The Obama administration has announced its willingness to compromise on a temporary extension of the Bush tax cuts for all income levels. But the Bush tax cuts never went far enough in providing sufficient incentives to promote higher rates of savings and investment. Temporary solutions like this one or the administration's proposed investment tax credit for businesses will not solve our problem of low capital accumulation. What matters is how the income from capital is taxed over its lifetime.

Economists agree that a large capital stock is a key ingredient for prosperity, as it expands our productive capacity and raises worker productivity, which in turn increases wages and consumer purchasing power. Our capital stock is comparatively much smaller today than it was before the Great Depression. The ratio of business-sector capital to output is about 30% smaller today than it was in 1929. This shortfall reflects the fact that recent investment rates have been lower and consumption rates have been higher compared to earlier in our history.

One important reason that our economy has less capital is because tax rates on capital gains, dividends and other forms of capital income have increased substantially. Prof. Douglas Joines of the University of Southern California has estimated that the average marginal tax rate on capital income, which includes all forms of taxable capital, was around 20% in 1929. In contrast, this rate is estimated to have averaged about 37% between 1990 and 2003, the most recent period for which estimates are available.

Higher tax rates on capital income reduce the incentive to save and invest, which in turn reduces investment and ultimately the capital stock. Capital can easily escape taxation by going abroad, and when that happens, the burden of capital income taxation falls on domestic workers in the form of higher unemployment and lower wages.

The most striking evidence for the impact of higher capital taxes comes from Britain, which increased tax rates on capital income (net of depreciation) to more than 90% in the 1940s, and continued to tax capital income at relatively high rates through the 1960s. Not surprisingly, per capita GNP growth in Britain was abysmal, averaging less than 1% per year between 1940 and 1960, and capital accumulation during this period was among the lowest of all developed economies.