Do Tax Cuts Create Jobs? If So, How?

Payroll Tax Cuts that Target New Hires Are the Most Effective.

do tax cuts create jobs
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Tax cuts create jobs in different ways, depending on the type of tax cut.

Income tax cuts stimulate demand by putting more money into consumers' pockets. That's important because consumer spending drives 70 percent of economic growth. It then creates jobs when businesses ramp up production to meet higher demand. A study by the Congressional Budget Office found that the Bush tax cuts would create 4.6 jobs for every $1 million if extended into 2011-2012.

But there is some debate over whether tax cuts for higher income families create as many jobs as tax cuts for low and moderate-income families. The theory is that lower income families must spend the tax cuts, driving demand, while higher income families will save their tax cut. Furthermore, higher income family spending is less influenced by tax cuts because these families can maintain their spending by cutting into their savings or getting loans or credit. Their tax cuts are more likely to be used to pay back loans.

Payroll tax cuts are one of the most cost-effective ways to increase jobs. According to the CBO, every $1 million in payroll tax cuts creates 13 new jobs. Payroll tax cuts create jobs in four ways. First, some companies use the savings to reduce prices. That increases demand, which necessitates hiring more workers. 

Second, other companies raise wages to retain good workers, who would then spend more, increasing demand. Third, some firms keep the tax savings, allowing them to buy more and increase demand. Fourth, companies that already had popular products would use the savings to hire more workers. This fourth method is the most cost-effective way to create jobs. 

In fact, if Congress only gives payroll tax cuts for new hires, then every $1 million in payroll tax cuts creates 18 new jobs.

By the way, the most cost-effective way to increase jobs is not a tax cut at all. The CBO study found that extending unemployment benefits are the best way to boost economic growth. Benefits create jobs because the unemployed wind up spending every dollar they receive on essentials such as food, clothing and housing. Every $1 million in unemployment benefits creates 19 new jobs. A study by found that every dollar spent on unemployment benefits stimulates $1.73 in economic demand. Although extended benefits cost taxpayers $10 billion every month, they generate $17.3 billion in economic growth, creating jobs and additional tax revenue.

Tax Cuts Boost Short-term Growth

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 cuts must ultimately be balanced with a reduction in spending to avoid increasing the federal debt. Left unchecked, the federal debt would eventually slow the economy. It's perceived as a tax increase on future generations, who ultimately must pay it off. That's especially true if the ratio of debt to gross domestic product is near 77 percent. That's the tipping point, according to a study by the World Bank. It found that if the debt-to-GDP ratio exceeds 77 percent for an extended period of time, it slows economic growth.

Every percentage point of debt above this level costs the country 1.7 percent in economic growth.

Effect of the Bush Tax Cuts

During the 2001 recession, the percentage of federal revenue to GDP went up to 20.9 percent. This value is higher than the norm because the economy shrank. To stimulate growth, the government cut taxes in 2001 with the Jobs and Growth Tax Relief Reconciliation Act and in 2003 with the Economic Growth and Tax Relief Reconciliation Act. After the tax cuts of 2001, federal revenue fell to 18 percent of GDP. The tax cuts of 2003 reduced the revenue percentage even further to 16 percent of GDP in 2004.

But these tax cuts were initially a success. The economy recovered. Even though the percentage of government revenue to GDP decreased, the total revenues increased because GDP increased.

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 Federal Reserve lowered the all-important fed funds rate from 6 percent to 1 percent between 2001 and 2003.

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. The percentage of GDP returned to 18 percent by 2006.

How Tax Cuts Increase Federal Budget Revenue

The Laffer Curve states that tax cuts reduce government revenue dollar-for-dollar, but 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.

Best Way to Create Jobs

If tax cuts aren't great at creating jobs, what about government spending? That's not a good way to create jobs either. It takes $1 million in spending to create 19 jobs. That's still over $50,000 of your tax dollars needed to create one job. The CBO didn't analyze what type of jobs or the income from the jobs.

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 to 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.