How can tax cuts help the economy

Congressional Research Service. University of California, Berkley. Board of Governors of the Federal Reserve System. The Brookings Institution. The White House. National Center for Biotechnology Information. Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content.

Create a personalised content profile. Measure ad performance. Select basic ads. Create a personalised ads profile. Select personalised ads.

Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. Table of Contents Expand. Table of Contents. What Are Tax Cuts? Types of Tax Cuts. Tax Cuts by President. How Tax Cuts Stimulate the Economy. By Kimberly Amadeo. Learn about our editorial policies.

Reviewed by Michael J Boyle. Article Reviewed May 22, Michael Boyle is an experienced financial professional with more than 10 years working with financial planning, derivatives, equities, fixed income, project management, and analytics. Failure to control for other factors that impact economic growth, such as government spending and monetary policy, could understate or overstate the impact of taxes on growth.

Some tax changes in particular may have stronger long-run impacts relative to the short run, such as corporate tax changes, and a study with only a limited time series would miss this effect. Finally, tax reforms involve many moving parts: Certain taxes may go up, while others may drop.

This can make it difficult to characterize certain reforms as net tax increases or decreases, leading to mistaken interpretations of how taxes impact growth. This research covers a wide variety of taxes, including income, consumption, and corporate taxation.

All seven papers reviewed here find that tax cuts have positive effects on growth, although some papers note that the strength of this effect depends on which taxes are cut, for whom, and when. Mertens and Olea used time series data from to to estimate the impacts of marginal tax rates on individual income. They found that marginal rate cuts led to both increases in real GDP and declines in unemployment. A 1 percentage-point decrease in the tax rate increases real GDP by 0.

Importantly, they find that changes in income following a tax change are responsive to the marginal rate change regardless of the change in the average tax rate. This illustrates that the positive GDP changes the authors find are the response to changes in the incentives, rather than due to an increase aggregate demand through the consumption channel. Cuts in tax rates for the top 1 percent also have positive impacts on other income groups, consistent with a supply-side narrative of how reductions in top marginal rates can increase incomes for other groups over time.

However, tax cuts for the top 1 percent do increase inequality. Zidar examines the impact of federal tax burdens on economic growth and labor supply across different income groups and states from He finds positive impacts of tax cuts on economic growth following two years after the change in policy but finds that tax cuts for low- and moderate-income taxpayers affect growth more than tax cuts for high-income taxpayers. The paper finds that a 1 percent of state GDP tax decrease for the bottom 90 percent of earners increases state GDP by 6.

Looking at labor supply effects in particular, he finds that a 1 percent of state GDP tax decrease increases labor force participation for the bottom 90 percent of earners by 3. He does not find any significant impact on labor force participation rates, hours worked, or GDP growth for the top 10 percent of earners from a similarly sized tax change, somewhat in contrast to the results found in Mertens and Olea for top earners.

However, the paper finds strong effects of tax cuts on real wages as well. However, this paper only looks at short-run impacts of tax changes on GDP and does not consider the broader implication of tax policy on long-run growth, human capital, or innovation. Tax cuts should therefore be focused on low- and middle-income households who tend to have a higher propensity to spend out of their income than do high-income households. Timing any new tax cut for households to coincide with the holiday season may be an effective way to encourage it to be spent.

Allow only temporary items. This will limit the long-term cost of the package and reduce the temptation for policy-makers to try to push through long-standing proposals that may or may not have merit for other reasons, but do little or nothing to stimulate the economy in the short run.

G Gene B. Sperling Peter R. Set an overall stimulus budget first. There appears to be some confusion as to the meaning of the overall stimulus ceiling.

In our opinion, the overall stimulus budget should include all stimulus legislation proposed and enacted since September It should cover all stimulus costs, as estimated by the Congressional Budget Office and Joint Committee on Taxation, over the next ten years. Minimize the long-term costs. Combining short-term stimulus with long-term fiscal discipline provides more stimulative impetus to the economy than a stimulus package alone, since it restrains any increase in interest rates that could undermine the effectiveness of the stimulus.

Declines in consumer confidence, spending, and employment have led to calls for a second round of consumer rebates to directly bolster consumer demand. Economic research suggests that households tend to immediately spend between 20 percent and 70 percent of any temporary income tax cuts they receive. Although it is too soon to fully evaluate the impact of the rebate checks distributed this summer, the checks appear to be generating only a small increase in consumption.

In August, personal after-tax income rose by 1. A survey undertaken by the University of Michigan in August and September found that only 19 percent of respondents said that they were going to spend their rebates. To make another round of rebates more effective as a stimulus, policy-makers could target the rebates to lower and middle income households. Economic research suggests that these households have tendencies to spend a greater proportion of any new income than high-income households do—and the more the rebate is spent, the more effective it is as a stimulus.

Furthermore, roughly 30 million lower and moderate income households did not receive a rebate earlier this year, even though they pay federal payroll and excise taxes. To better target such households, the rebates should be based on employee Social Security and Medicare payroll taxes.

