1 Why are tax cuts used as a form of economic policy and why do they stimulate economic growth? Brandon Shields 2465652 Economics the University of Akron Fall 2011 Abstract This analysis centers around why politicians and economists use taxes as form of economic policy. It will study how decreasing marginal tax rates work through labor supplied and aggregate supply to affect potential GDP. It should become clear through this analysis and examples from past policies that reducing the marginal tax rate stimulates the economy and leads to long-term economic growth.
2 Introduction There are many tools that governments can use in order to shape the economy. Recently, government spending in the form of a billion-dollar bailout has been one such tool that the Federal Government has employed in order to spur economic recovery during a recession. Government spending in order to shift the demand curve, increase GDP, and stimulate economic growth has been the sort of in the moment economic recovery plan that has been advocated by many economists such as John Maynard Keynes. However, one may find it curious that there are other, less direct, ways of affecting the economy through taxes. It is interesting how only within the least 30 years taxes have been used as a major form of economic policy, in order to stimulate growth. Furthermore, why are taxes used as a form of economic policy and why do they stimulate economic growth? Theoretical Overview Those that believe that taxes can, and should be used as a form of economic policy to stimulate growth are often referred to as supply-side economists because altering the marginal tax rate will affect the aggregate supply curve which will affect GDP. Supply-side economists build the foundation of their arguments on what is known as the Laffer curve 1. The Laffer curve suggests that there is one tax rate which will generate the most revenue, thus making it the most effective. Thus, not only may taxes need to be raised to achieve this max revenue, but taxes may need to be lowered in order to achieve the max revenue as well. A graphical representation of the Laffer curve can be found on figure 2A. The central idea being that lowering taxes increases the incentive to work and to earn and thus will actually boost revenue. In other words, Lower tax rates stimulate production by increasing incentives for saving, investment, risk taking, and work effort (Wesbury 2003). When looking to see exactly how the marginal tax rate effects aggregate supply and GDP, one should look towards the federal income tax. Essentially, income taxes create disincentive to work, as disposable income decreases. When the income tax is increased, labor supplied will decrease causing the labor supply curve to shift to the left, creating a tax wedge. The new equilibrium established by labor demanded and labor supplied will cause wages to initially increase, but be less after taxes than before the 1 The name Laffer Curve was coined in 1978 due to Arthur Laffer s modeling of the curve while in a meeting with high-powered political executives. However, the idea behind the curve originates as far back as the 14 century with Muslim philosopher Ibm Khaldum (Laffer 2004).
3 tax increase; furthermore the amount of labor hours after the tax increase has also decreased. A decrease in labor hours will mean a decrease in potential GDP, which guarantees a decrease in aggregate supply. A summarization from this analysis is that lower tax rates increase labor supply, increase employment, reduce pretax wages, and increase post tax wages (Roubini 1997). Thus, tax cuts lead to increased investment, which helps to foster new technologies and new goods for consumers. This supports Say s Law, which claims that supply creates its own demand as opposed to demand creating supply 2. Capital gains tax acts provides support on a smaller scale for the Laffer curve, showing how lowering or increasing the tax rate affects revenue. Decreasing the capital gains tax liberates locked-in capital 3, and thus revenues from the tax cut rise. President s from both parties have lowered this tax, and incurred similar results: After the 1981 capital gains tax was cut from 28 to 20 percent, real federal capital gains tax revenues leapt from 29.4 billion in 1981 to 36.6 billion by 1983-a 24 percent increase. After the capital gains tax was cut in 1997, the receipts from capital gains taxes rose from 66.9 billion in 1996 to 114.7 billion in 1999, an increase of more than 71 percent. (Moore 2008) The capital gains tax is a complex but the underlying principle for why capital gains tax revenues increase when the taxes are lowered is simple: incentive. The tax can be avoided by simply locking-in the capital when the tax is too high; however, when the tax is lowered, the incentive to sell the capital increases and the government will increase revenue from the new lower tax rate. This same principle of incentive applies to the entire population when dealing with the federal income tax. Reducing the marginal tax rate provides economic stimulus and increased revenues in the long run but at what cost? There are many discrepancies about the how much, if at all, revenues increase and if in fact tax cuts help to stimulate the economy. However, what is evident is that there will be a deficit in the short-run. In the time it takes for the market to adjust to the new tax system revenue will actually decrease. However, once adjusted, increased labor supply and investments should be able to recoup the 2 Also know as the law of the market, it is named after French businessman Jean-Babtiste Say who believed that one must spend money because the value of money itself is perishable. 3 Locked-in capital is delaying the selling of capital, such as stocks, properties, and businesses, in order to avoid paying a high capital gains tax.
