Tax cut

A tax cut is a reduction in taxes. Economic stimulus via tax cuts, along with interest rate intervention and deficit spending, are one of the central tenets of Keynesian economics.

Economic theory

The immediate effects of a tax cut are, generally, a decrease in the real income of the government and an increase in the real income of those whose tax rate has been lowered. In the longer term, however, the loss of government income may be mitigated, depending on the response that tax-payers make. Depending on the original tax rate, tax cuts may provide individuals and corporations with an incentive for investments which stimulate economic activity. This can generate additional taxable income which will offset some of the lost government revenue. In extreme cases this could generate more revenue than the was collected at the higher rate. (See: Laffer Curve)

The longer term macroeconomic effects of a tax cut are not predictable in general, because they depend on how the taxpayers use their additional income and how the government adjusts to its reduced income. Three idealized scenarios can be hypothesized:

1. Government cuts its expenditure, and taxpayers increase theirs, spending the money on commodities sourced from within the country. This combination is macroeconomically neutral, but advocates of a free-market economy argue that it improves economic welfare, since people are more accurate than the government in spending money on commodities that they actually want.
2. Government maintains its expenditure (thus incurring debt), and taxpayers increase theirs, spending the money on commodities sourced from within the country. This combination provides a stimulus to the economy, and it is on these grounds that advocates of supply-side economics frequently argue for tax cuts. It should lead to economic growth, bringing about greater general prosperity, though unless managed carefully it will also lead to inflation. A government making tax cuts and incurring debt usually hopes that the economic stimulus of the tax cut will be large enough to produce a long-term increase in tax revenues, allowing the debt to be paid off in the future. If that does not occur then the government can be left with a severe budgetary crisis.
3. Government maintains its expenditure (thus incurring debt), and taxpayers either save their increased income or spend it on commodities sourced from outside the country. This combination is not inherently deflationary, but it contributes to balance of payments difficulties which may have secondary deflationary effects and as noted above may lead to a government budgetary crisis with a painful readjustment to follow.

In practice it is likely that a mixture of these effects will occur, and the net effect of any tax cut will depend on the balance between them. It will therefore be a function of the overall state of the national economy. In conditions where most goods and services (especially those frequently purchased out of discretionary income, such as consumer durables) are produced domestically, a tax cut is more likely to provide a macroeconomic stimulus than in conditions where most consumer durables are imported. The effect of the cut will also depend on the level of taxation and the progressiveness of the tax system. If taxes are high before the cut there may be high levels of tax avoidance. If tax rates increase rapidly as income increases, marginal after tax income and the incentive to increase income will decline as income grows.

If government does reduce its expenditure to accommodate tax cuts, there must necessarily be reductions in government services, and there may also be a reduction of the government's capacity to redistribute income to reduce income inequalities. Critics of tax cuts argue that this leads to a fall in overall economic welfare because the effects fall disproportionately on those with the lowest incomes.

Tax cuts in the United States

In recent decades, most "supply-siders" in the United States have been Republicans (though a significant individual tax cut was proposed by President John F. Kennedy from the Democratic Party and passed by a Democrat led congress) with the belief that cutting the tax rate would stimulate investment and spending, with overall beneficial effects (including replenishment of some lost tax revenues). President Ronald Reagan signed tax cuts into law, which some believe stimulated a doubling in total tax revenues (from five hundred billion to one trillion dollars) during the period from 1980 to 1990. However, during this period the deficit and national debt more than tripled (from $908 billion in 1980 to $3.2 trillion in 1990). In addition, income tax receipts as a percent of GDP fell from 11.3% in 1981 to 9.3% in 1984 and failed to revert back to original levels until the late 1990s. Some supply-siders like Don Lambro of the Washington Times credit the Reagan tax cuts with the eventual surpluses of the late 1990s. Others doubt this claim however and instead believe the surpluses were a result of a combination of a decrease in government spending, the passing of the Omnibus Budget Reconciliation Act of 1993 (which dictated several tax increases), and the use of the PAYGO (pay-as-you-go) system. The Center on Budget and Policy Priorities and President’s Council of Economic Advisers argues that tax cuts do not pay for themselves stating that the "large reductions in income tax rates in 1981 were followed by abnormally slow growth in income tax receipts". The most recent federal tax cut of significance was derived from President George W. Bush. A conservative think tank called The Heritage Foundation has stated that the Bush tax cuts have led to the rich shouldering more of the income tax burden and the poor shouldering less; however, Bush is often highly criticized for giving tax cuts to the rich. Bush has claimed that the tax cuts have paid for themselves but critics argue that this is false. At the state level, Democratic Governor Bill Richardson in recent years has supported tax cuts to spur economic growth.

See also: Trickle-down economics, Reaganomics, and Starve the beast

Capital gains tax

Much discussion has occurred regarding the optimum capital gains tax rate, with some advocates calling for tax cuts in the belief that a lower rate (e.g., under 25%) will provide an incentive to investors to sell old stocks and invest in new stocks -- which supply siders maintain encourages the creation of new jobs, reduces unemployment, and has the paradoxical effect of increasing tax revenues more or less immediately, an idea first proposed by economist Arthur Laffer while an advisor to Ronald Reagan (See Laffer curve). In addition, a recent report issued by the Cato Institute argues that the burden of capital gains tax is felt by the poor much more than the rich. The report quotes a painting contractor as saying: "You're looking at a poor man who thinks the capital gains tax cut is the best thing that could happen to this country, because that's when the work will come back. People say capital gains are for the rich, but I've never been hired by a poor man." While this paradoxical effect is clearly possible in principle, opponents of capital gains tax cuts are not persuaded that it occurs in practice. They therefore argue that the rate of capital gains tax should be raised, since it is paid primarily by the better off, who can afford to contribute disproportionately to government revenues.

External links

• Congressional Research Service (CRS) Reports regarding U.S. tax cuts
• Cato Policy Analysis No. 242: The ABCs of the Capital Gains Tax
• Larry Kudlow on the Bush 2003 Tax Cuts and the U.S. Private Business Boom