Although the rebate would be based on payroll taxes, it should be financed through general revenues. To maximize the stimulative impact and minimize administrative hassles, the rebates could be set as one amount for anyone with earnings in calendar year over a minimum level.

Another way to stimulate the spending potential of any rebate may be to time the rebate checks for the holiday shopping season. Holiday purchases of presents for friends and family are highly seasonal. Intuitively, putting more resources in the hands of lower- and moderate-income families during the holiday season seems likely to bolster the volume of shopping during the holiday season.

Vendors—who have already experienced one rebate round—may now be particularly astute about marketing sales and deals based on the rebates. Another proposal for household tax cuts is to accelerate to January 1, the income tax rate cuts—or some portion thereof—currently scheduled to occur on January 1, and January 1, This proposal is problematic for several reasons.

First, and most importantly for its stimulative impact, the acceleration is not well-targeted to generating additional spending in the short run. The vast majority of the costs of accelerating the rate reductions would occur after The acceleration would also reduce revenue in , , , and Since most of the cost would not go to providing stimulus in , when it is needed most, the proposal does not maximize its bang-for-the-buck.

A temporary one-year tax cut would generate the same stimulus in at much less cost. There is also a good chance that, when any accelerated tax cuts become operative in years between and , the economy will already be growing rapidly. Furthermore, the accelerated rate cuts would only apply to high-income households—those who are in the top 25 percent of the income distribution. Tax cuts boost demand by increasing disposable income and by encouraging businesses to hire and invest more.

Tax increases do the reverse. These demand effects can be substantial when the economy is weak but smaller when it is operating near capacity.

Economic activity reflects a balance between what people, businesses, and governments want to buy and what they want to sell. In the short run—focusing on the next one or two years—economic policy has greater impact on the demand side. When the economy is weak, for example, the Federal Reserve tries to boost consumer and business demand by cutting interest rates or purchasing financial securities. Congress, for its part, can boost demand by increasing spending and cutting taxes.

How much tax cuts boost demand or tax hikes restrain it depends on the sensitivity of household and business behavior—for example, how households divide increased after-tax income between consumption and saving, and whether businesses choose to hire and invest more. Economists summarize these effects in a simple measure, the output multiplier, expressing how many dollars of increased economic activity result from a dollar reduction in taxes or a dollar increase in government spending.

As these estimates suggest, the stimulus from tax cuts or spending increases depends on the strength of the economy. If it is operating close to potential and the Federal Reserve is not constrained by the zero lower bound on interest rates, fiscal policies will have a small short-run economic effect, largely because the Fed will offset fiscal stimulus with interest rate hikes.

However, if the economy is far from potential and short-term interest rates are close to zero, fiscal stimulus can have significantly more impact because the Fed will not offset it. CBO estimates that fiscal multipliers are about three times larger when the economy is very weak than when it is strong. But some things are clear. If the federal government purchases goods and services itself or helps state and local governments do so , most or all of the spending will boost demand.

If the government cuts personal taxes, however, a substantial amount of the added spending power leaks into saving. That dampening effect can be moderated by targeting tax cuts to lower- and middle-income households, which are less likely to save. Tax policies can also affect the supply of labor in the short run. A cut in payroll taxes could bring some workers into the labor market or encourage those already working to put in more hours.

Such supply changes have little effect on output if the economy is operating well below potential. Under those conditions, people have difficulty finding more work even if they want it. If the economy is operating near potential, however, increased labor supply can translate to increased output.

The CBO model estimates direct effects on demand based on generic policy types, as in table 1. Congressional Budget Office.

Edelberg, Wendy. Joint Committee on Taxation. Page, Benjamin R. Nunns, Jeffrey Rohaly, and Daniel Berger. Whalen, Charles J. Skip to main content. Briefing Book Taxes and the Economy How do taxes affect the economy in the short run? How does the federal government spend its money? What is the breakdown of revenues among federal, state, and local governments?

How do US taxes compare internationally? Federal Budget Process How does the federal budget process work? What is the history of the federal budget process? What is the schedule for the federal budget process? What is reconciliation? How is a budget resolution enforced?

What are rescissions? Federal Budget Outlook How accurate are long-run budget projections? What have budget trends been over the short and long term?

How much spending is uncontrollable? What are tax extenders? What options would increase federal revenues? What does it mean for a government program to be off-budget? How did the TCJA affect the federal budget outlook? Taxes and the Economy How do taxes affect the economy in the short run? How do taxes affect the economy in the long run? What are dynamic scoring and dynamic analysis? Do tax cuts pay for themselves? On what do economists agree and disagree about the effects of taxes on economic growth?

What are the economic effects of the Tax Cuts and Jobs Act? Economic Stimulus What is the role of monetary policy in alleviating economic downturns? What are automatic stabilizers and how do they work? What characteristics make fiscal stimulus most effective?

Distribution of Tax Burdens How are federal taxes distributed? Are federal taxes progressive?