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Advocates of tax cuts argue that reducing taxes improves the economy by boosting spending. Those who oppose cuts say they only help the rich and reduce the government services on which lower-income individuals rely. Regardless of opinion, tax cuts reduce government revenues and lead to budget deficits or growth in government debt. Below, find out how tax cuts affect the economy.
Key Takeaways
- Tax cuts reduce government revenues and create a budget deficit or higher sovereign debt.
- The federal tax system relies on several taxes to generate revenue, including income tax and payroll tax.
- Proponents of tax cuts argue that cuts increase an individual or family’s disposable income, spur spending, and help grow the economy.
- Critics claim that tax cuts only benefit the wealthy and reduce necessary government services for the lower-income bracket.
Understanding the Tax System
The federal tax system relies on several taxes to generate revenue. Income tax is the largest source of funds. More than half of the taxes collected by the Internal Revenue Service (IRS) generally come from individual, estate, and trust income taxes.
Personal income taxes are levied against wages, interest, dividends, and capital gains. Ordinary income rates are marginal based on income.
Employment taxes that fund Social Security and Medicare are the second-largest source of national revenue. These are a fixed percentage shared by employers and employees. Corporate taxes and excise taxes on items like gasoline and tobacco make up a smaller portion of the total.
A Shifting Tax Burden
The federal government uses tax policy to generate revenue and generally aims to burden those taxpayers who will be the least affected, often the wealthy. However, the flypaper theory of taxation assumes the burdens of the tax stick to where the government places the tax and often proves to be incorrect and tax shifting occurs.
Tax shifting is an economic phenomenon in which the taxpayer transfers the tax burden to the purchaser or supplier by increasing the sales price or depressing the purchase price during the process of commodity exchange.
Shifting tax burdens has also been evident through tax cuts for the wealthy that may not “have any significant effect on economic growth and unemployment,” and “lead to higher income inequality” according to a study of 18 member countries of the Organisation for Economic Co-operation and Development (OECD), including the United States.
Since the 1980s, policies in countries like the United States have often been based on arguments that higher taxes on the wealthy have a negative influence on economic growth.
Tax Cuts and the Economy
Reducing marginal tax rates to spur economic growth is a commonly used policy with the notion that lower tax rates will give people more after-tax income that could be used to buy more goods and services.
This is a demand-side argument to support a tax reduction as an expansionary measure. Reduced tax rates may further boost savings and investment, leading to further production and reduced unemployment.
Lowering taxes raises disposable income, allowing the consumer to spend more, which increases the gross domestic product (GDP).
Supply-side tax cuts are aimed to stimulate capital formation. If successful, the cuts will shift both aggregate demand and aggregate supply because the price level for a supply of goods will be reduced, which often leads to an increase in demand for those goods.
The National Bureau of Economic Research (NBER) studies the persistent effects of temporary changes in U.S. federal corporate and personal income tax rates. According to its 2022 working paper, a corporate income tax cut leads to a sustained increase in GDP and productivity. In contrast, personal income tax cuts trigger a short-lived boost to GDP, productivity, and hours worked but have no long-term effects.
What Is Tax Equity?
Two distinct concepts of taxation are horizontal equity and vertical equity. Horizontal equity is the idea that all individuals should be taxed equally. Vertical equity is the ability-to-pay principle, where those who are most able to pay are assessed higher taxes.
What Is the Progressive Nature of Taxation?
Tax cuts affect individuals differently because of the progressive nature of the tax. Reducing taxes on a family with a small adjusted gross income (AGI) will save them less in total dollar amounts than a slightly smaller tax cut on a family with a much higher salary. Across-the-board cuts will benefit high earners more in a dollar sense simply because of their higher earnings.
What Does the GNP Measure and How Do Tax Cuts Increase It?
Gross national product (GNP) is the total value of all finished goods and services produced by citizens and the output generated by businesses. Tax cuts increase available funding to individuals and businesses and may increase production and investment.
The Bottom Line
Tax cuts reduce government revenues and create either a budget deficit or increased sovereign debt. Critics often argue that tax cuts benefit the rich at the expense of those with fewer resources, as services beneficial to those in a lower income bracket are cut. Proponents claim that cuts put money in consumers’ pockets, resulting in spending increases, which grow the economy.
