How Tax Cuts Affect the Economy

Investing News

Advocates of tax cuts argue that reducing taxes improves the economy by boosting spending. Those who oppose them say that tax cuts only help the rich because it can lead to a reduction in government services upon which lower-earning individuals rely. In other words, there are two distinct sides to this economic balancing scale.

The Tax System

The federal tax system relies on a number of taxes to generate revenue. By far the largest source of funds is the income tax that individuals, estates and trusts pay. In 2018, the Internal Revenue Service (IRS) collected a net $1.57 trillion in personal income taxes, or 52.4% of the total. Personal income taxes are levied against wages, interest, dividends and capital gains. Ordinary income rates are marginal based on income, while long-term capital gains enjoy preferential treatment. 

The payroll tax that funds Social Security benefits and Medicare is the next largest source of national revenue. The IRS collected a net $1.13 trillion in FICA taxes in 2018, or 37.6% of the total. The payroll tax is levied at a fixed percentage on salaries and wages, up to a certain limit, and is paid equally by both employer and employee.

The next biggest categories are the corporate tax, which contributed 6.8% to national coffers, and the excise tax levied against items such as gasoline and tobacco, which contributed 2.4%. See the chart below for more details.

Source: IRS.

A Shifting Tax Burden

The federal government uses tax policy to generate revenue and places the burden where it believes it will have the least effect. However, the “flypaper theory” of taxation (the belief that the burden of the tax sticks to where the government places the tax), often proves to be incorrect.

Instead, tax shifting occurs. A shifting tax burden describes the situation where the economic reaction to a tax causes prices and output in the economy to change, thereby shifting part of the burden to others. An example of this shifting took place when the government placed a sales tax on luxury goods in 1991, assuming the rich could afford to pay the tax and would not change their spending habits.

Unfortunately, demand for some luxury items (highly elastic goods or services) dropped and industries such as personal aircraft manufacturing and boat building suffered, causing layoffs in some sectors.

If a tax is levied on a non-price sensitive good or service such as cigarettes, it wouldn’t lead to big changes such as factory shutdowns and unemployment. Studies have shown that a 10% increase in the price of cigarettes only reduces demand by 4%. The tax imposed on luxury goods in 1991 was also 10%, but left yacht makers claiming an 86% drop in sales and thousands of lost jobs. Regardless, tax shifting should always be considered when setting tax policy.  

Gross National Product

Gross national product (GNP), a measure of a nation’s wealth, is also directly affected by federal taxes An easy way to see how taxes affect output is to look at the aggregate demand equation:

GNP = C + I + G + N X where: C = Consumption spending by  individuals I = Investment spending (business spending on machinery, etc.) G = Government purchases N X = Net exports begin{aligned}&textbf{GNP}=C+I+G+NX\&textbf{where:}\&C=text{Consumption spending by}\&qquadtext{ individuals}\&I=text{Investment spending (business}\&qquadtext{spending on machinery, etc.)}\&G=text{Government purchases}\&NX=text{Net exports}end{aligned}
GNP=C+I+G+NXwhere:C=Consumption spending by individualsI=Investment spending (businessspending on machinery, etc.)G=Government purchasesNX=Net exports

Consumer spending typically equals two-thirds of GNP. As you would expect, lowering taxes raises disposable income, allowing the consumer to spend additional sums, thereby increasing GNP.

Reducing taxes thus pushes out the aggregate demand curve as consumers demand more goods and services with their higher disposable incomes. 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.

Tax Cuts and the Economy

It’s a common belief that reducing marginal tax rates would spur economic growth. The idea is 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 fiscal stimulus. Further, reduced tax rates could boost saving and investment, which would increase the productive capacity of the economy.

However, studies have shown that this isn’t necessarily true. A working paper for the National Bureau of Economic Research found that tax cuts aimed at high-income earners have less economic impact that similarly sized cuts targeted at low and moderate income tax payers. Furthermore, the Congressional Research Service concluded that the steady reduction in the top tax rates for high earners over 65 years had no correlative impact on economic growth.

In other words, economic growth is largely unaffected by how much tax the wealthy pay. Growth is more likely to spur if lower income earners get a tax cut.

Tax Equity?

Because of the ideal of fairness, cutting taxes is never a simple task. Two distinct concepts are horizontal equity and vertical equity. Horizontal equity is the idea that all individuals should be taxed equally. An example of horizontal equity is the sales tax, where the amount paid is a percentage of the article being purchased. The tax rate stays the same whether you spend $1 or $10,000. Taxes are proportional.

A second concept is vertical equity, which is translated as the ability-to-pay principle. In other words, those most able to pay should pay the higher taxes. An example of vertical equity is the federal individual income tax system. The income tax is a progressive tax because the fraction paid rises as income rises.

The Optics and Emotions of a Tax Cut

Reducing taxes becomes emotional because, in simple dollar terms, people who pay the most in taxes also benefit most. If you cut the sales tax by 1%, a person buying a Hyundai may save $200, while a person buying a Mercedes may save $1,000. Although the percentage benefit is the same, in simple dollar terms, the Mercedes buyer benefits more.

Cutting income taxes is more emotional 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 they earn more.

A Taxing Decision

Cutting taxes reduces government revenues, at least in the short term, and creates either a budget deficit or increased sovereign debt. The natural countermeasure would be to cut spending. However, critics of tax cuts would then argue that the tax cut is helping the rich at the expense of those with fewer resources because the services that would likely get cut are beneficial to those in a lower income bracket. Proponents argue that by putting money back in consumer’s pockets spending will increase; hence, the economy will grow and wages will rise. At the end of the day, the outcome depends on where the cuts are made.

Articles You May Like

SoundHound AI Stock May Be Poised for a Correction. Be Careful.
3 Top Mega-Cap Chip Stocks to Watch for Major Moves
Beware the Intel Stock Mirage: Why This AI Boom May Be a Bust
IMF sees ‘bumps’ in path to lower inflation
3 Overpriced Darlings Short Sellers are Salivating Over