Tax cuts

A tax cut typically represents a decrease in the amount of money taken from taxpayers to go towards government revenue. This decreases the revenue of the government and increases the disposable income of taxpayers. Tax rate 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.

However, sometimes a tax cut can increase tax revenue, as economist Thomas Sowell explains:
:"What actually followed the cuts in tax rates in the 1920s were rising output, rising employment to produce that output, rising incomes as a result and rising tax revenues for the government because of the rising incomes, even though the tax rates had been lowered."

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". 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.

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, exemptions, and adjustments. Additionally, adjusting tax brackets may indirectly reduce the amount of income that is subjected to higher 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.

Tax cuts result in workers being better off financially. 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, if other factors hold even. Thus, income tax cuts increase the after-tax rewards of working, saving, and investing, increasing work effort and leading to 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 deficit, which can hinder economic growth in the long-term from increases in interest rates hindering investment. 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.

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. Aggregate supply and aggregate demand will be shifted as a result.

Corporate income tax cut

Corporate income tax cuts generate sustained effects on research and development (R&D) expenditures, productivity, and output, therefore increasing GDP. To evaluate the impact of appointed tax policy, studying R&D expenditure and technological adoption are crucial.

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 of labor utilization.

Value-added Tax

Value-added tax (VAT) is a general, broadly based consumption tax assessed on the value added to goods and services collected fractionally.

Cutting VAT can have significant repercussions on a country's economy. While it may stimulate short-term consumer spending and encourage business investment, there are trade-offs. Lower VAT rates reduce immediate government revenue, potentially impacting public services and infrastructure. However, if managed well, such cuts can contribute to long-term economic growth and fiscal stability. Policymakers must carefully balance the benefits of VAT reduction with the need for sustainable revenue collection.

One notable example of a focused VAT cut occurred in the UK during the pandemic. The standard rate of VAT dropped from 20% to 5%, specifically applying to the hospitality sector. This reduction aimed to support struggling businesses and boost consumer spending. However, it's essential to recognize that the main drawback of a VAT reduction lies in the fact that suppliers are not obligated to pass those savings directly to consumers. Therefore, while a VAT cut may create a small hole in overall VAT revenue, its impact on prices remains uncertain. EU regulations also allow for reduced VAT rates, but several countries have maintained VAT levels above the minimum thresholds.

Costs and Benefits Study

The working paper from 2017 for IMF listed three major factors regarding the effects 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.''

Any tax cuts will significantly reduce tax revenues in the first place. The growing tax revenue from economic growth will never fully offset this fact. Thus, the gap needs to be compensated and financed by an increase in public debt, raising other taxes, or cutting spending. Usually, cuts in income tax are compensated by an increase in consumption taxes, but there are several ways 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 led to an increase of inflation causing a boom-and-bust cycle.

d) By improved productivity

If the tax cuts leads to a more productive economy, the tax revenue may counterintuitively stabilize following tax cuts, given that the economy grows in a stable manner for a few years.

2. ''The tax cuts may help low-income groups even if they do not get the tax cuts directly.''

When the middle or upper class receives tax cuts, they often spend more money on the services which are provided by low-income individuals. On average, wealthier people tend to spend proportionally more of their income on services. With tax cuts, the expenditures of wealthier people increase together with the demand for services.

3. ''There is a tradeoff between growth and income inequality depending on what classes receive tax cuts.''

Even though upper class tax cuts may increase demand for services from the lower class, income inequality and polarization tend to increase. Income tax credits for the lower class do not make as large of an impact on the income gap as tax cuts for the upper class. On the other hand, targeting the middle class with tax cuts reduces income inequality and polarization but may provide lower dividends from growth.

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.
*The 2008 American Recovery and Reinvestment Act included a tax credit of $400, lower payroll tax rates, and higher earned income tax credits.
* The Economic Growth and Tax Relief Reconciliation Act of 2001 reduced business and investment taxes.
Tax policy varies from president to often propose tax changes, but Congress passes legislation that may or may not reflect those proposals.

John F. Kennedy

John F. Kennedy's plan was to lower the top rate from 91% to 65%, however, he was assassinated before implementing the change.

Lyndon B. Johnson

Lyndon B. Johnson supported Kennedy's ideas and lowered the top income tax rate from 91% to 70%. He reduced the corporate tax rate from 52% to 48%. Federal tax revenue increased from $94 billion in 1961 to $153 billion in 1968.

Ronald Reagan

Ronald Reagan's policies included tax reforms. His administration implemented two significant tax acts. First, the Economic Recovery Tax Act of 1981 (ERTA) was implemented to stimulate economic growth, incentivize investment, and reduce the tax burden on individuals and businesses. Key provisions included lowering the highest personal income tax rate from 70% to 50%, and lowering the capital gains tax rate from 28% to 20%. The ERTA decreased federal revenue initially. Following the ERTA was the Tax Reform Act of 1986 (TRA). The TRA built upon the ERTA, further reshaping the tax code with tax cuts. The highest personal income tax rate was reduced to 38.5% initially and eventually to 28%. The corporate tax rate also decreased, benefiting businesses. In 1988, Reagan cut the corporate tax rate from 48% to 34%. The TRA simplified the tax structure by reducing the number of brackets. While the TRA aimed for efficiency and fairness, it did not fully offset the revenue losses from previous tax cuts.

