How Tax Cuts Affect the Economy

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How Tax Cuts Affect the Economy

Tax reduction supporters say that lowering taxes boosts the economy by increasing expenditure. Those who oppose the cutbacks argue that they solely benefit the wealthy while reducing government services on which lower-income people depend.

Key Takeaways

• Tax cuts diminish government income, resulting in a budget deficit or an increase in national debt.

• The federal tax system generates money via a variety of levies, including income tax and payroll tax.

• Tax reduction supporters say that cuts improve an individual’s or family’s disposable income, stimulate spending, and help the economy thrive.

• Opponents of tax cuts argue that they solely benefit the wealthiest while reducing critical government services for the poor.

Understanding the Tax System

The federal tax system generates income via a variety of levies. Income tax is by far the most important source of money. The Internal Revenue Service (IRS) collected a net $2.35 trillion in individual, estate, and trust income taxes in 2021, accounting for 57.1% of the total.

Personal income taxes are collected on wages, interest, dividends, and capital gains, with ordinary income rates varying according to income.

The payroll tax, which finances Social Security and Medicare payments, is the country’s second biggest source of income. In 2021, the IRS collected a net $1.26 trillion in payroll taxes, accounting for 30.6% of the total. The payroll tax is a predetermined percentage of earnings and salaries that is paid equally by both the employer and the employee.

The corporation tax provided 10.2% to the national coffers, while the excise tax on commodities like fuel and cigarettes contributed 1.4%.

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2021 Tax Revenue by SourceAmount% of Total
Business Income Taxes$419,008,84110.2
Individual and Estate and Trust Income Taxes$2,348,054,22457.1
Employment Taxes$1,258,170,88630.6
Estate and Gift Taxes$28,045,7390.7
Excise Taxes$58,289,8221.4
Total Collected$4,111,569,512100

Source: IRS

A Shifting Tax Burden

Tax policy is used by the federal government to produce money, and it typically attempts to burden those taxpayers who would be least impacted, who are frequently the rich. However, the “flypaper hypothesis” of taxes, which posits that tax burdens adhere to where the government lays the tax, often proves to be erroneous, and tax shifting happens.

Tax shifting is an economic phenomena in which the taxpayer shifts the tax burden to the consumer or supplier by raising or lowering the purchase price throughout the commodity exchange process.

Furthermore, shifting tax burdens have been seen via tax cuts for the rich, which may have “no meaningful impact on economic growth and unemployment” and “lead to increasing income inequality,” according to a 2020 analysis of 18 OECD member nations, including the United States.

Since the 1980s, policies in nations such as the United States have often been predicated on the notion that increased taxes on the rich harm economic progress.

Tax Cuts and the Economy

Lowering marginal tax rates to stimulate economic development is a frequent strategy, with the idea that lower tax rates would provide individuals more after-tax income, which can be spent on more products and services.

This is a demand-side argument for lowering taxes as an expansionary strategy. Furthermore, lower tax rates may increase savings and investment, resulting in increased output and lower unemployment.

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Lowering taxes boosts disposable income, enabling consumers to spend more and increasing the GDP (GNP).Consumer spending accounts for almost two-thirds of GDP.

Gross National Product

GNP=C + I + G + NX


C = Consumptionspendingby


I = Investmentspending(business


G = Governmentpurchases

NX = Netexports

Tax cuts on the supply side are intended to boost capital creation. If the cutbacks are effective, they will alter both aggregate demand and aggregate supply since the price level for a supply of items will be decreased, which usually results in an increase in demand for those commodities.

The National Bureau of Economic Research investigates the long-term impacts of temporary adjustments in federal company and personal income tax rates in the United States. A corporate income tax decrease, according to their latest 2022 working paper, leads to a sustained improvement in GDP and productivity. Personal income tax cuts, on the other hand, give a short-term boost to GDP, productivity, and hours worked but have no long-term impact.

What Is Tax Equity?

Horizontal equity and vertical equity are two independent taxation ideas. The concept of horizontal equity holds that all persons should be taxed equally. Vertical equity is the ability-to-pay concept, which states that those who can pay the most get taxed the most.

What Is the Progressive Nature of Taxation?

Because of the progressive structure of the tax, tax cuts effect people differently. Reduced taxes on a household with a low adjusted gross income (AGI) save less money in total than a somewhat smaller tax reduction on a family with a considerably higher pay. Across-the-board cuts will benefit high earners more in terms of dollars simply because they earn more.

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What Does the GNP Measure and How Do Tax Cuts Increase It?

The Gross National Product (GNP) is the total worth of all completed products and services produced by residents as well as company production. Tax cuts boost the amount of money accessible to people and enterprises, which may lead to an increase in output and investment.

The Bottom Line

Tax cuts lower government income, resulting in a budget deficit or an increase in national debt. Many critics believe that the tax decrease helps the wealthy at the cost of others with less means, while programs that assist people in lower income brackets are reduced. Cuts, according to supporters, put money in consumers’ wallets and encourage spending, so expanding the economy.

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