Tax cut

A tax cut is a reduction in the rate of tax charged by a government, for example on personal or corporate income. Whether a given tax cut will increase or decrease total tax revenues is much discussed by both economists and politicians.

The immediate effects of a tax cut are, generally, a decrease in the real income of the government and to increase the real income of those whose tax rate has been lowered. In the longer term, however, the effect on government income may be reversed, depending on the response that tax-payers make. Supply-siders argue that tax cuts for corporations and wealthy individuals provide them an incentive for investments which stimulate so much economic activity that even at the lower rate more net tax revenue will be collected.

Some economists argue that even in the short term cutting some taxes, for example capital gains tax, may raise government income immediately due to long-postponed sales of securities being made at the lower rate.

The longer term macroeconomic effects of a tax cut are not predictable in general, since they will depend on what the taxpayers whose rate has been cut do with their additional income, and how the government adjusts to its reduced income. Four idealised scenarios can be hypothesised:

1. Government cuts its expenditure, and taxpayers increase theirs, spending the money on commodities sourced from within the country. This combination is macroeconomically neutral, but advocates of a free-market economy argue that it improves economic welfare, since people are more accurate than the government in spending money on commodities that they actually want.
2. Government maintains its expenditure (thus incurring debt), and taxpayers increase theirs, spending the money on commodities sourced from within the country. This combination provides a stimulus to the economy, and it is on these grounds that advocates of supply-side economics frequently argue for tax cuts. It should lead to economic growth, bringing about greater general prosperity, though unless managed carefully it will also lead to inflation. A government making tax cuts and incurring debt usually hopes that the economic stimulus of the tax cut will be large enough to produce a long-term increase in tax revenues, allowing the debt to be paid off in the future. If that does not occur then the government can be left with a severe budgetary crisis.
3. Government cuts its expenditure, and taxpayers either save their increased income under their mattresses, or spend it on commodities sourced from outside the country. This combination has a deflationary effect on the country's economy, and could lead to balance of payments problems, though it will tend to expand the economies of the countries sourcing the commodities that people purchase. However, if saving predominates over the purchase of imports, there may be an indirect stimulus to the economy because the additional supply of capital tends to reduce the interest rate.
4. Government maintains its expenditure (thus incurring debt), and taxpayers either save their increased income under their mattresses, or spend it on commodities sourced from outside the country. This combination is not inherently deflationary, but it contributes to balance of payments difficulties which may have secondary deflationary effects, and as noted above may lead to a government budgetary crisis with a painful readjustment to follow.

In practice it is likely that a mixture of these effects will occur, and the net effect of any tax cut will depend on the balance between them. It will therefore be a function of the overall state of the national economy. In conditions where most goods and services (especially those frequently purchased out of discretionary income, such as consumer durables) are produced domestically, a tax cut is more likely to provide a macroeconomic stimulus than in conditions where most consumer durables are imported. Furthermore, the actual effect will inevitably be difficult to discern, because much else will have changed in the economy between the time when a tax cut is proposed and the time when its full effects should be felt.

In the United States in recent decades, most "supply-siders" have been Republicans (though the largest individual tax cut was initially proposed by President Kennedy), and both President Ronald Reagan and President George W. Bush are well known for signing tax cuts into law, in the belief that cutting the tax rate would stimulate investment and spending, with overall beneficial effects -- including increased tax revenues. President Reagan's tax cuts were indeed followed by increased growth and substantial job creation. However, real (inflation-corrected) tax revenues dropped from 1981 to 1983 and did not surpass their 1981 level until 1985 (as shown in Table 1.3 in the Historical Tables of the 2006 U.S Budget). [1] (http://a255.g.akamaitech.net/7/255/2422/23feb20050900/www.gpoaccess.gov/usbudget/fy06/pdf/hist.pdf) Even this recovery was arguably helped by the Tax Equity and Fiscal Responsibility Act of 1982, the Social Security Amendments of 1983, and the Deficit Reduction Act of 1984, all of which were estimated to have a positive effect on revenues. [2] (http://www.ustreas.gov/offices/tax-policy/library/ota81.pdf) In addition, the federal deficit grew from 2.6% of GDP in 1981 to 6.0% of GDP in 1983. It began shrinking steadily after 1992, becoming a surplus in 1998. However, this was after tax bills in 1990 and 1993 which raised the top marginal tax rate. [3] (http://www.ustreas.gov/offices/tax-policy/library/ota81.pdf) Despite all of this apparent evidence to the contrary, there are some who credit the Reagan tax cuts with the eventual surpluses of the 1990s [4] (http://www.washtimes.com/commentary/20040204-084711-8539r.htm) Democratic Governor Bill Richardson in recent years has advocated tax cuts to spur job growth (http://www.upi.com/view.cfm?StoryID=20030219-071745-7704r).

If government does reduce its expenditure to accommodate tax cuts, there must necessarily be reductions in government services, and there may also be a reduction of the government's capacity to redistribute income to reduce income inequalities. Critics of tax cuts argue that this leads to fall in overall economic welfare because the effects fall disproportionately on those with the lowest incomes.

Much discussion has occurred regarding the optimum capital gains tax rate, with some advocates calling for tax cuts in the belief that a lower rate (e.g., under 25%) will provide an incentive to investors to sell old stocks and invest in new stocks -- which supply siders maintain encourages the creation of new jobs, reduces unemployment, and has the paradoxical effect of increasing tax revenues more or less immediately, an idea first proposed by economist Arthur Laffer while an advisor to Ronald Reagan (See Laffer curve). While this paradoxical effect is clearly possible in principle, opponents of capital gains tax cuts are not persuaded that it occurs in practice. They therefore argue that the rate of capital gains tax should be raised, since it is paid primarily by the better off, who can afford to contribute disproportionately to government revenues.