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.
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.)
In fact, this is no surprise, for several reasons:
1) Supply Side assumes that the rich have a zillion other uses for their cash and thus have to be lured into investing it! Now ponder that nonsense statement. Roll it around and try to imagine it making a scintilla of sense! Try actually asking a very rich person. Once you have a few mansions and their contents and cars and boats and such, actually spending it all holds little attraction. Rather, the next step is using the extra to become even richer. Naturally, you invest it. Whatever the tax rates, you invest it, seeking maximum return.
Instead of enticing the rich to invest, these super low dividend and capital gains rates simply used money taxed from middle class wage earners to give bonuses for speculations wealthy folks were doing anyway. If anything, the only major effect, other than budget deficits, was a pumping up of asset value bubbles.
2) Now to be sure, some of the rich ... a few... put a fair amount of their wealth into truly bold and risky new enterprises. I know such men and women, who engage in Venture Capitalism or starting up creative new enterprises. And just so you know that I'm no socialist I believe this kind of investment truly should be encouraged by taxing it at a very low rate! Not only because of the risk, but also because equity shares that are bought de novo directly from a new firm actually deliver nearly all of that value directly into capitalization and company development.
In contrast, most exchanges through the NYSE or NASDAQ are purchases from other stock-owners who happen to disagree with you about prospects for future capital gains and dividends. It is just as much a betting/gambling system as any Vegas casino, Your trades may marginally raise or lower the posted price, allowing the company to raise a little capital on the side, but almost nothing from your stock transaction actually goes to the company itself, or into new products or plants and equipment.
(Hence, that kind of investing - by far the largest portion - helps industry only at appallingly low levels of efficiency, but diverts management into spending nearly all its time trying to bribe stockholders with short term benefits, ignoring long-term company health.)
No wonder Adam Smith himself expressed contempt for passive investments that he called "rents"... compared to investments in which the owner actually gets involved in starting up or entrepreneurial development of long term company or enterprise health.
4) In fact, we spoke earlier about how stock and equities markets have lately become the tail wagging the dog. Instead of serving the capital needs of companies, firms like Mitt Romney's Bain Capital show that productive corporations making goods and services are now like cattle, farmed by Wall Street, to be bled or dissected at whim. Nor is the whim even human anymore! Most trades are now propelled by hyper-aggressive, parasitical "flash trading" computer programs that vastly amplify volatility, sap investor earning potential, and threaten our entire economic system in a dozen ways.
5) The reduction of dividend and capital gains tax rates almost to zero has coincided with the rapid ending of the relatively flat social structure that we inherited from the Greatest Generation of the 1950s and 1960s. Back then, the rich managers of major corporations earned only ten or twenty times what factory workers got, a situation that still exists in Japan. Only now, American wealth disparities are approaching levels not seen since the American Revolution.
The last thing that the GOP or Fox wants you to do is look across the last 6000 years. The class that they call "job creators" used to have another name. Lords.
6) The outrageous inherent unfairness of passive dividend-clipping getting far better tax treatment than earned wages is inherently suspect. It is exactly what you would expect rich and powerful men to lobby for, whether or not their supply side rationalizations were true! It should be no surprise that, in our money-drenched political system, those with such power and influence have benefited immensely.
But are the arguments and rationalizations valid at all? At minimum, supply-siders should bear some burden of proof. Their experiment has been run, now, for more than three decades, and never once has their core predication come true... that cutting taxes on the rich will result in increased overall revenues and a vanishing federal deficit.
Yes, reducing deficits would be good! Indeed, under Clinton they vanished. The middle class, according to all opinion polls at the time, wanted any surplus to go to buying down debt. It was the upper caste who used the surpluses as an excuse to demand immediate tax cuts. So where does maturity reside?
The results are utterly conclusive.
Supply side is disproved, top to bottom.
"All for ourselves and nothing for other people, seems, in every age of the world, to have been the vile maxim of the masters of mankind. As soon, therefore, as they could find a method of consuming the whole value of their rents themselves, they had no disposition to share them with any other persons."
Smith is not talking about charity, but the vigor of trade. In this case, we "share" by buying from one another. The middle class is very good at that. It is the middle class that - assisted prodigiously by technology and science - propelled our economy to be the wonder of the world.
It is the middle class who should get whatever tax benefits can be doled out. They'll use it to make small startups. They'll use it to educate bright, competitive kids. They'll spend it!
They are the real "job creators."
Addendum: November 3, 2012 - R.I.P. "supply side economics"
In a November 1 report we learn that that Senate Republicans applied pressure on the nonpartisan Congressional Research Service (CRS) in September to withdraw a report finding that lowering marginal tax rates for the wealthiest Americans had no effect on economic growth or job creation.
"The pressure applied to the research service comes amid a broader Republican effort to raise questions about research and statistics that were once trusted as nonpartisan and apolitical," the Times reported. Democrats in Congress resurfaced the report. Republicans objected that it underminde the governing fiscal philosophy of the party, that tax cuts for the wealthy will spur growth and benefit everybody.
Changes over 65 years in the top marginal tax rate and the top capital gains rate do not correlate with economic growth. Reduction in top rates appears to be uncorrelated with saving, investment, and productivity growth. However, top rate reductions do associate with increasing divergence of national income going to the top 0.1%
This is important... and was always obvious. Even in 1776 Adam Smith described what the rich actually do with sudden cash infusions. They put it to work in "passive rent seeking" and only rarely into capital equipment or risky new products and services. (Risk taking can be rewarded in other ways.) And that cash flow to the rich reduces the velocity of money. If there were ever a time not to do that, it is during a recession, when we want high money velocity, put cash in middle class pockets! (In fairness, during runaway inflation, largesse to the rich - reducing money velocity - actually makes some sense.)
George H.W. Bush called Supply Side "voodoo economics. It was and is.