Barack Obama’s economic plan would raise federal tax rates on capital gains, dividends, and other forms of capital income. Many voters might respond with a collective shrug. These tax hikes would only affect the wealthiest Americans, right? Think again.

Increasing taxes on capital income goes against current economic thinking on how to finance government spending. Indeed, taxing capital income ultimately hurts the very people it was supposed to help. It reduces investment, which reduces the amount of capital in the economy. A lower capital stock reduces economic growth, productivity, job creation, and wages.

Most studies of taxation, including President Bush’s 2005 bipartisan Advisory Panel on Federal Tax Reform, suggest that tax reforms should follow three central guidelines: increase tax incentives for savings and investment; broaden, rather than narrow, the tax base; and change the tax system so that taxes are used to pay for government services rather than to redistribute income.

Taxing capital income ultimately hurts the very people it was supposed to help.

The Obama plan violates all three of these guidelines. It would reduce incentives to save and invest, which would further narrow the tax base by shifting the tax burden to the top income earners and would increase the extent to which the tax system redistributes income.

The current federal tax system already taxes capital income at a high rate, and it places the majority of the income tax burden on the most productive earners. The top 10 percent of income earners collect about 47 percent of all income but pay about 71 percent of federal income taxes. By contrast, the bottom 50 percent of income earners pay about 3 percent of federal income taxes. The highly progressive nature of the tax system spurs demands for even more redistribution, often through taxation of capital income.

A growing number of economic studies conclude that raising taxes on capital income leads to a substantial drop in capital formation. America’s capital income tax rates are about twice as high today as they were in the 1920s, and capital formation rates are much lower today than they were then. Economists use the “capital-output” ratio—the ratio of the capital stock to gross domestic product—to compare rates of capital formation over time. The capital-output ratio was almost 90 percent higher in the 1920s than it is today.

A lower capital stock reduces economic growth, productivity, job creation, and wages.

What would happen if the United States returned to the capital income tax rates of the 1920s? Its capital stock would be about 50 percent larger, and average wages and real incomes would be about 17 percent higher.

More evidence comes from British history. During World War II, legendary economist John Maynard Keynes recommended to the British Treasury that taxes on capital income should be raised considerably so that wealthy Britons would bear a greater share of the war’s costs. This recommendation was challenged by other prominent economists, who warned that raising tax rates on capital income would lead to lower rates of savings and investment. Keynes responded that tax incentives to save and invest had very little impact on people’s behavior.

Keynes was wrong. British capital income tax rates rose substantially during the war—they approached 90 percent—and remained high after it. Not surprisingly, savings and investment were close to zero over this period, reflecting the very low after-tax return to savings. In time, London reduced tax rates on savings and investment—and, as a result, savings and investment began to rise, increasing from about 3 percent of British GDP in the early 1950s to 20 percent of GDP in the 1980s. But before its capital income tax rates fell, the United Kingdom was among the slowest growing countries in the industrialized West.

America’s capital income tax rates are about twice as high today as they were in the 1920s, and capital formation today is much lower than it was then.

Policymakers frequently underestimate how much taxes will affect economic activity, particularly taxes that target the highest income earners. For example, the Luxury Tax of 1990 was intended to raise revenue from wealthy households by taxing yachts, private aircraft, jewelry, expensive cars, and other big-ticket items. But rather than increase tax revenue, this tax proved to be a net revenue loser. It brought in only half the revenue it was supposed to, because purchases of the taxed luxury items dropped substantially. In fact, the tax crippled the American yacht industry, leading to an estimated loss of 7,600 jobs.

The lesson is that voters should always be skeptical of tax policies that are designed to soak “the rich.” Such policies invariably wind up hurting all Americans.

Lee E. Ohanian is a professor of economics at UCLA and director of the Ettinger Family Program in Macroeconomic Research.

Credit: Shutterstock/Dianna Ingram.