The 1980s witnessed economic expansion, often referred to as the "Reagan boom". In 1983, 1984, and 1985, the GDP grew by 4.6, 7.2, and 4.2% respectively.

While the tax cuts contributed to this growth, other factors, such as Federal Reserve actions, increased federal spending, and business investment, also played roles. The tax cuts worsened budget deficits in the short term, but the economic expansion eventually lead to lower deficits. After peaking in 1986, the federal deficit gradually declined by 1989.

George W. Bush

George W. Bush's tax cuts were implemented to stop the 2001 recession. They reduced the top income tax rate from 39.6% to 35%, the long-term capital gains tax rate from 20% to 15%, and the top dividend tax rate from 38.6% to 15%.

Although these tax cuts boosted the economy, these tax cuts increased the U.S. debt by $1.35 trillion over a 10-year period. These tax cuts primarily targeted high-income individuals.

Barack Obama

Barack Obama arranged for several tax cuts to defeat the Great Recession.

The $787 billion American Recovery and Reinvestment Act of 2009 promised $288 billion in tax cuts and incentives. Its taxation aspects included a payroll tax cut of 2%, health care tax credits, a $400 reduction in income taxes for individuals 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.

Donald Trump

Donald Trump signed the Tax Cuts and Jobs Act in 2017, which reduced the corporate tax rate from 35% to 20%.

Other changes included income tax rate cuts, doubling of the standard deduction, capping the state and local tax deduction and eliminating personal exemptions.

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.

Joe Biden

Joe Biden has proposed several tax policies during his tenure. His 2025 budget includes tax breaks for millions of families, low-income workers, and senior citizens. One significant proposal is the revival of the expanded Child Tax Credit (CTC), which helped lift millions of children out of poverty during the pandemic. Under Biden's plan, the expanded CTC would provide $3,000 per child six years and older and $3,600 for each child under six. Additionally, Biden supports continuing tax cuts for families making less than $400,000 but opposes extending tax cuts for higher earners. His goal is to pay for these tax breaks by raising taxes on corporations and the wealthy.

United Kingdom

Margaret Thatcher

Margaret Thatcher's policies included several tax cuts. Thatcher's government significantly lowered income tax rates. The top rate reduced from 83% in 1979 to 40% by 1988. The basic rate also decreased from 33% to 25% during the same period. These cuts aimed to encourage work, entrepreneurship, and investment, ultimately stimulating economic growth. To offset the revenue loss from income tax cuts, Thatcher's administration raised the VAT rate from 8% to 15%. The increased VAT became a crucial source of government revenue. The trade-off between income tax reduction and higher VAT sparked debates. Thatcher's strategy also included tax cuts for corporations. By 1986, the rate had fallen to 35%, down from the 52% burden on businesses in the late 1970s. These cuts aimed to enhance the UK's competitiveness, attract investment, and foster business growth.

While the tax cuts spurred economic activity, critics argued that they disproportionately benefited the wealthy. Poverty rates increased during Thatcher's tenure, with child poverty more than doubling.

Germany

Gerhard Schröder

During his tenure as Chancellor of Germany from 1998 to 2005, Gerhard Schröder implemented significant tax cut policies aimed at stimulating economic growth and improving the country's competitiveness. One notable move was the acceleration of income tax reductions in 2004, which lowered income tax levels by 10%. This reduction left approximately €18 billion in federal, state, and local coffers. Schröder planned to pay for these tax cuts through a combination of measures: reducing subsidies, privatization revenues, and increasing state debt. His goal was to provide a signal of economic revival and boost consumer confidence. However, Schröder faced criticism and pressure to denounce his business and political ties to Russia, particularly in light of Moscow's war in Ukraine. Despite the controversies, Schröder's tax policies left a lasting impact on Germany's fiscal landscape.

Argentina

Javier Milei

Javier Milei's tax cut policies were aimed at transforming the country's financial landscape. Milei proposed a tax reform known as the Ómnibus Law. One of its central tenets was the elimination of the maximum marginal tax rate. Over time, this would gradually reduce the tax burden for high-net-worth individuals, from 1.75% to 0.5% by 2027.

Multiplier Effect

With cuts in tax rates, households have higher disposable income. Some of this disposable income is spent or invested, stimulating the economy. This phenomenon is known as 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 2015 study by J. Whalen and F. Reichling, 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.

Tax Cuts and Productivity

The relation between the tax rate and government revenue is often depicted by the Laffer curve. Experience has shown 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, although 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.

Reasons

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. 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.

Tax burden

Tax burden refers to the indirect responsibility of paying taxes irrespective of the legal taxpayer. In the US, the overall tax burden in 2020 was equal to 16% of the total gross domestic product.{{Cite web, url=https://datalab.usaspending.gov/americas-finance-guide/revenue/#:~:text=In+Fiscal+Year+2020,+federal,that+year+($21.00+trillion)., title=Government Revenue | U.S. Treasury Data Lab, website=datalab.usaspending.gov

See also

*Laffer curve
* Rahn curve
*Reaganomics
* Starve the beast
* Trickle-down economics
*S corporation
*Tax reform

References

Tax policy