A tax cut represents a decrease in the amount of money taken from taxpayers to go towards government revenue. Tax cuts decrease the revenue of the government and increase the disposable income of taxpayers. Tax cuts usually refer to reductions in the percentage of tax paid on income, goods and services. As they leave consumers with more disposable income, tax cuts are an example of an expansionary fiscal policy. Tax cuts also include reduction in tax in other ways, such as tax credit, deductions and loopholes.[1]
How a tax cut affects the economy depends on which tax is cut. Policies that increase disposable income for lower- and middle-income households are more likely to increase overall consumption and "hence stimulate the economy".[2] Tax cuts in isolation boost the economy because they increase government borrowing. However, they are often accompanied by spending cuts or changes in monetary policy that can offset their stimulative effects.[3]
Types
Tax cuts are typically cuts in the tax rate. However, other tax changes that reduce the amount of tax can be seen as tax cuts. These include deductions, credits and exemptions and adjustments.
Term
Definition
Example
Rate cut
A reduction in the fraction of the taxed item that is taken.
An income tax rate cut reduces the percentage of income that is paid in tax.
Deduction
A reduction in the amount of the taxed item that is subject to the tax
An income tax deduction reduces that amount of taxable income.
Credit
A reduction in the amount of tax paid. Credits are usually fixed amounts.
A tuition tax credit reduces the amount of tax paid by the amount of the credit. Credits can be refundable, i.e., the credit is given to the taxpayer even when no actual taxes are paid (such as when deductions exceed income).
Exemption
The exclusion of a specific item from taxation
Food might be exempted from a sales tax.
Adjustment
A change in the amount of an item that is taxed based on an external factor
An inflation adjustment reduces the amount of tax paid by the rate of inflation.
By expanding tax brackets, the government increases the amount of income that is subjected to lower tax rates.
Effects
Since a tax cut represents a decrease in the amount of tax a taxpayer is obliged to pay, it results in an increase in disposable income. This greater income can then be used to purchase additional goods and services that otherwise would not have been possible.[citation needed]
Tax cuts result in workers being better off financially.[citation needed] With more money to spend, we would expect to see consumer spending to increase. Consumer spending is a large component of aggregate demand. This increase in aggregate demand can lead to an increase in economic growth, other things being equal. Tax cuts on income increase the after-tax rewards or working, saving and investing and thereby they increase work effort, contributing to economic growth.
If tax cuts are not financed by immediate spending cuts, there is a chance that they can lead to an increase in the national budget deficit, which can hinder economic growth in the long-term through potential negative effects on investment through increases in interest rates. It also decreases national saving and therefore decreases the national capital stock and income for future generations. For this reason, the structure of the tax cut and the way it is financed is crucial for achieving economic growth.[4][5]
Supply-side tax cut
Supply-side tax cuts are designed to stimulate capital formation by lowering the price level of a good and therefore increasing the demand for the good, both aggregate supply as well as aggregate demand will be shifted.
Corporate income tax cut
Corporate income tax cuts generate sustained effects on R&D expenditures, productivity and output, therefore increase GDP. To evaluate the impact of appointed tax policy the variables R&D expenditure and technological adoption are crucial.[6]
Personal income tax cut
Personal income tax cuts only lead to a momentary boost to GDP and productivity, having no long-term effect on the GDP as they trigger extensive but short-lived response of capital expenditure, productivity and output. The key to evaluating the effect of personal income tax cut is the variable labor utilization.[6]
Costs and Benefits Study
The working paper from 2017 for IMF showed some of the three takeaway key results of tax cuts:
1. The tax cuts can boost the economy in the short term however these effects are never strong enough to prevent loss of revenue.[7]
Any tax cuts significantly reduce tax revenues in the first place. Subsequently, the gap needs to be compensated and financed by an increase in public debt, raising other taxes, or cutting spending. Usually, the cuts in income tax are compensated by an increase in consumption taxes.
