Tax cuts can do more harm than good

Tax cuts are the one guaranteed path to prosperity. Or so politicians have told Americans for so long that the claim has become a secular dogma.

But tax cuts can do more harm than good, a new report shows. It draws on decades of empirical evidence analyzed with standard economic principles used in business, academia and government.

What ultimately matters is the way a tax cut is structured and how it affects behavior. A well-designed tax cut can help increase future prosperity, but a poorly structured one can result in a meaner future with fewer jobs, less compensation and higher costs to society.

William G. Gale of the Brookings Institution, a nonprofit Washington policy research house, and Andrew Samwick, a Dartmouth College professor, last week issued the report, “Effects of Income Tax Changes on Economic Growth.”

Gale said he expects emailed brickbats from those who have incorporated the tax cut dogma into their views without really understanding the issue.

“The idea that tax cuts raise growth is repeated so often it is taken like a form of gospel,” Gale told me. “We are not buying into that gospel” because it fails to consider their total effects.

Gale and Samwick show that while tax rate cuts can stimulate the economy immediately and, if well designed, encourage the savings and investment to support long-term growth, they can also do harm. When cuts are financed with borrowing, as they have in the post–Ronald Reagan tax-cutting era, it just pushes tax, plus interest, into the future.

How taxes are cut matters too. Tax cuts can discourage work, create windfalls for existing investments without encouraging new investment and tilt the playing field in ways that produce unproductive investments.

Tax cuts have proved to have some paradoxical effects. Although they are supposed to put more money in people’s pockets that they can then save or invest, tax cuts can have negligible or negative effects on savings rates and investment.

Consider the data on personal savings rates. The graphic below shows the personal savings rate peaked right after the brief but sharp 1973–74 recession, as unions began to shrink. Savings were rebounding until Reagan’s tax cuts started the long-term tax cut trend, which continued until 2012. As income tax rates were cut and federal deficits grew, savings rates trended down. 

Why is that? Lower income taxes should induce more savings because people retain a larger share of their gross income. But only people with more income than they need to get by can save. If deficit spending reduces private investment and paychecks stagnate, then personal savings rates would be expected to decline.

Tax cuts can also have a negative effect on national savings rates, which include not just personal savings but also government savings. If a tax cut is financed with government borrowing, then overall national savings must be less. When tax cuts are not matched with spending cuts, it increases federal budget deficits, as the 1981 and 1986 Reagan tax cuts and the 2001 and 2003 George W. Bush tax cuts did.

If federal deficit spending rises by the amount of tax cuts, the ultimate result is no tax savings; the obligation to pay is just postponed into the future along with a growing bill for interest charges. The interest expense means less is available for investment, which in turn means less growth.

Lower tax rates may also discourage investment. Consider a small business facing a 60 percent tax on each added dollar of profit. If the profit is reinvested — say, by buying new equipment — the tax is avoided, the owner spends only 40 cents on the dollar compared with paying tax on the profit and taking it home, and the increased investment should mean more jobs and more profits.

But if the tax rate is cut to 35 percent, the owner has to put up two dollars of his or her money against one dollar of tax savings. That may encourage the owner to take the money for him- or herself, spending it on economically inefficient things such as a bigger house and fancy clothing. 

All of this is more complicated and has more parts than these simplified examples, but the broad point remains: While tax cuts may encourage economic growth, they do not automatically do so and can often have negligible or negative effects, depending on their structure. Understanding how the design of tax policies affects behavior is crucial to understanding whether their likely outcome is a better or worse future.

Unfortunately for Americans, the design of Bush’s 2001 tax cuts was focused on producing a short-term sense of confidence by putting more money in people’s pockets in ways that did little to nothing for the future and, the evidence shows, actually harmed the economy. Americans who earned more than 99.9 percent of the rest of the population got 12.5 percent of the tax cuts. While many at the top saved their tax cut money, for many millions of Americans the cuts only partly offset falling wages and did not add to overall spending or saving.

Gale and Samwick, citing numerous studies, some theoretical work and empirical evidence, came to this conclusion about the 2001 Bush tax cut: While the lower tax rates encouraged more work because people can keep a larger share of what they earn, that benefit is smaller than the damage from higher federal budget deficits.

This is not a new insight, just one drowned out by chants from tax cut cheerleaders. The crucial idea to remember, Gale said, is that “there is no one size fits all for responses to tax policy.”

The simple truth is that the structure and financing of tax policies determine whether they benefit the economy. The net result of a tax cut without government spending cuts, the pattern since the Reagan era, is that at best there is a tiny improvement in economic growth but with a high cost and potentially negative effects on savings and investment.