4 deficit and begin to yield revenues higher as compared to before the tax break. The benefit of long-term economic growth is greater than the cost of a short-term deficit; the rational economic line of thinking thus supports the use of tax cuts as a viable economic policy. Cutting taxes to stimulate economic growth is not a measure that will produce immediate results; cutting taxes should be used as a policy of long-term economic growth as opposed to solving short-term economic issues. This is due to the fact that it takes time to adjust to the new tax structure set in place. It will take time to invest money, purchase capital, and take risks to innovate new products.. A case study that demonstrates how cutting taxes can lead to overall economic prosperity is comparing labor hours between the United States and France. This comparison is outlined in Edward Presscotts Richard T. Ely lecture: Prosperity and Depression: I find it remarkable that virtually all of the large differences in labor supply between France and the United States is due to differences in tax systems. I expect institutional constraints on the operation of labor markets and the nature of the unemployment benefit system to be more important. I was surprised by the welfare gain from reducing the intratemporal tax wedge is so Large (Prescott 2002) Decreasing the marginal tax rate expands supply of resources, expands output, and decreases taxshelter avoidance (Gwartney 2008). These effects along with those aforementioned help to stimulate economic growth in the long run. President George W. Bush demonstrated these positive, long-term effects of tax cuts in the years following the recession in 2001. President Bush enacted twp policies to reduce taxes in order to strengthen the economy. These included the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003. Figure 1A shows how income tax receipts largely increased after these two pieces of legislation had been passed. The Bush tax cuts also caused GDP to increase and bring The United States of America out of the recessionary period, which can be seen in figure 3A. Of course there are many factors that affect revenue and GDP but figures 1A and 3A provide strong support that the economic theory of tax cuts does work in the real world.
5 Many of the effects and policies of tax breaks have been criticized and debated amongst politicians and economists. Even though there is evidence to support that tax breaks lead to economic growth, some argue that labor supplied is not very elastic and thus there are very few fluctuations in the labor supply curve when taxes are increased, and furthermore lead to deficits as opposed to increased revenue. Perhaps the most heated debate occurs when dealing with decreasing income taxes is which tax bracket should receive the biggest tax cuts. Often in the American political system Republicans argue for tax cuts for the wealthy, while Democrats advocate for increased tax rates on the wealthy. The ideology of tax breaks on the wealthy is that they encourage investment and risk taking that the wealthiest Americans are financially in the position to make. These investments and technologies then lead to new products, increased labor hours, which benefit the middle class and all Americans. Believing that tax cuts for the wealthiest Americans result in economic prosperity for all everybody is referred to as Trickle- Down Economics. Summary Reducing the marginal tax rate has been a hotly debated economic policy for the past 30 years and will continue to be in the future. While the success and claims of supply-side economics will be contested, the logic behind the Laffer Currve and shifting aggregate supply curves is fairly simple. Taxes do make a difference in terms of economic progress and this can be seen all over the world. In 1980, only six countries levied a personal income tax with a top marginal rate of less than 40 percent. By 2000, fifty-six countries had a top marginal income tax rate of less than 40 percent (Gwartney 2008). However, there is a cost involved and that occurs in the short-run when a deficit occurs due to the change in tax structure due to insufficient time for the markets to adjust. However, the long-term economic gains far out weigh the costs and that is why many presidents and politicians have supported reducing the marginal tax rate as a viable economic policy. Furthermore, tax cuts help to stimulate the economy through increased labor hours supplied and increased investment, all which leads to long-term economic prosperity.
