How Tax Cuts Affect the Economy

Advocates of tax cuts argue that reducing taxes improves the economy by boosting spending. Those who oppose cuts say they only help the rich and reduce the government services on which lower-income individuals rely. Regardless of opinion, tax cuts reduce government revenues and lead to budget deficits or growth in government debt. Below, find out the ways in which tax cuts affect the overall economy.

Understanding the Tax System

The federal tax system relies on several taxes to generate revenue. By far the largest source of funds is income tax. In 2022, the Internal Revenue Service (IRS) collected a net $2.9 trillion in individual, estate, and trust income taxes, or 59.2% of the total.

Personal income taxes are levied against wages, interest, dividends, and capital gains, and ordinary income rates are marginal based on income.

The employment taxes that fund Social Security benefits and Medicare are the next largest source of national revenue. The IRS collected a net $1.4 trillion in employment taxes in 2022 or 28.9% of the total. The employment tax is a fixed percentage levied on salaries and wages and is paid equally by both employer and employee.

The corporate tax contributed 9.7% ($475.9 billion) to national coffers, and the excise tax levied against items such as gasoline and tobacco contributed 1.4% ($70.7 billion).

Source: IRS

A Shifting Tax Burden

The federal government uses tax policy to generate revenue and generally aims to burden those taxpayers who will be the least affected, often the wealthy; however, the "flypaper theory" of taxation, which assumes the burdens of the tax stick to where the government places the tax, often proves to be incorrect and tax shifting occurs.

Tax shifting is an economic phenomenon in which the taxpayer transfers the tax burden to the purchaser or supplier by increasing the sales price or depressing the purchase price during the process of commodity exchange.

Additionally, shifting tax burdens have been evident through tax cuts for the wealthy that may not “have any significant effect on economic growth and unemployment,” and “lead to higher income inequality” according to a 2022 study of 18 member countries of the Organisation for Economic Co-operation and Development (OECD), including the United States.

Since the 1980s, policies in countries like the United States have often been based on arguments that higher taxes on the wealthy have a negative influence on economic growth. 

Tax Cuts and the Economy

Reducing marginal tax rates to spur economic growth is a commonly used policy with the notion that lower tax rates will give people more after-tax income that could be used to buy more goods and services.

This is a demand-side argument to support a tax reduction as an expansionary measure. Further, reduced tax rates may boost savings and investment, leading to further production and reduced unemployment.

Lowering taxes raises disposable income, allowing the consumer to spend more, which increases the gross domestic product (GDP).

Supply-side tax cuts are aimed to stimulate capital formation. If successful, the cuts will shift both aggregate demand and aggregate supply because the price level for a supply of goods will be reduced, which often leads to an increase in demand for those goods.

The National Bureau of Economic Research studies the persistent effects of temporary changes in U.S. federal corporate and personal income tax rates. According to their recent 2022 working paper, a corporate income tax cut leads to a sustained increase in GDP and productivity. In contrast, personal income tax cuts trigger a short-lived boost to GDP, productivity, and hours worked but have no long-term effects.

The Bottom Line

Tax cuts reduce government revenues and create either a budget deficit or increased sovereign debt. Critics often argue that tax cuts benefit the rich at the expense of those with fewer resources, as services beneficial to those in a lower income bracket are cut. Proponents claim that cuts put money in consumers' pockets, resulting in spending increases, which grow the economy.