Do Tax Cuts Create Jobs? If So, How?
Payroll Tax Cuts that Target New Hires Are the Most Effective
Tax cuts do create jobs, but the results vary widely. They depend on the type of tax cut, the recipient, and how high taxes were before the cut. The Congressional Budget Office did a comprehensive study of the number of jobs created by different government policies. It analyzed seven types of tax cuts. It found that the most cost-effective policy was payroll tax cuts targeted to new employees.
The CBO also compared that to the number of jobs created by other government programs. It included spending on infrastructure, increasing unemployment benefits, and aid to the states.The report found that extending unemployment benefits is more cost effective than any tax cut.
Income Tax Cuts
Income tax cuts stimulate demand by putting more money into consumers' pockets. That's important because consumer spending drives 68 percent of economic growth. It creates jobs when businesses ramp up production to meet the higher demand.
Across-the-board income tax cuts aren’t very cost effective. The CBO study found that, at best, they create 4 jobs for every $1 million in lost tax revenue.
Tax cuts for the middle class and poor do better. Middle-income families are likely to spend the tax cuts. During a recession, they need every dollar they can get. They pump the money directly into local shops, who hire more workers to meet the increased demand.
The CBO study found that providing tax credits for the households with low and middle incomes created 7 jobs per $1 million in credits.
Do tax cuts for the rich create jobs? High-income families are more likely to save their tax cut than spend it. During a recession, they don't need the extra money to maintain their standard of living. They already have savings and lines of credit to do that.
The CBO found that tax cuts for the rich would create 4 jobs for every $1 million in cuts. It reviewed the impact of maintaining higher exemption amounts for the Alternative Minimum Tax. The AMT gets triggered when taxpayers make more than the exemption. It’s more likely to catch those in higher tax brackets. Keeping the exemption higher would benefit wealthy households.
Corporate Tax Cuts
Across-the-board corporate tax cuts don't do much to create jobs. That's according to a 2018 study by the Institute for Policy Studies. It compared 92 publicly-held corporations who paid less than the 35 percent corporate tax rate. It found that, between 2008 and 2015, these corporations lost jobs while the overall economy increased jobs by 6 percent. Instead of paying taxes or hiring, these companies bought back their own stocks. They also increased CEO pay at a higher rate than the average for companies listed on the S&P 500.
This was a similar finding to a 2014 New York University study. It compared companies in low-tax states to those in high-tax states. They found the tax rate didn't affect job creation unless tax cuts were offered during recessions.
Payroll tax cuts are the most cost-effective ways to increase jobs because they lower the cost of labor. These cuts create jobs in four specific ways:
- Companies with popular products immediately use the savings to hire more workers.
- Other companies use the savings to reduce prices. That increases demand, which necessitates hiring more workers.
- Some firms use tax savings to allow them to buy more goods. This benefits manufacturers.
- Many businesses use the cuts to raise wages to retain good workers. The workers spend more, increasing demand.
According to the CBO, every $1 million in payroll tax cuts creates 13 new jobs.
The payroll tax cuts specifically targeted for new hires is the most cost-effective tax cut. Every $1 million in targeted payroll tax cuts creates 18 new jobs. It lowers the cost of new employees when compared to existing workers or investment in new equipment. That changes employers’ decision-making in favor of new hires.
Jobs Created by Past Tax Cuts
Another way to look at the impact of tax cuts is review how past presidents used them. The problem with this method is that many other things could have happened at the same time. The federal government could have increased spending, another form of expansionary fiscal policy. The Federal Reserve could have lowered interest rates, a tool of expansionary monetary policy. In a recession, the government will use all of those tools. That makes it difficult to evaluate the impact of tax cuts alone.
Here's a quick analysis of well-known past tax cuts and their impacts.
Kennedy Tax Cuts: John F. Kennedy advocated a cut in income taxes. He wanted to lower the top rate from 91 percent to 65 percent. But he was assassinated before he could implement the cuts. Instead, Lyndon Johnson pushed through JFK's tax cuts on February 7, 1964. Congress lowered the top income tax rate to 70 percent from 91 percent over two years. It lowered the bottom rate to 14 percent from 20 percent. It lowered the corporate rate to 48 percent from 52 percent.
It's difficult to determine the impact of the tax cuts because government spending rose in both administrations. Kennedy's deficit spending was $18 billion, a 6 percent increase. Johnson's budget deficits totaled $36 billion, an 11 percent increase. That expansionary fiscal policy ended the recession. Economic growth averaged between 2.7 percent to 6.6 percent during the two administrations after the recession ended.
Reagan Tax Cuts: Ronald Reagan cut the income tax rate from 70 percent to 28 percent for the top levels. He reduced taxes for all other levels of income by similar amounts. Reagan cut the corporate tax rate from 48 percent to 34 percent.
Reagan's budget deficits were $1.4 trillion, a 142 percent increase. The Fed lowered the benchmark fed funds rate from 20 percent to 6 percent during Reagan's term. It's difficult to determine which action ended the 1981 recession and created jobs.
Bush Tax Cuts: The Bush tax cuts were implemented to stop the 2001 recession. The government cut income taxes in 2001 with the Jobs and Growth Tax Relief Reconciliation Act. In 2003, it cut corporate taxes with the Economic Growth and Tax Relief Reconciliation Act. The Bush tax cuts also reduced the marriage penalty, repealed the personal exemption phaseout and the limitation on itemized deductions, reduced taxes on long-term capital gains and qualified dividends, and expanded tax credits.