6 Graphs Figure 1A This graph shows that Federal Income tax receipts saw a dramatic increase between that start around 2003, which can be attributed to the Jobs and Growth Tax Relief Reconciliation Act of 2003 and the Economic Growth and Tax Relief Act of 2001. Figure 2A The Laffer curve demonstrates that revenue from an income tax at 0% and 100% will yield no revenue. Thus, some tax rate in between will yield maximum revenue.
Figure 3A After the recession in 2001, the United States GDP saw economic growth due to tax cuts in the Jobs and Growth Tax Relief Reconciliation Act of 2003 and the Economic Growth and Tax Relief Act of 2001 7
8 References Gwartney, James. "Supply-Side Economics." The Concise Encyclopedia of Economics. 2008. Library of Economics and Liberty. Retrieved September 7, 2011 from the World Wide Web: Laffer, Arthur. The Laffer Curve: Past Present & Future. June 1, 2004. The Heritage Foundation. Retrieved September 7, 2011 from the World Wide Web:http://www.heritage.org/research/reports/2004/06/the-laffer-curvepast-present-and-future Moore, Stephen. "Capital Gains Taxes." The Concise Encyclopedia of Economics. 2008. Library of Economics and Liberty. Retrieved September 7, 2011 from the World Wide Web: http://www.econlib.org/library/enc/capitalgainstaxes.html Prescott, Edward C. Richard T. Ely Lecture: Prosperity and Depression. American Economic Review Papers and Proceedings, 92, no. 2 (2002) Roubini, N. 1997. Supply Side Economics: Do Tax Rate Cuts Increase Growth and Revenues and Reduce Budget Deficits? Or Is It Voodoo Economics All Over Again?. Stern School of Business. Retrieved September 8, 2011, from people.stern.nyu.edu/nroubini/supply.htm Wesbury, Brian. "Taking the Voodoo Out of Tax Cuts." June 2, 2003. Library of Economics and Liberty. Retrieved September 7, 2011 from the World Wide Web: http://www.econlib.org/library/columns/y2003/wesburytaxcuts.html http://www.econlib.org/library/enc/supplysideeconomics.html
9 Brandon Shields Module 3 Assessment Doing this first analytical paper had not only taught me so much about the topic I researched but also about the difficulties and steps in writing an analytical essay. In reference to the topic, I learned how taxes work through labor supplied in order to aggregate supply. This subject has interested me for some time now because of how often the topic is in the media. I also learned about the Laffer curve and it intrigued me because the logic was so simple but the implications were so grand. This paper also got my mind thinking about Say s Law. I have always been so conventional in thinking that demand creates supply, supply creating its own demand is very fascinating. The overall process of writing the paper is daunting because of the amount of details required to create a professional looking article. Finding recourses, graphs, and ideas can be very challenging and overwhelming. I also struggled with finding a good structure. There is a certain flow that we all strive for in writing a paper and it can be hard to achieve. Having a good note-taking and organizational skills helped to make this easier but I still struggled at times. I definitely know how I could do things differently next time and where I could make the most effective improvements. In terms of this assignment, I would like to do more analysis with Say s Law. This was perhaps one of the most fascinating things I learned. Perhaps this is because in both of my principles courses we never talked about this; instead demand always created its own supply. Another point that I found interesting was the Laffer curve and using economic data from the past try and determine what the tax rate that maximizes revenue would be. As aforementioned, I find the Laffer curve so interesting because it is logically so simple but explains so much. Recently, there has been a push by some politicians to completely eliminate the capital gains tax; it would be interesting to research how that would affect the economy. I would say that there is nothing that is unclear to me after researching this topic other than perhaps the areas that I would like to do further research in. I would like to work with data next time so that I could draw more of my own conclusions perhaps. I also think that tax cuts have more costs than I was able to rationalize and I think that would be helpful in drawing my conclusions.
10