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 rarely do so enough to make up for the revenue lost
- Cuts are most effective if tax rates are high or occur during a recession
- Tax cuts are always popular with voters
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. This generally occurs only when tax rates are high.
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 drives almost 70% of the economy because it’s one of the four components of gross domestic product.
Capital Gains Tax Cuts
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 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. These cuts give more money to firms to invest and hire workers.
- Small business tax cuts help entrepreneurs. It's a great way to add jobs since small businesses create almost 65% of all new jobs.
- Corporate tax cuts lower corporate income taxes. That gives corporations more money to invest back into their businesses. 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 federal tax cuts is to review how past presidents used them. He must convince Congress to make the change to 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. 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 tools available. 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 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%. He cut the corporate tax rate from 48% to 34%. This helped spur GDP growth for the next several years:
- 1983: 4.6%
- 1984: 7.2%
- 1985: 4.2%
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. It reduced the tax rate on long-term capital gains and dividends from 20% to 15% in 2003.
The Bush tax cuts boosted the economy in the short-term:
- 2002: 1.7%
- 2003: 2.9%
- 2004: 3.8%
- 2005: 3.5%
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% in 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. It 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 $858 billion American Recovery and Reinvestment Act of 2009 had $288 billion in tax cuts. Specifically, it:
- Reduced that year's income taxes for individuals by $400 each and $800 for families
- Reduced income taxes by the amount equal to the sales tax on a new car purchase
- Provided $17 billion in tax cuts for households who invested in renewable energy
- Included $54 billion in small business tax cuts
- Cut payroll taxes by 2%, adding $120 billion to consumer spending
- Extended the college tuition tax credit.
- Continued the unemployment benefits extension through 2011
- 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.
The Great Recession ended in July 2009. The economy grew 2.6% in 2010, 1.6% in 2011, and 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 zero 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 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 effective 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.
TurboTax. "What Are Tax Cuts?" Accessed July 18d, 2020.
The Heritage Foundation. "Executive Summary: The Laffer Curve: Past, Present, and Future." Accessed July 18, 2020.
Bureau of Economic Analysis. “National Income and Product Accounts Tables," Download "Table 1.1.6. Real Gross Domestic Product, Chained Dollars." Accessed July 18, 2020.
Small Business Administration. "Frequently Asked Questions." Accessed July 18, 2020.
John F. Kennedy Presidential Library and Museum. "John F. Kennedy on the Economy and Taxes." Accessed July 18, 2020.
The Tax Foundation. "Happy Birthday to the Kennedy Tax Cuts." Accessed July 18, 2020.
Tax Foundation. "Federal Individual Income Tax Rates History," Page 8. Accessed July 18, 2020.
Tax Policy Center. "Corporate Top Tax Rate and Bracket, 1909 to 2018." Accessed July 18, 2020.
Bureau of Economic Analysis. “National Income and Product Accounts Tables: Table 1.1.1. Percent Change From Preceding Period in Real Gross Domestic Product,” Select “Modify,” Select “First Year 1960,” Select “Series Annual,” Select “Refresh Table.” Accessed July 18, 2020.
Congressional Research Service. "Individual Income Tax Rates and Other Key Elements of the Federal Individual Income Tax: 1988 to 2019 Tax Years," Page 2. Accessed July 18, 2020.
Library of Congress. "H.R.2 - Jobs and Growth Tax Relief Reconciliation Act of 2003." Accessed July 18, 2020.
Board of Governors of the Federal Reserve System. “Open Market Operations Archive.” Accessed July 18, 2020.
The Brookings Institution. "An Economic Evaluation of the Economic Growth and Tax Relief Reconciliation Act of 2001," Page 10. Accessed July 18, 2020.
New York City Mayor's Office of Operations. "The Impact of the American Recovery and Reinvestment Act on New York City," Page 5. Accessed July 18, 2020.
Board of Governors of the Federal Reserve System. “Open Market Operations.” Accessed July 18, 2020.
U.S. Congress. "H.R.8 - American Taxpayer Relief Act of 2012." July 18, 2020.
U.S. Congress. “H.R. 1- An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018,” Accessed July 18, 2020.