At the end of this year, tax cuts approved by George W. Bush are set to expire. If nothing is done, the top two income tax brackets will revert back to 36% and 39.6%, up from 33% and 35% currently. Capital gains and dividend tax rate changes also lie in the balance. Right now, politicians are fighting over whether to let the cuts expire or to maintain them. There could also be other changes, such as letting them expire for wealthy individuals, such as those who make more than $250,000 per year.
Those advocating extending the cuts believe that letting them expire will hurt economic growth. There doesn't appear to be clear-cut evidence, however, that lower personal tax rates help the economy. For starters, rates have already been low and they didn't help prevent the financial crisis or speed up the recovery from the Great Recession.
A recent study by the Congressional Budget Office showed that economic growth during tax cuts implemented by Ronald Reagan in 1981 and through the Tax Reform Act of 1986 didn't stand out from the growth that the economy experienced when Bill Clinton raised taxes in 1993. The Bush tax cuts around 2001 also took place during a weak economy and didn't do much to help it recover.
Bloomberg Businessweek cited a 1989 study entitled "Budget Deficits, Tax Incentives and Inflation: A Surprising Lesson From the 1983-1984 Recovery" that also found the Reagan tax cuts weren't the main reason for strong economic growth in the 1980s. Instead, it found that expansionary monetary policy was the primary reason for the growth. Tax changes more favorable to businesses were also seen as a reason for the strong growth.
Corporate Tax Rates
It does appear that changes to corporate tax rates have a stronger ability to influence economic growth than changes to personal income tax rates. Both presidential candidates are currently advocating lowering the corporate tax rate in the United States. It officially stands at 35%, which qualifies as one of the highest in the world, though actual rates paid by businesses are much lower due to deductions and the ability to conduct business outside of the U.S. where rates can be much lower. President Obama would like to lower it to closer to 28%, while Romney would like to be more aggressive and lower it closer to 25%.
As the 1989 study cited, lower corporate tax rates can help spur investment. It is pretty clear that a lower domestic tax rate could encourage businesses to return to the U.S. or at least start investing at home more aggressively.
A final consideration was a U.S. News study that looked at tax rates and growth among U.S. states. One of its findings detailed that, between 2001 and 2010, states with the highest tax rates experienced among the strongest economic growth in the country. It found little evidence to suggest that "low rates lead to prosperity," at least when it comes to individual state personal income tax rates and growth or income levels among the respective states' residents.
The Bottom Line
It appears rather clear that changes to personal tax rates in the United States have little impact on economic growth. Raising them may help shore up tax revenues, but the impact on federal coffers or economic growth looks to be minimal. The same goes for either extending or cutting personal tax rates. Based on the evidence, politicians may want to focus more on lowering corporate tax rates and other business-friendly reforms. The Federal Reserve is doing all it can to maintain an expansionary monetary policy, which has helped spur economic growth following past downturns.