away on, say, educating their children.

If you buy the above, the most direct way for government to help is to cut the tax on capital gains, because the wealthy earn most of their income as capital gains. In effect, the Treasury provides more after-tax income for wealthy people to invest and everyone is supposed to gain from the consequent economic growth. But in exchange for doing the investing, the rich get to own the things that grow.

One part of the argument is certainly correct: Those with incomes of $200,000 or more would get richer. They would gain, on average, $30,000 a year in tax relief; families earning less than $50,000 would gain, on average, $20. But even in less conspicuously extravagant times than our own, wealthy people do not sink most additional income back into the market.

In any case, the promised spur to savings and investment doesn’t add up. The investors’ tax gain would be Washington’s revenue loss. Once the Treasury borrowed back what it had released for investment, the capital available for business investment would be unchanged.

If the Democrats want to get it right and help middle-class families, they could tax only the post-inflation gains from all forms of savings, including bank interest as well as profits on stocks and bonds. That, at least, should make the capital markets more efficient.

But even so, the original problem would remain. Our standard of living is stagnating, and we are losing the race for world markets because we don’t invest as much or as productively as we once did, or as our rivals do today.

If the President means to be serious about getting the economy moving, he could start by showing leadership on the deficit. Congress could scout for new sources of capital, too, perhaps with new inducements for workers to invest in their own firms. Washington could follow the lead of successful firms that commit themselves to investing in the basic elements of economic growth. And that could mean following the Democrats’ instinct for more public investment in training American workers, in developing new American technologies and in restoring America’s economic infrastructure.