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

Definition: Tax cuts are changes that reduce the amount paid under the law to government revenue. The taxes cut are on income, profits, sales, or assets. Tax cuts occur in many different forms. They are a one-time rebate, a reduction in the overall rate, or a tax credit. Most comprehensive tax reform plans include them. For examples, see Fair Tax and Flat Tax.

Tax cuts also refer to tax deductions, loopholes, or credits.

 The recipient benefits from a change that reduces taxes. Tax cuts are always popular while tax increases are not.


The types of tax cuts correspond to the different types of taxes.

Income tax cuts reduce the amount paid by individuals and families on wages earned. This increases consumer spending, which drives nearly 70% of the economy.  To understand why, see 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 employing 50 or fewer workers. That'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 them more money to invest back into their businesses. That 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

    Barack Obama proposed the $787 billion American Recovery and Reinvestment Act (ARRA), passed by Congress in March 2009. It 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 new car purchases. It provided $17 billion in tax cuts for households who invested in renewable energy sources. It included $54 billion in small business tax cuts  Here are the ARRA details.

    In 2010, Congress approved the $858 billion Obama tax cut plan. It cut payroll taxes by 2%, adding $120 billion to consumer spending. It extended the college tuition tax credit. It continued the unemployment benefit extension through 2011. It reinstated the 35% inheritance tax on estates worth $5 million ($10 million families) to pay for the cuts.

    It cut $55 billion in taxes for specific industries.

    In 2013, Congress extended the Obama tax cuts were kept on incomes below $400,000 (or $450,000 for married couples). There was no expiration date. For more, see Fiscal Cliff 2013.

    George Bush used tax cuts to fight the 2001 recession. There were three Bush tax cuts. The first, known as EGTRRA, was passed in 2001.  It reduced tax rates by three percentage points and created a new 10% 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%.

    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. However, the economy had already slid into a recession, so it didn't stimulate the economy enough to reverse course. 

    Bill Clinton raised the income tax rate early in his first term. But in 1997, Clinton reduced the capital gains tax rate to 20% from 28%. He raised the exemption on the inheritance tax to $1 million from $600,000. He created Roth IRAs that allowed capitals gains to grow and be withdrawn tax-free. He raised the limits for deductible IRAs. (Source: The Dangerous Myths About the Bill Clinton Tax Increase, Forbes, July 16, 2012)

    Ronald Reagan cut the income tax rate from 70% to 28% for the top levels, and similarly for all other levels of income. He cut the corporate tax rate from 48% to 34%. He was such an advocate of supply-side economics that it's sometimes known as Reaganomics.  It worked to stop the 1981 recession because taxes were in the "Prohibitive Range," according to the Laffer Curve.  This theory also states that tax revenue from a stronger economy replaces any funds initially lost.

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

    Lyndon Johnson pushed through JFK's tax cuts. The Senate approved on February 7, 1964. It 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%.

    John F. Kennedy advocated a cut in income taxes.  He wanted to lower the top rate from 91% to 65%. (Sources: JFK Presidential Library and Museum, Address to the Economic Club of New York,  December 14, 1962. U.S. News, The Myth of JFK as a Supply-Side Tax Cutter, January 26, 2011)

    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. That's what happened when the Bush tax cuts were due to expire in 2010. 

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