A tax cut (or tax rate cut) is a reduction in taxes collected by a government. It usually refers to reductions in the percentage of tax paid on income, goods and services. Tax cuts also include reductions in tax in other ways, such as tax credits, deductions, and loopholes.
The effects of a tax cut depend on the type of tax that is cut. Policies that increase disposable income for lower- and middle-income households are more likely to increase overall consumption and "hence stimulate the economy". Tax cuts in isolation may boost the economy because they increase government borrowing. However, they are often accompanied by spending cuts or changes in monetary policy that can offset their stimulative effects.
Sometimes a tax cut can increase tax revenue, as economist Thomas Sowell explains: "What actually followed the cuts in tax rates in the 1920s were rising output, rising employment to produce that output, rising incomes as a result and rising tax revenues for the government because of the rising incomes, even though the tax rates had been lowered."Thomas Sowell on the Relationship Between Tax Rates and Tax Revenues By Mark J. Perry During the Coolidge administration, the highest tax rate on personal income was brought down (in steps) from 75% to 25%, with the surprising result that tax revenue increased and also that the richest 1% paid a higher share of taxes.
Types Tax cuts are typically cuts in the tax rate. However, other tax changes that reduce the amount of tax can also be seen as tax cuts. These include deductions, credits, exemptions, and adjustments. Additionally, adjusting tax brackets may indirectly reduce the amount of income that is subject to higher tax rates.
TermDefinitionExampleRate cutA reduction in the fraction of the taxed item that is collected.An income tax rate cut reduces the percentage of income that is paid in tax.DeductionA reduction in the amount of the taxed item that is subject to the tax.An income tax deduction reduces that amount of taxable income.CreditA reduction in the amount of tax paid. Credits are usually fixed amounts.A tuition tax credit reduces the amount of tax paid by the amount of the credit. Credits can be refundable; i.e., the credit is given to the taxpayer even when no actual taxes are paid (such as when deductions exceed income).ExemptionThe exclusion of a specific item from taxation.Food might be exempted from a sales tax.AdjustmentA change in the amount of an item that is taxed based on an external factor.An inflation adjustment reduces the amount of tax paid by the rate of inflation.
Predictions about effects
Tax cuts generally reduce the amount of tax paid by affected taxpayers, increasing after-tax income. Economists disagree about the extent to which this leads to higher consumer spending, investment, wages, or long-term economic growth, depending on the type of tax cut and broader economic conditions.
Consumer spending is a large component of aggregate demand. This increase in aggregate demand can lead to economic growth if other factors remain consistent. Thus, income tax cuts increase the after-tax rewards of working, saving, and investing, increasing work effort and contributing to economic growth.
If governments reduce taxes without reducing spending or increasing other revenue sources, budget deficits may increase, potentially contributing to higher interest rates and reduced private investment over time. This also decreases national saving and, therefore, reduces the national capital stock and income for future generations. For this reason, the structure of the tax cut and the way it is financed are crucial for achieving economic growth.
Supply-side tax cut Supply-side tax cuts are designed to stimulate capital formation by lowering the price level of a good and therefore increasing the demand for the good. Aggregate supply and aggregate demand will be shifted as a result.
Corporate income tax cut Corporate income tax cuts generate sustained effects on research and development (R&D) expenditures, productivity, and output, thereby increasing GDP. To evaluate the impact of a given tax policy, studying R&D expenditure and technological adoption is crucial.
Personal income tax cut According to the National Bureau of Economic Research, personal income tax cuts only lead to a momentary boost to GDP and productivity, having no long-term effect on GDP as they trigger an extensive but short-lived response of capital expenditure, productivity, and output. The key to evaluating the effect of personal income tax cut is labor utilization.
Value-added tax cut Value-added tax (VAT) is a general, broadly based consumption tax assessed on the value added to goods and services and collected fractionally.
Cutting VAT can have significant repercussions on a country's economy. While it may stimulate short-term consumer spending and encourage business investment, there are trade-offs. Lower VAT rates reduce immediate government revenue, potentially impacting public services and infrastructure. However, if managed well, such cuts can contribute to long-term economic growth and fiscal stability. Policymakers must carefully balance the benefits of VAT reduction with the need for sustainable revenue collection.
One notable example of a targeted VAT cut occurred in the UK during the pandemic. The standard rate of VAT dropped from 20% to 5%, specifically for the hospitality sector. This reduction aimed to support struggling businesses and boost consumer spending. However, it is essential to recognize that the main drawback of a VAT reduction is that suppliers are not obligated to pass those savings directly to consumers. Therefore, while a VAT cut may create a small hole in overall VAT revenue, its impact on prices remains uncertain. EU regulations also allow for reduced VAT rates, but several countries have maintained VAT levels above the minimum thresholds.
Costs and benefits study A 2017 working paper from the IMF posited three major factors regarding the effects of tax cuts:
1. Tax cuts can boost the economy in the short term; however, these effects are generally not strong enough to prevent a loss of revenue.
