Income Tax Cuts Increase Growth but Reduce Revenue

November 10, 2014
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Some of the most heated debate over taxes focuses on a single feature of the tax code: the top marginal rate. Some people argue that the top marginal rate on income is an important feature in the incentives to work and invest. Others argue that the top bracket of the income tax is a key source of revenue for public priorities. Both arguments are fair.

In 2012, a deal was passed that increased the top marginal rate from 35% to 39.6%. In order to illustrate the effects of the top marginal rate on government revenue and the economy at large, I ran a simple tax change through our Taxes and Growth model. I reversed the 4.6 percentage point increase in the top rate and found the following effects on the economy over the long term:

GDP 0.43%
Static Revenue Change -$27.6 billion
Dynamic Revenue Change -$14.8 billion
Hours Worked 0.23%
Private Business Stocks 0.99%

Income taxes affect the economy by changing incentives. Cutting taxes on personal income increases the returns to work; people would work slightly more as a result of this tax change.

An additional peculiar feature of the personal income tax code is that it also affects small businesses; some businesses, known as “pass-throughs,” file their taxes through their owners via the individual tax code. Taxes on these businesses tend to hurt the economy at large much more than taxes on regular individuals by lowering the return on the sort of new business projects that raise wages and create jobs. Our model shows a small uptick in business investment as a result of a personal income tax reduction.

While this feature of the income tax is important, it is somewhat limited in scope. The vast majority of personal income is wages and salaries. This is even true for Americans with high incomes. The top bracket is mostly about high salaries, not about small businesses. Income taxes could be made more efficient if a comprehensive tax reform took business income out of the personal income tax.

In the end, some of the revenue of the tax cut is returned to the government as a result of the increased private-sector labor and investment.

At the beginning of this post, I acknowledged two reasonable, fair arguments about the income tax. The first is that it creates incentives, and people change their behaviors in response. The second is that it is a strong source of revenue. Both of these arguments are consistent with the results of the Taxes and Growth Model. We should also, then, say that the converses of these arguments are unreasonable.

It is unreasonable to say – as the current “static” models of tax bills do – that income taxes do not affect the economy. But it is also unreasonable to say that cutting top personal income taxes would produce more revenue. These tax cuts aren’t even close to being self-financing. The national dialogue on taxes and spending would be far better without these unreasonable arguments.

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