Do Tax Cuts Help or Hurt?

There are two distinct sides to this economic balancing scale. We see it as Republican and Democrat or even more so Conservative and Liberal. Advocates of tax cuts argue that reducing taxes improves the economy by boosting spending; those who oppose them say that tax cuts only help the rich because it can lead to a reduction in government services upon which lower income people rely.

Let’s look at this is a step by step format to first create understanding of our current system.  We can then discuss this as a pros and cons debate.

The Tax System
The federal tax system relies on a multitude of different taxes to generate revenues. 43% of tax revenues are generated through the federal income tax according to the Internal Revenue Service (IRS). Personal income taxes are levied against income, interest, dividends and capital gains, with higher earners generally paying higher tax rates.  This in is based on raw dollars not necessarily higher percentage.

The second largest source of funds for the IRS is the payroll tax. This accounts for nearly 40% of total revenues. The payroll tax is a tax levied at a fixed percentage on salaries and wages, up to a certain limit and is paid equally by both employer and employee.  Payroll taxes have become an important source of revenue for the federal government and have grown more quickly than income taxes as the government has raised rates and income limits. Commonly known as the FICA (the Federal Insurance Contributions Act) tax, the payroll tax is used to pay Social Security benefits, Medicare and unemployment benefits. Whether or not it is all used for that is one of the complaints.

The other major sources of revenues for the IRS are corporate taxes, and excise taxes.  They account for approximately 14% of the total tax revenue.

Tax Cuts and the Economy
Tax cuts, when used properly, have stimulated the economy. Here are some examples: 

President George W. Bush's tax cuts for moving the economy out of recession. Similarly, in 1964, Congress enacted an 18% cut in personal taxes to spur growth. The legislation was designed to encourage consumer spending - many believe that it succeeded admirably as consumers delivered a textbook reaction.

Ireland's recent tax cuts are believed to have improved living standards significantly. For years, the Irish were faced with high unemployment, budget deficits and high taxes. In 1986, Ireland faced a fiscal crisis (sound familiar?). After reducing government spending, the government lowered taxes on both individuals and corporations. Over the next 13 years, Ireland's per capita income went from only 63% of the United Kingdom's average to besting it in 2000. Ireland now enjoys one of the highest standards of living in Europe.

Fairness in Taxes

With the current ideal of fairness, cutting taxes is never a simple task. Two distinct concepts are horizontal equity and vertical equity.

Horizontal equity is the idea that all individuals should be taxed equally. An example of horizontal equity is the sales tax, where the amount paid is a percentage of the article being purchased. The tax rate stays the same whether you spend $1 or $10,000. Taxes are proportional.  This is where proposals like the Fair Tax and Flat Tax come in.

A second concept is vertical equity, which is translated as the ability-to-pay principle. In other words, those most able to pay should pay the higher taxes. An example of vertical equity is the federal individual income tax system. The income tax is a progressive tax because the fraction paid rises as income rises.  This is where the argument of “Fair Share” come in.

Why are taxes emotional and not logical?
Reducing taxes becomes emotional because, in simple dollar terms, people who pay the most in taxes also benefit most. If you cut the sales tax by 1%, a person buying a Hyundai may save $200, while a person buying a Mercedes may save $1,000. Although the percentage benefit is the same, in simple dollar terms, the Mercedes buyer benefits more. 

Cutting income taxes is more emotional because of the progressive nature of the tax. Reducing taxes 25% on a family with an adjusted gross income of $60,000 will save them approximately $2,042. But a smaller 10% tax cut for a family with a taxable income of $150,000 would save them $3,333.

This “imbalance” is the argument of the current administration to fight tax cuts. Tax cutters are always open to the rich versus the poor argument. Even when tax cut proposals eliminate the taxes altogether for lower income individuals, some critics still maintain the cuts support the rich. This is true, in a sense, but if a tax cut generates broad-based increases in disposable income, it is likely that people who pay the most in tax dollars will save the most. In other words, those who do not pay taxes cannot benefit from a tax cut.  Since 47% of the people in the US don’t pay taxes….  Ummm…

Another problem for tax cut advocates is balancing the budget. Cutting taxes, at least theoretically, reduces government revenues, which creates a budget deficit. To counter this deficit, the government could cut spending. However, critics of tax cuts would then argue that the tax cut is helping the rich at the expense of the poor.  In other words it removes the ability of the government to make people dependant as they can not funding all their entitlement programs.

Let’s look at it like this.  Cutting taxes generally increases disposable income, which can boost consumer spending, directly enhancing GNP. If tax cuts succeed in increasing economic growth, the rich and poor may both benefit.  You see if you have more demand for product you need more labor to make it.  If you need more labor you have to create more jobs.  If you have more jobs then you need less government assistance.  If you need less government assistance you need less government.  If you need less government then… well you get the point.  This is a chain reaction, a domino effect, and we are waiting for that first domino to fall.