How Tax Cuts Affect the Economy

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.

Key Takeaways

  • Tax cuts reduce government revenues and creates either a budget deficit or increased 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 of tax cuts claim that 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. By far the largest source of funds is income tax. In 2021, the Internal Revenue Service (IRS) collected a net $2.35 trillion in individual and estate, and trust income taxes, or 57.1% of the total.

Personal income taxes are levied against wages, interest, dividends, and capital gains and ordinary income rates are marginal based on income.

The payroll tax that funds Social Security benefits and Medicare is the next largest source of national revenue. The IRS collected a net $1.26 trillion in payroll taxes in 2021 or 30.6% of the total. The payroll tax is a fixed percentage on salaries and wages and is paid equally by both employer and employee.

The corporate tax contributed 10.2% to national coffers, and the excise tax levied against items such as gasoline and tobacco, contributed 1.4%.

2021 Tax Revenue by Source Amount % of Total
Business Income Taxes $419,008,841 10.2
Individual and Estate and Trust Income Taxes $2,348,054,224 57.1
Employment Taxes $1,258,170,886 30.6
Estate and Gift Taxes $28,045,739 0.7
Excise Taxes $58,289,822 1.4
Total Collected $4,111,569,512 100

Source: IRS

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, which assumes the burdens of the tax stick to where the government places the tax, 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.

Additionally, shifting tax burdens have 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 2020 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. Further, reduced tax rates may boost savings and investment, leading to further production and reduced unemployment.

Lowering taxes raises disposable income, allowing the consumer to spend more, and increases the Gross national product (GNP). Consumer spending typically equals two-thirds of GNP.

Gross National Product

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



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 studies the persistent effects of temporary changes in U.S. federal corporate and personal income tax rates. According to their recent 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 the tax cut benefits 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 and spending increases, growing the economy.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Internal Revenue Service. "2021 Data Book," Page 3.

  2. Internal Revenue Service. "IRS provides tax inflation adjustments for tax year 2022."

  3. Internal Revenue Service. "Topic No. 751 Social Security and Medicare Withholding Rates."

  4. Brittanica. "Shifting and Incidence."

  5. World Economic Forum. "Trickle-Down Tax Cuts Don't Work Study Says."

  6. Federal Reserve Bank of St. Louis. "Personal Consumption Expenditures/Gross Domestic Product."

  7. National Bureau of Economic Research. "Short Term Tax Cuts, Long Term Stimulus."

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