Tax Cuts, Types, and How They Work

The Truth About Tax Cuts

tax cuts boost spending
••• Credit: Gallo Images - Guy Bubb PREMIUM A

Tax cuts do create jobs, but the results vary widely. They depend on the type of tax cut, the recipient, and when during the business cycle they are given. 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 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. They included spending on infrastructure, increasing unemployment benefits, and aid to the states. Increasing aid to the unemployed 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 then creates jobs when businesses ramp up production to meet higher demand.

But 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.

But tax cuts for the middle class and poor do better. Lower income families are more likely to spend the tax cuts. 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? Higher-income families are more likely to save their tax cut than spend it. Furthermore, higher income family spending is less influenced by tax cuts. During a recession, 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.

The CBO looked at extending 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. Making the exemption higher would benefit wealthy households. The CBO found it would create 4 jobs for every $1 million in cuts.

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.

But payroll tax cuts are the most cost-effective ways to increase jobs. Payroll tax cuts lower the cost of labor. These cuts create jobs in four specific ways.

  1. Companies with popular products would immediately use the savings to hire more workers.
  2. Some firms use tax savings them to buy more goods, benefiting manufacturers.
  3. Other companies use the savings to reduce prices. That increases demand, which necessitates hiring more workers. 
  4. Other companies 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 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 toward new hires.

Reducing employees' payroll taxes was less effective than lowering corporate payroll taxes, but more effective than lowering the personal income tax. It created 9 jobs per $1 million cut. An across-the-board tax cut includes wealthier people, who are less likely to spend their savings. A payroll tax cut is more likely to catch middle-income people, who are more likely to spend and boost demand.

Impact of Past Tax Cuts

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.

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.

Bush Tax Cuts: The Bush tax cuts were implemented to stop 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. The government cut income taxes in 2001 with the Jobs and Growth Tax Relief Reconciliation Act. Federal revenue fell to 18 percent 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 percent 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 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 revenue to GDP returned to 18 percent 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 percent, adding $120 billion to consumer spending. It extended the college tuition tax credit. It continued the unemployment benefit extension through 2011. It cut $55 billion in taxes for specific industries. To pay for all of these cuts, the plan reinstated the 35 percent inheritance tax on estates worth $5 million (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 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.

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 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.

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.

Tax Cuts Compared to Government Spending

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. These benefits create jobs because the unemployed wind up spending every dollar they receive on essentials such as food, clothing and housing. 

Providing an additional Social Security payment creates 9 jobs per $1 million spent. Social Security is targeted to the elderly, who tend to be in lower income brackets. They are also more likely to spend because they don't need to save for education, a house, or retirement.

The CBO found that payments to states created 9 new jobs for every $1 million spent. That's if the payments weren't for infrastructure. Investing in infrastructure, such as roads and bridges, created 10 jobs for each $1 million spent.

A study by 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 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.