How Tax Reform Increases Jobs and Wages

January 13, 2014

In a Washington Post op-ed, Glenn Hubbard points out that the real solution to income inequality is fundamental tax reform:

“A policy shift in favor of mass prosperity — dynamism and inclusion — is best conducted via fundamental tax reform. The discussion and policies to be considered, however, should look different from those in the present debate. The Obama administration has supported raising taxes on high-income earners and corporations to pay for expanded benefits to low-income Americans. Such an approach is unlikely to raise labor demand or labor-market earnings for those or other workers.”

Hubbard is right. Tax reform can improve the economy and improve jobs and wages. But it has to be done right, by encouraging investment and economic growth. A cut in the top rate to 25 percent for corporations and individuals (and move to two rates: 25 and 10 percent) would bring increase the size of the economy by 4.74 percent, create the equivalent of 5.2 million jobs, and increase wages for all incomes groups with an overall increase in after-tax income by 7.57 percent. This is all good news.

Now, the growth effects of this type of tax reform aren't caused by some magical fairy dust – it's economics.

These tax cuts (especially the corporate rate and the capital gains and dividends rates) lower the cost of investment. The lower cost of capital means higher returns to investment, so more people invest. Start-ups receive more venture capital funds and create new businesses and jobs, because investors want to invest more money. Likewise, money becomes more readily available for existing companies to invest into better machines, faster computers, and other high tech gadgets. This new and better equipment improves workers’ productivity, which will lead to higher wages due to the increased value workers create for their company.

A similar effect is felt by workers. The decrease in taxes decreases a workers cost of additional work. The lower cost lessens the worker's disincentive to work that the high tax rate had created. Instead of receiving 60 cents on every dollar, they would receive 75 cents instead – effectively a 25 percent wage increase. This increases the number of hours worked economy wide, because people work longer hours.

Because of the additional productivity created by the extra investment and addition hours worked, the economy grows.

This is good for everyone. This means higher wages, more jobs, and a better quality of life. And pro-growth tax reform is the catalyst for all these beneficial things.

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