Tax Cuts, Types, and How They Work
The Truth About Tax Cuts
Tax cuts are reductions to the amount of citizens’ money that goes toward government revenue.
Tax cuts occur in many different forms. Congress can cut taxes on income, profits, sales, or assets. They can be a one-time rebate, a reduction in the overall rate, or a tax credit. Most comprehensive tax reform plans include cuts, such as the Fair Tax Plan and or the flat tax. Tax cuts also refer to tax deductions, loopholes, or credits.
Because they save voters money, tax cuts are always popular. Tax increases are not.
The types of tax cuts correspond to the different types of taxes.
Income tax cuts reduce the amount individuals and families pay on wages earned. When people can take home more of their paychecks, consumer spending increases. This personal consumption drives almost 70% of the economy because it’s one of the four components of gross domestic product.
Capital gains tax cuts reduce taxes on sales of assets. That gives more money to investors. They put more money into companies, through stock purchases, helping them grow. It also drives up the prices of housing and other real estate, oil, gold, and other assets.
Inheritance or estate tax cuts reduce the amount paid by heirs on their parents' assets.
Business tax cuts reduce taxes on profit. These give more money to companies to invest and hire workers.
- Small business tax cuts help entrepreneurs who employ 50 or fewer workers. It's a great way to add jobs since small businesses create 65% of all new jobs.
- Corporate tax cuts lower corporate income taxes. That gives corporations more money to invest back into their businesses. This boosts spending on durable goods orders, including capital goods. It also creates jobs.
- Payroll tax cuts lower the payments made to Social Security, Medicare, and unemployment taxes. Businesses and employees share this cost, so a payroll tax cut helps both.
Tax Cuts by President
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% to 65%. 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% from 91% over two years. It lowered the bottom rate to 14% from 20%. It lowered the corporate rate to 48% from 52%.
Reagan Tax Cuts: Ronald Reagan cut the income tax rate from 70% to 28% for the top levels. He reduced taxes for all other levels of income by similar amounts. Reagan cut the corporate tax rate from 48% to 34%.
Bush Tax Cuts: The George W. Bush tax cuts were implemented to stop the 2001 recession. The percentage of federal revenue to GDP went up to 20.9%. This value is higher than the norm because the economy shrank. The government cut income taxes in 2001 with the Jobs and Growth Tax Relief Reconciliation Act. Federal revenue fell to 18% of GDP. In 2003, it cut corporate taxes with the Economic Growth and Tax Relief Reconciliation Act. That lowered the percentage of revenue to GDP to 16% in 2004.
These tax cuts boosted the economy in the short-term. 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 benchmark fed funds rate from 6% to 1% 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 revenue to GDP returned to 18% by 2006.
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.
The $858 billion Obama tax cut plan cut payroll taxes by 2%, adding $120 billion to consumer spending. It extended the college tuition tax credit. It continued the unemployment benefits extension through 2011. It cut $55 billion in taxes for specific industries. To pay for all of these cuts, the plan reinstated the 35% inheritance tax on estates worth $5 million for individuals or $10 million for families.
To avert the fiscal cliff in 2013, Obama agreed to extend the Bush tax cuts on incomes below $400,000 for individuals and $450,000 for married couples.
Trump: Donald Trump signed the Tax Cuts and Jobs Act on December 22, 2017. It cut the corporate tax rate from 35% to 20% 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.
How Tax Cuts Work to Stimulate the Economy
How tax cuts affect the economy depends on the type of tax being cut. Tax cuts boost the economy by putting more money into circulation. They also increase the deficit if they aren't offset by spending cuts. As a result, tax cuts improve the economy in the short-term but depress the economy in the long-term if they lead to an increase in the federal debt.
Once tax cuts are put in place, they are difficult to revoke. Why? A tax cut reversal feels like, and has the same impact, as a tax increase. Members of Congress risk their reelection if they support a tax increase. That's why the Bush tax cuts never really expired.
The Bottom Line
Tax cuts reduce citizens' tax burden but also increase the nation's debt. They can boost growth but rarely do so enough to make up for the revenue lost. That's especially true if tax rates aren't high to start with or if the cut occurs during an expansion. Because they save voters money, tax cuts are always popular.