Any tax cuts will significantly reduce tax revenues initially. The increase in tax revenue from economic growth does not fully offset this effect. Thus, the gap must be financed through an increase in public debt, higher taxes, or reduced spending. Usually, cuts in income tax are offset by increases in consumption taxes, but there are several ways a government may compensate for tax cuts:
a) By spending cuts
The final effect on equity and aggregate demand will be neutral, as some individuals will be better off from tax cuts while others will have to reduce their spending as the government decreases welfare payments. Overall, there is no change in aggregate welfare in the economy.
b) By government borrowing
The government may compensate for the loss in revenue by borrowing money and issuing bonds. The overall result of this type of compensation may vary depending on the state of the economy. In a recession, borrowing would probably result in higher aggregate demand. In a boom, borrowing may result in crowding out—a situation in which the private sector has fewer funds available for investments as it purchases bonds.
c) By cutting taxes in boom
Chancellor Nigel Lawson's tax cuts in 1988 occurred during a period of economic growth. These tax cuts led to a further increase in economic growth; however, they also led to increased inflation, contributing to a boom-and-bust cycle.
d) By improved productivity
If tax cuts lead to a more productive economy, tax revenue may counterintuitively stabilize, provided that the economy grows steadily for a few years.
2. Tax cuts may help low-income groups even if they do not receive them directly.
When the middle or upper class receives tax cuts, they often spend more money on services provided by low-income individuals. On average, wealthier people tend to spend proportionally more of their income on services. With tax cuts, the expenditures of wealthier individuals increase along with the demand for services.
3. There is a trade-off between growth and income inequality, depending on which groups receive tax cuts.
Even though upper-class tax cuts may increase demand for services from the lower-income groups, income inequality and polarization tend to increase. Income tax credits for the lower-income groups do not have as large an impact on the income gap as tax cuts for the upper-income groups. On the other hand, targeting the middle class with tax cuts may reduce income inequality and polarization but may provide lower gains in economic growth.
Countries
United States Notable examples of tax cuts in the United States include: The Tax Cuts and Jobs Act of 2017 lowered the corporate tax rate to 21%, while also reducing personal income tax rates, among other changes. The 2009 American Recovery and Reinvestment Act included a $400 tax credit, lower payroll tax rates, and higher earned income tax credits. The Economic Growth and Tax Relief Reconciliation Act of 2001 reduced business and investment taxes. Tax policy varies by president, who often proposes tax changes, but Congress passes legislation that may or may not reflect those proposals.
John F. Kennedy
John F. Kennedy's plan was to lower the top personal income tax rate from 91% to 65%; however, he was assassinated before implementing the change.
Lyndon B. Johnson Lyndon B. Johnson supported Kennedy's ideas and lowered the top personal income tax rate from 91% to 70% through the Revenue Act of 1964. He reduced the corporate tax rate from 52% to 48%. Federal tax revenue increased from $94 billion in 1961 to $153 billion in 1968.
Ronald Reagan
Ronald Reagan's policies included tax reforms. His administration implemented two significant tax acts. First, the Economic Recovery Tax Act of 1981 (ERTA) was implemented to stimulate economic growth, incentivize investment, and reduce the tax burden on individuals and businesses. Key provisions included lowering the highest personal income tax rate from 70% to 50% and reducing the capital gains tax rate from 28% to 20%. The ERTA decreased federal revenue initially. The Tax Reform Act of 1986 (TRA) followed the ETRA. The TRA built upon the ERTA, further reshaping the tax code with tax cuts. The highest personal income tax rate was reduced to 38.5% initially and eventually to 28%. The corporate tax rate also decreased, benefiting businesses. In 1988, Reagan cut the corporate tax rate from 48% to 34%. The TRA simplified the tax structure by reducing the number of brackets. While the TRA aimed for efficiency and fairness, it did not fully offset the revenue losses from previous tax cuts.
The 1980s witnessed economic expansion, often referred to as the "Reagan boom". In 1983, 1984, and 1985, the GDP grew by 4.6%, 7.2%, and 4.2%, respectively.
While the tax cuts contributed to this growth, other factors such as Federal Reserve actions, increased federal spending, and business investment also played roles. The tax cuts worsened budget deficits in the short term, but the economic expansion eventually led to lower deficits. After peaking in 1986, the federal deficit gradually declined through 1989.
George W. Bush
George W. Bush's tax cuts were implemented to help address the 2001 recession. They reduced the top personal income tax rate from 39.6% to 35%,https://sgp.fas.org/crs/misc/RL34498.pdf Federal Individual Income Tax Brackets, Standard Deduction, and Personal Exemption: 1988 to 2024 the long-term capital gains tax rate from 20% to 15%, and the top dividend tax rate from 38.6% to 15%.
Although these tax cuts boosted the economy, they increased the U.S. debt by $1.35 trillion over a 10-year period. These tax cuts primarily targeted high-income individuals.
Barack Obama