There are several ways how a government may compensate for tax cuts.
a) By spending cuts
The final equity and change in aggregate demand will be equal to zero as some individuals will be better of from tax cuts while others will have to cut their spending as the government decreases welfare payments. At the end of the day, there is no change in overall welfare circulating in the economy.
b) By government borrowing
The government may compensate for the loss in revenue by borrowing money and issuing bonds. The overall result of this type of compensation may vary based on the situation of the economy. In a recession, borrowing would probably result in higher aggregate demand. In the boom, the borrowing may result in crowding out – a situation in which the private sector has fewer finances for their investments as they buy the bonds.
c) By cutting taxes in boom
Chancellor Nigel Lawson’s tax cuts in 1988 occurred during a period of economic growth. These taxes led to a further increase in economic growth, however, also to an increase of inflation causing the boom-and-bust situation.
d) By improved productivity
If the economy has evidence of stable economic growth for several years it may step in for the tax cuts while maintaining stable tax revenues. [8]
2. The tax cuts apparently help low-income groups even if they do not get the tax cuts directly.[7]
It seems, that when the middle or higher class has a bigger disposable income, they spend their money on the services which are mostly provided by low-income individuals. Wealthier people tend to spend higher ratios of income on services. With lower tax cuts the expenditures of wealthier people increase together with the demand for services.
3. The tax cuts of higher income individuals promote the raise in income inequality.[7]
Even though the tax cuts may increase the disposable income of high-income groups promoting services for lower-income individuals and increasing GDP, the income gap tends to increase. On the other hand, targeting middle-income groups may help in the fight against income inequality regarding lower dividend growth. [9]
Countries
United States
Notable examples of tax cuts in the United States include:
The Tax Cuts and Jobs Act of 2017 lowered the corporate tax rate to 20%, while also lowering income tax rates, among other changes.
Another way to analyze tax cuts is to have a look at their impact. Presidents often propose tax changes, but the Congress passes legislation that may or may not reflect those proposals.
John Kennedy
John Kennedy's plan was to lower the top rate from 91% to 65%,[12] however, he was assassinated before implementing the change.
Lyndon Johnson
Lyndon Johnson supported Kennedy's ideas and lowered the top income tax rate from 91% to 70%.[13] He reduced the corporate tax rate from 52% to 48%.
Federal tax revenue increased from 94 billion dollars in 1961 to 153 billion in 1968.
Ronald Reagan
In 1982 Ronald Reagan cut the top income tax rate from 70% to 50%.[14] GDP increased 4.6% in 1983, 7.2% in 1984 and 4.2% in 1985.[15]
In 1988, Reagan cut the corporate tax rate from 48% to 34%.[16]
George W. Bush
President Bush's tax cuts were implemented to stop the 2001 recession. They reduced the top income tax rate from 39.6% to 35%,[17] reducing the long-term capital gains tax rate from 20% to 15% and the top dividend tax rate from 38.6% to 15%.[18]
These tax cuts may have boosted the economy, however, they may have stemmed from other causes.
The American economy grew at a rate of 1.7%, 2.9%, 3.8% and 3.5% in the years 2002, 2003, 2004 and 2005, respectively.
In 2001, the Federal Reserve lowered the benchmark fed funds rate from 6% to 1.75%.
Apart from boosting the economy, these tax cuts increased the U.S. debt by $1.35 trillion over a 10-year period[19] and benefited high-income individuals.
The $787 billion American Recovery and Reinvestment Act of 2009 promised $288 billion in tax cuts and incentives.[20] Its taxation aspects included a payroll tax cut of 2%, health care tax credits, a reduction in income taxes for individuals of $400 and improvements to child tax credits and earned income tax credits.
