Tax cuts spur growth, but not always

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, economists Robert Barro and Charles 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 one percentage point raised the next year’s per-person economic output by about 0.5 percent.

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 — posing a conundrum of how a tax cut may affect your working behavior.

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 people’s work habits are just one of the ways tax policy ripples through the economy.

Although many conservative arguments around the pro-growth effects of income tax tend to focus on the marginal rate — how much people must pay on each incremental dollar of income they receive — there are also situations where cutting other rates to leave more money in people’s pockets matters.

When the economy is in recession, both conservative and liberal economists have argued that tax rebates (like one supported by George W. Bush in 2001) or reductions in the payroll tax (which were a part of Barack Obama’s stimulus efforts in 2009) can help support demand in the economy and promote short-term growth.

But the more you game out the various ways taxes can affect the economy, the more obvious it becomes why the economic impact of tax cuts is so uncertain and subject to debate.

For one thing, taxes exist for a purpose — funding the government — and it doesn’t help much to look at one side of the government’s ledger, taxes, without also looking at the other, spending.

That is to say, in assessing the economic impact of taxes, it helps to know what the tax money is going toward. If taxes are raised to pay for programs that increase the productive capacity of the country — programs that make workers more efficient, or infrastructure projects that have longlasting benefits — the net effect on growth is more likely to be positive than if the projects that tax increases pay for are wasteful.

That’s not to say that different taxes are likely to have different implications for growth. While economists are divided on whether the corporate income tax is ultimately borne more by shareholders or by workers, it’s fairly straightforward math that a lower tax rate on businesses lowers the threshold at which companies can justify capital investments, which over time should lead to greater investment.

Conversely, consumption taxes, like the sales taxes charged by many states or value-added taxes charged in many countries around the world, seem to cause less of a drag on growth than taxes on income and investment. After all, they don’t tax work or investment, the roots of economic growth.

And even most diehard liberals would agree that taxes can be damaging to the economy if they are overly complex to comply with, erratically enforced, or set at levels so high that the incentive to evade them is high. The dispute, of course, is what would count as too complex or too high.

“Tax increases associated with productive investments can help growth, and deficit-financed tax cuts can harm growth,” said Chye-Ching Huang, who studies taxes at the Center on Budget and Policy Priorities. “Some people claim there’s a broad consensus that tax cuts are good or bad, but there isn’t one, because the question is too big. The answer to a question that imprecise is always going to be, ‘It depends.’ ”