Tax Cuts: Definition, Types, and How They Work

The Truth About Tax Cuts

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

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.

Types

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 percent of the economy because it’s one of the four components of GDP.

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 percent of all new jobs.

    Tax Cuts by President

    John F. Kennedy advocated a cut in income taxes. He wanted to lower the top rate from 91 percent to 65 percent.

    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.

    Richard Nixon did not cut taxes. Instead, he added a 10 percent import tax.

    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. He was such an advocate of supply-side economics that it's sometimes known as Reaganomics. Supply-side economics worked to stop the 1981 recession because taxes were in what is called the "Prohibitive Range" of the Laffer Curve. This theory also states that tax revenue from a stronger economy replaces any funds initially lost.

    Bill Clinton raised the income tax rate early in his first term. But in 1997, Clinton reduced the capital gains tax rate to 20 percent from 28 percent. He raised the exemption on the inheritance tax to $1 million from $600,000.

    He created Roth IRAs that allowed capital gains to grow and be withdrawn tax-free. He raised the limits for deductible IRAs.

    George W. Bush used tax cuts to fight the 2001 recession. There were three Bush tax cuts. Congress passed EGTRRA in 2001. It reduced tax rates by three percentage points and created a new 10 percent rate at the lowest incomes. It cut the marriage, estate, and gift tax. It expanded the child tax credit and earned income tax credit

    In 2003, Congress passed JGTRRA to speed up the EGTRRA tax cuts and help investors. It reduced the maximum tax rate on long-term capital gains and dividends to 15 percent.

    In 2008, the Bush tax rebate was mailed to taxpayers. Although costly to execute, it worked because people knew they were getting a break. They felt they could spend it. But the Great Recession had already begun, so it didn't stimulate the economy enough to reverse course.

     

    Barack Obama proposed the $787 billion American Recovery and Reinvestment Act, passed by Congress in March 2009. ARRA had $288 billion in tax cuts. It reduced that year's income taxes for individuals by $400 each and $800 for families. Employers lowered the amount withheld so workers could spend the money right away. Because it wasn't publicized very well, many people didn't even notice the increased amount of their paychecks. 

    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 sources. It included $54 billion in small business tax cuts. It did even more too.

    In 2010, Congress approved the $858 billion Obama tax cut plan. It 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, Congress kept the Bush tax cuts on incomes below $400,000 (or $450,000 for married couples), with no expiration date.

    Donald Trump proposed a tax cut plan in 2017. He asked Congress to create base legislation on his plan by January 1, 2018. The Senate version of the Tax Cuts and Jobs Act cuts the corporate tax rate from 35 percent to 20 percent beginning in 2019. It cuts income tax rates, doubles the standard deduction, and eliminates personal exemptions. On November 14, 2017, the Senate included a repeal of the Obamacare tax on those who don't get health insurance.

    How Tax Cuts 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 increased 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.