Tax Cuts, Types, and How They Work
The Truth About Tax Cuts
Tax cuts are reductions to the amount of taxpayers' money that goes toward government revenue. Since they save voters' money, tax cuts are always popular. Tax increases are not.
Tax cuts occur in different forms. Governments can cut taxes on income, profits, sales, or assets. The cut can be a one-time rebate, a reduction in the overall rate, or a tax credit.
Tax cuts also include tax deductions, loopholes, or credits.
- Tax cuts reduce taxpayers' burden but also increase the nation's debt.
- Cuts can boost growth, but they rarely do so enough to make up for the revenue lost.
- Cuts are most effective if tax rates are high or if the tax cuts occur during a recession.
- Tax cuts are always more popular with voters than tax hikes.
What Are Tax Cuts?
Tax cuts are changes in the law that reduce your tax payment along with government revenue.
Why would the government cut taxes? Usually, it's to boost the economy by putting more money into taxpayers' pockets.
Most of the time, tax cuts are used to end a recession. It's a popular form of expansionary fiscal policy.
In the short term, all tax cuts increase government debt since they reduce revenue. Proponents of supply-side economics argue that, in the long term, tax cuts pay for themselves.
Economist Arthur Laffer explained that tax cuts have a multiplier effect on the economy. They can stimulate growth enough to eventually generate higher tax revenue. However, this generally occurs only when tax rates are high.
Economists use something called the "Laffer Curve" to measure this relationship between current tax rates, the proposed tax cuts, and the expected economic growth.
Types of Tax Cuts
The types of tax cuts correspond to the different types of taxes.
Income Tax Cuts
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 is one of the four components of gross domestic product (GDP). Since the turn of the century, it has typically made up between two-thirds and 70% of the overall U.S. GDP.
Capital Gains Tax Cuts
Capital gains tax cuts reduce taxes on sales of assets. That gives more money to investors.
By putting more money in investors' pockets, they are more likely to buy more stock in companies, helping the companies grow. It also drives up the prices of real estate, oil, gold, and other assets.
Inheritance Tax Cuts
Inheritance or estate tax cuts reduce the amount paid by heirs on their parents' assets.
Business Tax Cuts
Business tax cuts reduce taxes on a company's profits. The goal of these cuts is to give firms more money to invest in growth, wages, and hiring.
- Small business tax cuts help entrepreneurs starting new businesses. This can help add jobs since small businesses create roughly 64% of all new private-sector jobs.
- Corporate tax cuts lower corporate income taxes. That gives corporations more money to invest back into their businesses, which could, in turn, help create 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 parties.
Tax Cuts by President
Another way to look at the impact of federal tax cuts is to review how past presidents used them.
While presidents may propose tax cuts, they cannot change the tax code on their own, and they must ultimately convince Congress to change the tax law.
It's difficult to analyze the effects of tax cuts since many other policies could have been implemented at the same time.
For example, an increase in debt could be the result of tax cuts or increased spending. The Federal Reserve could have lowered interest rates, a tool of expansionary monetary policy.
Any actions like these affect the economy, and it's challenging to assign specific economic trends to a specific economic policy.
It's especially tough to determine the impacts of tax cuts during a recession. Governments typically use any tools at their disposal during recessions, and the more tools that are used, the more difficult it becomes to figure out the specific impact of each policy.
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%. However, he was assassinated before he could implement the cuts.
Lyndon Johnson later pushed through JFK's tax cuts on February 26, 1964. LBJ lowered the top income tax rate from 91% to 70%. He lowered the corporate rate to 48% from 52%.
Federal revenue increased from $94 billion in 1961 to $153 billion in 1968.
Reagan Tax Cuts
In 1982, Ronald Reagan cut the top income tax rate from 70% to 50%. The economy experienced GDP growth in the years that followed:
- 1983: 4.6%
- 1984: 7.2%
- 1985: 4.2%
In 1988, 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 government cut the top income tax rate from 39.6% to 35% in 2001.
Bush also reduced the top tax rate on long-term capital gains from 20% to 15% and reduced the top dividend tax rate from 38.6% to 15%.
The Bush tax cuts may have boosted the economy in the short-term:
- 2002: 1.7%
- 2003: 2.9%
- 2004: 3.8%
- 2005: 3.5%
However, the tax cuts might not have been the only reason for increased growth. The Federal Reserve also lowered the benchmark fed funds rate from 6% to 1.75% throughout 2001.
The tax cuts benefited high-income individuals the most. Tax rates fell by 4.1% for the top 1% of households compared to only 2% or less for other households.
These cuts also increased the U.S. debt by $1.35 trillion over a 10-year period.
Obama Tax Cuts
Barack Obama pushed through several tax cuts to end the Great Recession.
In February 2009, Congress passed the $787 billion American Recovery and Reinvestment Act of 2009 had $288 billion in tax cuts and incentives. These tax cuts included:
- A reduction in income taxes for individuals of $400 ($800 for couples)
- Enhancements to Child Tax Credits and Earned Income Tax Credits
- A cut to payroll taxes of 2%
- Up to $10,000 for families putting a child through college
- Health care tax credits that decreased premiums by an average of 76%
The Great Recession ended in July 2009. The economy grew:
- 2.6% in 2010
- 1.6% in 2011
- 2.2% in 2012
In this case, the ARRA tax cuts were probably more effective than monetary policy in boosting growth. The Fed had already lowered rates to 0% in 2008.
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. The American Taxpayer Relief Act of 2012 taxed incomes at and above the top income threshold at the Clinton-era 39.6% tax rate.
Trump Tax Cuts
Donald Trump signed the Tax Cuts and Jobs Act on Dec 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.
The GDP growth rate increased by about 0.7% in 2018, but it fell below 2017 levels in 2019. In 2020, the GDP sharply declined—though this was likely due in large part to the COVID-19 pandemic.
How Tax Cuts Work to Stimulate the Economy
How tax cuts affect the economy depends on the type of tax being cut. In general, 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, if they lead to an increase in the federal debt, they will depress the economy in the long-term.
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.