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.
Key Takeaways
- Tax cuts reduce government revenues and create either a budget deficit or increasedsovereign debt.
- The federal tax system relies on several taxes to generate revenue, including income tax and payroll tax.
- Proponents of tax cuts argue that cuts increase an individual or family's disposable income, spur spending, and help grow the economy.
- Critics of tax cuts claim that cuts only benefit the wealthy and reduce necessary government services for the lower-income bracket.
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. Theemploymenttax 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 taxlevied against items such as gasoline and tobacco contributed 1.4% ($70.7 billion).
| 2022 Tax Revenue by Source | Amount | % of Total |
|---|---|---|
| Business Income Taxes | $475.9 billion | 9.7 |
| Individual and Estate and Trust Income Taxes | $2.9 trillion | 59.2 |
| Employment Taxes | $1.4 trillion | 28.9 |
| Estate and Gift Taxes | $33.4 billion | 0.7 |
| Excise Taxes | $70.7 billion | 1.4 |
| Total Collected | $4.9 trillion | 100 |
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).
Consumer spending typically constitutes two-thirds of GDP and was 68% of GDP as of Q2 2023.
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.
What Is Tax Equity?
Two distinct concepts of taxation are horizontal equity and vertical equity. Horizontal equity is the idea that all individuals should be taxed equally. Vertical equity is the ability-to-pay principle, where those who are most able to pay are assessed higher taxes.
What Is the Progressive Nature of Taxation?
Tax cuts affect individuals differently because of the progressive nature of the tax. Reducing taxes on a family with a small adjusted gross income (AGI) will save them less in total dollar amounts than a slightly smaller tax cut on a family with a much higher salary. Across-the-board cuts will benefit high earners more in a dollar sense simply because of their higher earnings.
What Does the GNP Measure and How Do Tax Cuts Increase It?
Gross national product (GNP) is the total value of all finished goods and services produced by citizens and the output generated by businesses. Tax cuts increase available funding to individuals and businesses and may increase production and investment.
The Bottom Line
Tax cuts reduce government revenues and create either a budget deficit or increasedsovereign 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.
Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in oureditorial policy.
Internal Revenue Service. "2022 Data Book," Page 3.
Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2023."
Internal Revenue Service. "Topic No. 751 Social Security and Medicare Withholding Rates."
Hope, David, and Julian Limberg. "The Economic Consequences of Major Tax Cuts for the Rich." Socio-Economic Review, vol 20, no 2, Spring 2022.
World Economic Forum. "Trickle-Down Tax Cuts Don't Work Study Says."
Federal Reserve Bank of St. Louis. "Personal Consumption Expenditures/Gross Domestic Product."
National Bureau of Economic Research. "Short Term Tax Cuts, Long Term Stimulus."
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As an expert in economics and fiscal policy, I bring a wealth of knowledge to elucidate the intricate dynamics of tax cuts and their impact on the economy. My expertise is rooted in a comprehensive understanding of economic theories, empirical studies, and historical perspectives, allowing me to provide nuanced insights into the subject matter.
First and foremost, let's dissect the key concepts discussed in the article:
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Tax Revenue and Sources: The federal tax system relies on various taxes to generate revenue, including income tax, employment taxes (funding Social Security and Medicare), corporate tax, and excise tax. In 2022, income taxes constituted the largest share, contributing 59.2% of the total revenue.
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Shifting Tax Burden: The government aims to burden those least affected by taxation, often the wealthy. However, the "flypaper theory" may not always hold true, as tax shifting can occur. This refers to the phenomenon where taxpayers transfer the tax burden to purchasers or suppliers through changes in prices during commodity exchange.
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Tax Cuts and Economic Impact: Advocates argue that tax cuts stimulate the economy by increasing disposable income, fostering spending, and promoting overall economic growth. However, critics contend that such cuts primarily benefit the wealthy and result in reduced government services for lower-income individuals.
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Supply-Side and Demand-Side Arguments: Tax cuts can be viewed through both supply-side and demand-side perspectives. Demand-side arguments suggest that lower tax rates increase after-tax income, leading to more spending, while supply-side cuts aim to stimulate capital formation, potentially increasing both aggregate demand and supply.
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Tax Equity: The article introduces two important concepts of taxation—horizontal equity and vertical equity. Horizontal equity advocates for equal taxation for all individuals, while vertical equity, based on the ability-to-pay principle, imposes higher taxes on those most able to pay.
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Progressive Nature of Taxation: Tax cuts affect individuals differently due to the progressive nature of taxation. Reducing taxes across the board may benefit high earners more in absolute dollar terms because of their higher earnings.
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Gross National Product (GNP): GNP measures the total value of finished goods and services produced by citizens and businesses. Tax cuts are argued to increase available funding for individuals and businesses, potentially leading to increased production and investment.
In conclusion, the article provides a comprehensive overview of the multifaceted implications of tax cuts on government revenues, economic growth, and income distribution. The debate surrounding the efficacy of tax cuts remains complex, with proponents emphasizing their potential to spur economic activity and critics highlighting concerns about income inequality and reduced public services.
