Do tax cuts really spur growth? It depends on the details

Donald Trump's plans to induce stronger economic growth by cutting taxes won't necessarily work

If your tax rate were lowered tomorrow, how would it affect your work habits?

Maybe you would work harder — put in longer hours, take on special projects, do everything you can to get that next promotion. After all, lower taxes would mean you get to keep more of each dollar you earn.

Or maybe you would work less. After all, if you are happy with your current standard of living, lower taxes would mean that you could maintain it while putting in fewer hours at the office. Who needs that promotion when you’re able to keep more of the money you already make?

Or possibly you would work exactly the same amount, because life is too short to sit around making every decision based on what is in the tax code.

That little mental exercise — and the fact that reasonable people may choose any of the options — helps explain why the Trump administration’s plans to induce stronger economic growth by cutting taxes won’t necessarily work.

At the core of decades of Republican economic policy is a simple idea: Cutting taxes will unleash investments and lead to higher incomes, more jobs and more rapid growth. And there are historical episodes that would seem to support that idea, most notably when Ronald Reagan cut taxes in the early 1980s, and the economy boomed in the years that followed.

But there’s considerably less evidence that this cause-and-effect applies at all times and at all places. George W Bush’s 2001 and 2003 tax cuts were followed by years of disappointing growth. Bill Clinton’s tax increases in 1993 were followed by a boom that surpassed the Reagan-era expansion.

In a large body of academic research on this question, it seems that the exact time period and country examined and how tax changes are measured matters a lot — as does what the government does with the revenue.

For example, the economists Robert J.Barro and Charles J Redlick looked at the relationship, studying the United States from 1912 to 2006, and found that cutting the average marginal tax rate on Americans by 1 percentage point raised the next year’s per-person economic output by about 0.5 per cent.

But research across time periods and countries shows more ambiguous results.

“The basic finding in the literature is that it’s very hard to detect a robust impact from changing taxes to growth,” said Andrew Samwick, a Dartmouth economist who co-wrote a review of the evidence. “If you look across countries, unless they’re actually out there confiscating assets through their tax system, you don’t find a strong relationship.”

In other words, there are countries with high or rising taxes that have strong growth, and countries with low or falling rates that don’t.

Part of that has to do with the many factors that go into economic growth that have nothing to do with taxes, including demographic change and technological advances (or lack thereof), which makes trying to isolate the impact of tax changes tricky. But it also ties to the importance of understanding how tax cuts may fuel growth — and the limits of those channels.

If the government lowers income taxes on individuals, it changes the incentives for them to work and spend — going back to the conundrum of how a tax cut may affect your working behaviour.

If individual income tax rates are lowered and it leads people, in the aggregate, to work more hours or strive harder for a promotion, secure in the knowledge they will keep a bigger chunk of higher earnings, then it could increase the productive potential of the economy — and more people working more hours with higher productivity means higher economic growth.

If the reverse effect prevails — people needing to work less to support themselves thanks to lower taxes — a tax cut could even cause lower growth, in theory. But the possible effects on peoples’ work habits are just one of the ways tax policy ripples through the economy. 

©2017 The New York Times News Service