How Tax Cuts Stimulate the Economy

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 federal tax system relies on a number of different types of taxes to generate revenues. The largest sources of funds is the individual income tax and payroll tax. Approximately 80% of tax revenues are generated through these taxes. Personal income taxes are levied against income, interest, dividends and capital gains, with higher earners generally paying higher tax rates, while the 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.

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)

In third comes corporate taxes, comprising 10.6% of total taxes, and followed by excise taxes. Excise taxes are a form of federal sales tax, levied on miscellaneous items such as gasoline and tobacco. They account for 3.1% of the total tax revenue.

^{Via Tax Policy Center}

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 (highly elastic goods/services) dropped and industries such as personal aircraft manufacturing and boat building suffered, causing layoffs in some sectors.

If a tax is levied on a non-price sensitive good or service — like cigarettes — it wouldn't lead to big changes such as factory shutdowns and unemployment. Studies have shown that a 10% increase in the price of cigarettes, only reduces demand by 4%. The tax imposed on luxury goods in 1991 was also 10%, but the tax revenue fell $97 million short of projection, and yacht retailers saw a 77% drop in sales. Regardless, tax shifting should always be considered when setting tax policy. 

Gross national product (GNP), a measure of a nation's wealth, is also directly affected by federal taxes (See also: Explaining GDP vs. GNP) . 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.)

It's a common belief that reducing marginal tax rates would spur economic growth. The idea is 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 fiscal stimulus. Further, reduced tax rates could boost saving and investment, which would increase the productive capacity of the economy and productivity. 

However, studies have shown that this isn't necessarily true. Data collected over 25 years by the Bureau of Labor Statistics shows that high income earners spend much less for every tax dollar saved, than low income earners — 86 cents versus 48 cents respectively. Further, a 65-year study by the Congressional Research Service showed that economic growth was not correlated with changes in the top marginal tax and capital gains rate. In other words, economic growth is largely unaffected by how much tax the wealthy pay. Growth is more likely to spur if lower income earners get a tax cut.

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.

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. Across-the-board cuts will benefit high earners more in a dollar sense simply because they earn more. 

Cutting taxes reduces government revenues, at least in the short term, creates either a budget deficit, or increased sovereign debt. The natural countermeasure would be to cut spending. However, critics of tax cuts would then argue that the tax cut is helping the rich at the expense of the poor, because the services that would likely get cut, is beneficial to the poor. Proponents argue that by putting money back in consumer's pockets spending will increase, hence the economy will grow and wages will rise. At the end of the day, the outcome depends on where the cuts are made.