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The Logic of a Tax Cut

We frequently see claims that a lower tax rate – particularly of corporate or personal income taxes – will work miracles. That is seldom the case.

First, the stated tax rates are not the realized tax rates. While on paper someone with $500,000 in income is paying a 39.9% rate, the rate on the first $450,000 in income is lower: even without deductions the average rate drops to 29%. With the normal array of deductions for mortgages and this and that it will be lower. Yes, as economists we look at marginal rates. But is someone in this tax position working for an hourly wage, where they can choose to put in another hour a day and thereby boost their income, but aren’t doing so because they just don’t earn enough? (Working 10-hour days and 6-day weeks gives 3000 hours a year, so they’re earning $160 an hour before tax, $100 an hour after income tax. [There are other taxes.] So dropping taxes to 30% so that they earn $117 an hour will lead them to work 3200 hours??)

The example above is for individuals. If your income is high, though, you’re unlikely to be earning all of this as a wage. Everything else – dividends, gains on shares – are taxed at lower rates. Unfortunately W&L doesn’t pay me with stock options… Anyway, the ability to shield income is far greater for large corporations, many of which pay no tax at all. Cutting taxes from zero to zero provides no incentive effect.

…there’s not much room for a boom…

Second, for companies the incentive is presumably to expand their business. Cutting taxes provides a higher return on investment. So does lowering interest rates. But we’ve already performed the latter experiment many times over, we have a lot of data on how that affects business investment. The answer is that on the margin the impact is almost nil. Most businesses have a hurdle rate of return that they use, one that surveys show is infrequently adjusted. The bottom line, robust across work in different time periods and different countries with several different methodologies, is that expectations affect investment, but that small changes in the cost of capital from shifts in tax rates and interest rates do not.

Exploring the latter is a potential Econ 398 Capstone project.

Now relative to the recent distant past there is room for improvement. As we’ve just read, that distant past was also one of higher real and nominal growth rates. In addition, the US economy is approaching its full potential (full employment, high capacity utilization). There’s not much room for a boom.

There are tax rates that are high, particularly for power workers. Even on minimum wage you need to pay social security and medicare taxes. You may lose benefits if you go back to work, even part-time at a low wage, if you’re on disability or receive certain other benefits. That can result in an effective tax of over 100%. Those in the next administration operate in a world where they never encounter such taxes.