Do Tax Cuts Stimulate The Economy?

By Richard Cloutier AAA

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 income people 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 different types of taxes to generate revenues. The largest source of funds is the personal federal income tax. According to the Internal Revenue Service (IRS), approximately 43% of tax revenues are generated through this tax. Personal income taxes are levied against income, interest, dividends and capital gains, with higher earners generally paying higher tax rates.

The second largest source of funds for the IRS, accounting for nearly 40% of total revenues, is the payroll tax. The payroll tax is a tax levied at a fixed percentage on salaries and wages, up to a certain limit and is paid equally by both employer and employee. For 2007, the percentage is 6.2% of income up to $97,500, up from $94,200 in 2006. Payroll taxes have become an important source of revenue for the federal government and have grown more quickly than income taxes as the government has raised rates and income limits. Commonly known as the FICA (the Federal Insurance Contributions Act) tax, the payroll tax is used to pay Social Security benefits, Medicare and unemployment benefits. (For related reading, see Introduction To Social Security and Medicare: Defining The Lines.)

The other major sources of revenues for the IRS are corporate taxes, comprising roughly 10% of total taxes, and excise taxes. Excise taxes are a form of federal sales tax, levied on miscellaneous items such as gasoline and tobacco. They account for approximately 4% of the total tax revenue.

A Shifty 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. 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 dropped and industries such as personal aircraft manufacturing and boat building suffered, causing unemployment for many factory workers. Tax shifting must 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 + NX

where:

  • C = consumption spending by individuals
  • I = investment spending (business spending on machinery, etc.),
  • G = government purchases
  • NX = 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. (To learn more, read Economic Indicators To Know.)

Reducing taxes, therefore, 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. (To learn more, read Economics Basics.)

Tax Cuts and the Economy
Tax cuts, when used properly, have stimulated the economy. Many credit President George W. Bush's tax cuts for moving the economy out of recession. Similarly, in 1964, Congress enacted an 18% cut in personal taxes to spur growth. The legislation was designed to encourage consumer spending - many believe that it succeeded admirably as consumers delivered a textbook reaction.

According to a December 2004 article in Celtia.info, a magazine distributed in Celtic countries, tax cuts have also shown positive results in other countries as well. Ireland's recent tax cuts are believed to have improved living standards significantly. For years, the Irish were faced with high unemployment, budget deficits and high taxes. In 1986, Ireland faced a fiscal crisis. After reducing government spending, the government lowered taxes on both individuals and corporations. Over the next 13 years, Ireland's per capita income went from only 63% of the United Kingdom's average to besting it in 2000. Ireland now enjoys one of the highest standards of living in Europe.

According to a May 2007 article in the Herald Tribune, tax cuts in Poland, Slovakia and Hungary before their entry in the EU have spurred economic growth in those countries.

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 25% on a family with an adjusted gross income (AGI) of $60,000 will save them approximately $2,042. But a smaller 10% tax cut for a family with a taxable income of $150,000 would save them $3,333.

It seems that every politician who opposes tax cuts uses this imbalance to fight the cut. Tax cutters are always open to the rich versus the poor argument. Even when tax cut proposals eliminate the taxes altogether for lower income individuals, some critics still maintain the cuts support the rich. This is true, in a sense, but if a tax cut generates broad-based increases in disposable income, it is likely that people who pay the most in tax dollars will save the most. In other words, those who do not pay taxes cannot benefit from a tax cut

A Taxing Decision
Another problem for tax cut advocates is balancing the budget. Cutting taxes, at least theoretically, reduces government revenues, which creates a budget deficit. To counter this deficit, the government could cut spending. However, critics of tax cuts would then argue that the tax cut is helping the rich at the expense of the poor. That said, cutting taxes generally increases disposable income, which can boost consumer spending, directly enhancing GNP. If tax cuts succeed in increasing economic growth, the rich and poor may both benefit.

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