The Joint Committee on Taxation estimated that EGTRRA and JGTRRA would cost $1.173 trillion for 2007 through 2011. That includes revenue loss and interest on the additional debt incurred.
The Tax Increase Prevention and Reconciliation Act of 2005 extended lower tax rates for long-term capital gains and dividends through 2010. That did not significantly impact government income.
Supply-side proponents said the growth in GDP was because of the tax cuts. Other economists pointed out that interest rates were also lowered during the same period. The Fed lowered the fed funds rate from 6 percent to 1 percent between 2001 and 2003.
Obama Tax Cuts: Barack Obama pushed through several tax cuts to end the Great Recession. The American Recovery and Reinvestment Act had $288 billion in tax cuts. It reduced that year's income taxes for individuals by $400 each and $800 for families. Instead of checks, workers received a lower withholding in their paychecks. It wasn't publicized very well, so many people didn't even notice the increase.
ARRA also reduced income taxes by the amount equal to the sales tax on a new car purchase. It provided $17 billion in tax cuts for households who invested in renewable energy. It included $54 billion in small business tax cuts.
In 2010, Obama cut taxes by $858 billion. Unemployment was still at 9.8 percent, a lingering effect of the Great Recession. The plan extended the Bush tax cuts until 2013. It also extended college tuition tax credit and unemployment benefit extensions through 2011. It cut payroll taxes by 2 percent, putting $120 billion into workers' pockets. It cut $55 billion in taxes for specific industries. To pay for all these cuts, the plan reinstated the 35 percent inheritance tax on estates worth $5 million for individuals or $10 million for families.
The CBO estimated that extending the Bush tax cuts would add between 300,000 and 900,000 jobs in 2011. It would add between 500,000 and 1.7 million jobs in 2012.
Extending the Bush tax cuts also added to the debt. The Congressional Research Service estimated the revenue lost to the cuts would be $2.023 trillion between 2011 and 2020. The service cost on that debt would add another $450 billion.
To avert the fiscal cliff in 2013, Obama agreed to permanently extend the Bush tax cuts on incomes below $400,000 for individuals and $450,000 for married couples. It continued the unemployment benefits extension until 2014. It raised the AMT income trigger.
Trump: Donald Trump signed the Tax Cuts and Jobs Act on December 22, 2017. It cut the corporate tax rate from 35 percent to 20 percent beginning in 2018. It cut income tax rates, doubled the standard deduction, and eliminated personal exemptions. It also repealed the Obamacare tax on those who don't get health insurance starting in 2019.
The Joint Committee on Taxation said the Act would increase growth by 0.7 percent annually. It would increase the deficit by $1 trillion in its first 10 years.
The Tax Foundation said the Act would boost growth by 1.7 percent a year. It would create 339,000 jobs and add 1.5 percent to wages over its first 10 years. It would also add almost $448 billion to the deficit.
How Tax Cuts Create Jobs
Supply-side economics is the theory that says tax cuts increase economic growth. Tax cuts do provide a boost, but only in the short term. In an economy that was already weak, tax cuts served an immediate lift.
The Laffer Curve states that tax cuts reduce government revenue dollar-for-dollar. It argues that the government will recoup that loss over the long term by boosting economic growth and the tax base. But the National Bureau of Economic Research found that only 17 percent of the revenue from income tax cuts was regained and 50 percent of the revenue was lost from corporate tax cuts.
One reason for this discrepancy could be the tax rate before taxes were cut. According to Laffer's model, the tax rate must be in the "Prohibitive Range," which is above 50 percent, for the cuts to stimulate the economy enough to recoup all the losses.
For example, the Bush tax cuts boosted the economy in the short-term. But increased growth wasn't enough to recoup the revenue lost. In 2001, the percentage of federal revenue to GDP went up to 20.9 percent. This value is higher than the norm because the economy shrank. After EGGTRA, federal revenue fell to 18 percent of GDP. In 2004, the percentage of revenue to GDP fell to 16 percent. By 2006, the percentage of revenue to GDP rose a bit to 18 percent. Even though the percentage of government revenue to GDP decreased, the total revenues increased because GDP increased.
To avoid increasing the federal debt, Congress should also reduce spending. Investors see the excessive debt as a tax increase on the future generations who must pay it off. That occurs when the ratio of debt to gross domestic product is near 77 percent. The World Bank found that if the debt-to-GDP ratio exceeds this the tipping point for an extended period of time, it slows the economy. Every percentage point of debt above this level costs the country 1.7 percent in economic growth.
What's Better Than Tax Cuts at Creating Jobs?
If tax cuts aren't great at creating jobs, what about government spending? The CBO study found that extending unemployment benefits works better than any tax cuts. It creates 19 jobs per $1 million spent. Benefits create jobs because the unemployed wind up spending every dollar they receive on essentials such as food, clothing, and housing.
A study by Economy.com found that every dollar spent on unemployment benefits stimulates $1.73 in economic demand. For example, the Obama benefit extensions cost taxpayers $10 billion every month. But they generated $17.3 billion in economic growth per month.
The best way to create jobs is not through tax cuts, government spending, or any fiscal policy at all. Instead, it's through monetary policy, one that expands the money supply, making more liquidity available for businesses to invest. Fiscal policy is only necessary when monetary policy is already as expansionary as possible. That happened in 2009 and 2010 after the Great Recession forced the fed funds rate to zero.