Will Republican Candidates Triple-Down on Trickle-Down Tax Policies?

At present, the top statutory tax rate on capital income is 20 percent, compared to a top marginal rate of 39.6 percent for ordinary income. However, a tax code laden with special interest deductions and expenditures for the wealthy can often bring the effective tax rate for capital income down to zero. Seventy-five percent of stocks in the U.S. are owned by the wealthiest 10 percent of Americans; most of those other 90 percent of share owners, though, will rarely pay a dime in capital gains tax. To the extent that most Americans earn any capital gains, these tend to be on assets in tax-protected retirement savings accounts and from the sale of a home, which is also generally exempted from capital gains tax.

The reality is that the trickle-down tax cuts fail to meet basic tax principles of fairness, efficiency, and simplicity, or to show empirical evidence of positive results. Rather than cutting capital taxes further, we should be talking about treating income from investment and income from work on the same basis, and ending the unfair, inefficient, and complex privileges granted to capital income over ordinary labor income.

It is fundamentally unfair for the tax system to treat people who earn income from investment differently from people who earn it through labor. No other tax benefit is as concentrated among top earners as lower capital gains tax rates. Supply-side economics offers a false rationale for cutting capital taxes and violating this basic tax fairness: cutting taxes for the people conservatives describe as “job creators” and lowering the cost of investment should accelerate growth as the supply of savings for investment and the appetite for risk-taking increase. There’s no evidence to suggest that this is true, but even if we were to assume that it was, we could conclude that other factors have more than offset any positive effects.

Figure 1 shows that trickle-down has failed to deliver growth by accelerating business investment. Statutory and effective tax rates on capital income, top earners, inheritance, and corporations have all come down to or are near historic lows over the past 35 years, and while this has increased the flow of income to the top, it has failed to produce any real economic benefits; the rate of net business investment by non-financial corporations in the United States, averaged across each business cycle expansion, shows that the supply-side tax shift that began in 1980 has resulted in no improvement over past performance.

Net business investment—taking account of depreciation—is the metric for changes in the total capital stock that economists view as the foundation for increasing productivity, output, and general well-being. In the two decades preceding the implementation of trickle-down, even during the stagflation of the 1970s, net investment averaged 2.8 percent of GDP. But in the first expansion following the rise of trickle-down tax policies—1983 to 1990—the pace of corporate investment beat out only one prior postwar business cycle. When top individual income tax and capital gains taxes increased under President Clinton, corporate investment actually accelerated over levels of the Reagan–Bush I economy and ran a full percentage point stronger than during the post-Bush II tax cut 2000s.

Recent thinking on taxes, which includes a more nuanced understanding of tax incentives and behavioral effects, explains why capital gains tax cuts fail the efficiency test. The cost of capital is only one factor in the evaluation of an investment’s expected return, and U.S. corporations already have more than $2 trillion in cash available for investment. Moreover, we are part of a larger global market that supplies savings for investment.

So long as we don’t continue to jeopardize our leading status as a destination for foreign investment with unforced errors like shutting down the federal government and threatening to default on U.S. Treasury bonds—the bedrock of the global financial system—and so long as we continue to invest in the bedrock of America’s economic strengths—its people, infrastructure, and innovation—we won’t really have to worry about supplying enough capital for investment in the U.S.

The experience of the 2000s real estate bubble that led to the Great Recession should have taught us that we need to incentivize better risk-taking, if not less risk-taking. Our current tax scheme for capital income does little on this front, and in fact increases the incentive for rent-seeking investment behaviors. Taxing capital (and top incomes) at lower rates incentivizes aggressive rent-seeking behavior—directing resources toward deterring market entry, and thereby lowering real investment. Changes to capital tax rates also incentivize short-termist behavior in financial markets and corporate governance, which has resulted in companies disgorging cash through dividend payouts and share buybacks rather than allocating those resources to productive investment.

Using different tax rules for different kinds of income complicates the tax system opens the door to special interests skewing the tax rules in their favor, and also creates opportunities for tax evasion by disguising ordinary income as capital gains that are taxed at a lower rate. For example, the well-known “carried interest” deduction allows hedge fund managers to elude ordinary income tax altogether by claiming their income is really just capital gains earned by managing someone else’s money. Remarkably, both Donald Trump and former Governor Jeb Bush have said they favor eliminating this loophole. However, they and other candidates continue to support numerous other egregious tax giveaways to the wealthy, from loopholes that encourage soaring CEO “performance” pay to eliminating the inheritance tax, thus gifting an extra $644 billion to the 0.1 percent of families who pay the tax.

Parsing the evidence and the rules that structure our economy helps to clarify why supply-side policies have not delivered expected investment growth, but have instead accelerated the concentration of income and wealth. What is less clear is how conservative candidates keep getting away with asking American voters to take another gamble on trickle-down economics.