Unit 4: Impact of Tax Cuts on Jobs

Questions that comes up time and time again in the synoptic paper are the following:

Does any evidence exist to support the argument that tax cuts for the wealthy will lead to an increase in jobs here in the U.S., not abroad?

Any evidence that "trickle-down" economics is valid?

What are the benefits of "supply-side" economics, particularly for the working class, the middle-class if you will?


Cutting taxes can have two effects:

1.Short term boost in demand as people have more income to spend

2.Long term increase in productive capacity as people more willing to work.

Do Tax cuts for the wealthy increase jobs?

Tax cuts can lead to an increase in jobs. For example, the UK has a 50% rate of marginal income tax for those earning over £145,000 a year. At this rate of marginal tax, there is a reasonable degree of disincentive to work. For example, some people may be disinclined to do overtime. There may be a bigger incentive to work abroad. If you cut this 50% tax rate to 40%, it is quite likely, there will be some supply side incentive for greater innovation and investment, which could trickle down to higher growth and lower unemployment. (Economists call for 50% tax rate cut)

However, there is still a lot of uncertainty:

•How much this higher tax rate will raise for HMRC (we will find out at end of tax year)

•How much disincentive this tax rate actually is.

The impact of cutting income tax is not straight forward. There are two effects at work:

•substitution effect - tax cuts make work more attractive - increasing productivity and output.

•income effect - tax cuts mean you can earn a target income by working less. This effect encourages less work.

Also, it depends whether people expect tax cut to be temporary or lead to higher taxes in the future (to balance budget)

Therefore there is no guarantee cutting income tax rates does actually increase productivity.

Which Tax Rate boosts Productivity?

There is also a big difference between cutting a higher income tax rate of 80% and cutting an income tax rate of 30%. Yes, there is a disincentive from higher taxes but clearly a marginal rate of 80% has a much greater disincentive impact than 20 or 30%. Cutting very high tax rates should give a bigger boost to hours worked than low tax rates.

Cutting Taxes for the Wealth?

As Warren Buffet pointed out, the tax on investment income is very low in the US. He says he pays around 17% on his investment income. This is a lower tax rate than other workers in his office who pay closer to 40% in tax. If you cut tax on this investment income, there will be a very minimal trickle down effect. The wealthy just get more from their investments.

Also as Warren Buffet pointed out, when tax rates were 39% in the 1970s, the wealthy didn't leave the US. People didn't stop working. The disincentive effect of higher taxes is often grossly over-exaggerated.

Tax cuts for Wealthy v Poor

Cutting tax on the wealthy may lead to small improvements in productivity and small increase in demand. But, cutting tax on low income earners would have much greater impact on boosting growth and jobs.

A millionaire has a low marginal propensity to consume. If a millionaire gets a tax cut, he may spend some of this extra income, but he is likely to save a high %.

If you cut tax for someone struggling on $15,000 a year, they are likely to spend it all. They don't have the luxury of saving. They have a low marginal propensity to consumer.

Therefore tax cuts for low income earners have a bigger impact on increasing spending and demand in the economy.

Depends on the Tax

When you talk of taxing the wealthy it depends which tax you cut.

•Cutting inheritance tax will have little, if any impact on boosting economic investment and productivity.

•Cutting payroll taxes, will have a much bigger impact on creating incentive to employ workers.

Empirical Evidence

•Some claim the Reagan tax cuts helped create jobs (joint economic committee)

•Some expected tax increases of Clinton administration to create recession and job losses, but they didn't. The Clinton era saw one of fastest eras of job creation and economic output.

•The Tax cuts in US of 2001, led to a very poor job creation.