Do tax cuts stimulate the economy? - Jonathan Smith
When President Ronald Reagan began his first term in 1981, the US economy was struggling. Unemployment rates were high and getting higher, and in 1979, inflation had peaked at an all-time high for peacetime. In an effort to combat these issues, Reagan's administration introduced a number of economic policies, including tax cuts for large corporations and high-income earners. The idea was that tax savings for the rich would cause extra money to trickle down to everyone else, and for that reason, these policies are often referred to as trickle-down economics.
From the 80s to the late 90s, the US saw one of its longest and strongest periods of economic growth in history. Median income rose, as did rates of job creation. Since then, many politicians have invoked trickle-down theory as a justification for tax cuts— but did these policies actually work, either in the sense of stimulating economic growth, or in terms of improving circumstances for Americans? Would they work in other circumstances?
To answer these questions, the main things to consider are whether the impact of the tax cut on the government’s tax revenue is harmful, whether the money saved in taxes actually stimulates the economy, and whether stimulating the economy actually improves people’s lives. The idea behind tax cuts is that if taxes are too high, people will be less willing to work, which would ultimately decrease tax revenue. So, at a lower tax rate, the government might actually gain more tax money that it can theoretically put towards improving life for its citizens because people will work more when they get to keep more of their earnings.
Of course, there’s a limit to how much the government can cut taxes: at a zero tax rate there is no tax revenue, regardless of how much people are working. So while cuts from a very high tax rate might be fine, cuts from a lower tax rate might be counterproductive, hampering the government's ability to accomplish crucial things. Tax rates were extremely high when Reagan took office. His administration cut the highest income tax bracket from 70% to 28% and corporation tax from 48% to 34%. By comparison, as of early 2021, those rates were 37% and 21% respectively.
When tax rates are lower, tax cuts for the wealthy can be harmful. For example, in 2012 to 2013, lawmakers cut the top tax-rate in the state of Kansas by almost 30% and reduced some business tax rates to zero. As a result, the government’s balance sheet immediately fell into negative territory and did not recover, implying that wealthy individuals and companies did not invest back into the economy. In short, the money did not trickle down.
This appears to be a trend: in a study over multiple periods of history and across 18 countries, The London School of Economics found that cutting taxes increased the wealth of the top 1% of people but had little effect on the economy as a whole. In order for tax cuts for the rich to truly stimulate the economy, they would have to spend the saved money putting it back into, for example, local businesses— but this isn’t what happens in practice.
No economic policy operates in isolation: each time and place is unique with multiple policies in place simultaneously, so there is only ever one test case for each set of scenarios. This makes it difficult to deliver definitive rulings on whether an economic policy worked, whether something else might have worked better, or whether it would work in a different situation. And yet, rhetoric around trickle-down economics, both during the Reagan era and since, often promises something definitive: that spending by society’s richest members on things other than taxes directly improves the financial circumstances of the less wealthy. And there’s not much evidence to support that.