To prevent the fiscal cliff in 2013, Obama extended the Bush tax cuts on incomes below $400,000 for individuals and $450,000 for married couples. Incomes exceeding the threshold were taxed at the rate of 39.6% (the Clinton-era tax rate), following the American Taxpayer Relief Act of 2012.[21]
Donald Trump
On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act, which reduced the corporate tax rate from 35% to 20%.[22]
GDP growth rate increased by 0.7% in 2018, however, in 2019 it fell below 2017. In 2020, GDP took a sharp downturn, likely due to the COVID-19 pandemic.
Multiplier Effect
With decreased cuts in tax rates, households earn higher disposable income. The final effect on the economy is the result of the ratio in which households tend to save and spend the additional after-tax money. Economists simply represent these phenomena by the multiplier effect. The effect represents the relation between the money spent on economic activity and the quantitative money reduction in taxes or an increase in government spending. The Fiscal Multiplier and Economic Policy Analysis in the United States, a study by J. Whalen and F. Reichling (2015) focused on the short-term effects of tax cuts and the potential of the economy. The results showed that the tax cuts or spending increases are dependent on the economic situation. If the economy is close to its potential and the Federal Reserves were not affected by the zero interest rates, tax cuts had small short-run economic effects mostly because the fiscal stimulus was outperformed by interest rate hikes. On the other hand, if the economy performs further from the economic potential and is bounded by zero interest rates the effect of fiscal stimuli is much higher. Congressional Budget Office estimated that the weak economy’s multiplier effect potential is three times higher than the one of a strong economy. The study has mostly shown the uncertainty about fiscal policies. The study has shown the large differences between the low and high estimates of the multipliers effect of tax cuts. On the other hand, the study indicated that government spending is a more reliable form of fiscal policy than tax cuts.[24]
Tax Cuts and Productivity
The relation between the tax rate and overall productivity is often depicted by the Laffer curve. It has the shape of a classic bell curve with the tax rate on one axis (often a horizontal one) and the tax revenues on the other one. The theory says that with a continuous increase in the tax rate, at one point, the tax revenues start to decrease. This phenomenon can be explained by a decrease in the willingness of individuals to work as the government takes away their money. The apex point of the parabola represents the revenue-maximizing point for the government. The Laffer curve is often criticized for its abstractness as it is in reality very difficult to find the revenue-maximizing point. It is hugely dependent on society and its tastes which is mostly fluid while the model simplifies the reality into general tax revenues and tax rates. It also considers the single tax rate and single labor supply. Furthermore, it does not take into account that tax revenues are not often a continuous function, and with higher tax rates people try to avoid taxes through tax avoidance and tax evasion. All these facts bring uncertainty into the position of the revenue-maximizing point. Nevertheless, the theoretical ground of the Laffer curve is often used as the justification for tax increases or decreases. [25][26]
Governments may cite several reasons for cutting taxes.
Fairness
To begin with, money belongs to the person who possesses it, particularly if they earned it. Reducing the amount of money that is taken by the government can be seen as increasing fairness. However, if tax cuts are financed by cutting government spending, it can be argued that this disproportionately disadvantages low-income earners, as cuts in spending will affect services used mostly by low-income earners, who pay proportionately less tax.
Tax Equity
There are two main concepts focused on equity in taxation - horizontal equity and vertical equity. The former focuses on the belief, that all individuals should be affected by the same tax burden. The latter highlights the importance of the equal relative tax burden, the so-called ability-to-pay principle resulting in the belief that those with higher income should be taxed more heavily.
Efficiency
Tax cuts can serve to increase efficiency in the market. Cutting taxes can lead to more efficient allocation of resources than would have been the case with higher taxes. Generally, private entities are more efficient with their spending than governments. Tax cuts allow private entities to use their money in a more efficient manner.
Incentives
High taxes generally discourage work and investment. When taxes reduce the return from working, it is not surprising that workers are less interested in working.[citation needed] Taxes on income create a wedge between what the employee keeps and what the employer pays. Higher taxes encourage employers to create fewer jobs than they would with lower taxes.
