Do Tax Cuts Matter?

October 26, 2017

Who doesn’t like a tax cut? If personally choosing between more taxes or less, every one of us would vote “less.” So, when the proposed tax reform promises to not only put more dollars in Americans’ pockets but also greatly stimulate the U.S. economy, the knee-jerk reaction is “that sounds great!” But is it? Do tax cuts always spur economic growth?

The answer is not clear cut. Ask yourself, if your tax rate were lowered, would you work more because you’d get to keep more of what you earn? Or work less because with lower taxes, you could maintain your standard of living working less hard? Maybe you wouldn’t change your behavior at all? That’s the dilemma of cutting taxes – the impact on economic activity isn’t necessarily a certainty.

Some economists have argued that tax cuts lead to higher income, more jobs, and greater economic growth. High earners would invest more in new businesses, creating jobs for those down the economic ladder. Low earners would spend more because they have more to spend. Overall, economic activity would increase. Is this true?

The 1981 tax cuts were the largest in American history. They were intended to bring the U.S. economy out of recession. Tax rates were lowered across the board and the top rate was reduced from 70% to 50%. Did the cuts work? For the most part, yes. The U.S. economy recovered. However, the recovery was not only due to tax cuts but also to the Fed drastically lowering interest rates and the government increasing spending on infrastructure and defense. As a side note, the increase in economic activity didn’t fully offset the tax cuts and the increases in spending, causing the national debt to grow by almost $2 trillion.

In 2001 and 2003, taxes were reduced. However, these cuts had a negligible effect on economic growth. Furthermore, because the cuts were accompanied by an increase in spending on the wars in Afghanistan and Iraq, the national debt grew by nearly $5 trillion as a result. On the flip-side, in 1993, taxes were raised, the economy boomed, and the budget was balanced by the end of the decade.

Lowering taxes can spur economic growth. However, tax cuts and economic activity aren’t perfectly correlated. The magnitude, nature, and permanency of the cuts matter. It’s also important not to lose sight of how tax cuts can ultimately have an impact on deficits and debt. If not paid for by cuts in spending or if increased economic activity doesn’t materialize, deficits increase and the national debt grows – neither of which is good for the economy and the markets in the long run.

So, what about the latest tax proposal? Because we don’t yet have many details, it’s difficult to predict its impact on the economy. However, a potentially lower corporate tax rate could boost company earnings and allow for U.S. corporations to bring cash back into the country at a lower rate. These are both positives for the economy and the markets. The effect of potentially lower personal tax rates is harder to surmise as it will depend upon what other tax reforms accompany the cuts and how the cuts are spread across income brackets. And, as far as how tax cuts might impact the deficit, that too, is tough to predict. If net revenue decreases because the tax cuts aren’t offset by increased economic activity, spending cuts, or both, then deficits will result and the national debt will grow.

Stay tuned…