The Impact of Tax Cuts - Essay Example

The impact of tax cuts The main purpose of this paper is to find out the effect of tax-cuts on both micro-economic and economic environment of a country. The paper follows this objective through a review of literature and a quantitative assessment of the issue from both positive and negative fronts. It is discovered that a progressive taxation system is a culture that has already been embedded in people over along span of life. As a result, citizens do not oppose tax reform especially with a promise of stimulating economic activity. However, none of the promised gains from the taxation system has matched the real results. It is, therefore, necessary that the government implements a tax-cuts with caution and one of the ways of achieving this is letting the tax cut on the rich expire and extent AMT at a permanent way. Introduction In lieu of turning around the living standards of individuals, family and society through promoting economic activity, different national administrations around the world have brought together economists and lawyers to draft government policies whose principal pillar is tax cuts. The most notable of all is that tax cut polices are the ones proposed and enacted by The President George W. Bush’s administration in years 2001-2003. The basic tenet of this ideology is the macro-economist approach of supply-siders that, according to the Laffer’s curve, a reduction in the tax rate especially for the middle class increase their spending, which in turn increases demand that forces supply to increase by the law of demand and supply. Eventually, this leads to an increase in economic activity. Increased economic activity means that the labor market absorbs many people and at a better pay, people pay low prices for commodities, business have more capital to invest, and government can broaden its tax base by closing tax breaks and other tax leaks. However, there is no empirical backing to this claim, by the respective governments, even after adopting tax cuts on temporary terms. This is explained by the fact that reducing the tax rate actually increases government debt in the long-run, which may cause budgetary problems in the future. The best way of dealing with this is to reduce tax rates and simultaneously reduce government spending in response to reduced government revenue. However, in an effort to ensure equality, welfare and improved living conditions/standards for all, some essential services are not an obligation or mandate of players such as the corporate world, but the responsibility of the government. In this view, reducing spending may not be an appropriate option. Although the controversy surrounding the tax cuts debate is legitimate, the issue remains complicated. The complexity arises out of the fact that, although legitimate empirically backed reservations (legally and economically) are raised on tax cuts, related proposed policies have been adopted and implemented in bipartisan ways. This implies that tax cuts are there and will be there as long as they are politically correct and the majority approves it on its basic first sight implication of reducing tax burden. Therefore, how can the minority (economic experts) who are bearing the correct but bitter truth be heard and given an opportunity to suggest better ways of ensuring equality and welfare of all without causing budget deficits or failing to stimulate economic activities through encouraging increased business activity? This situation leads to the following general claim (hypothesis) for this study. H0: Although tax cuts may seem necessary for the sake of the majority of a country’s population, its burden to the same population in the long-run may be unbearable. Literature review A number of studies have been done with respect to tax cuts and have arrived to more or less similar conclusion, on both sides of the coin. This means that, in general, the available literature highlights the benefits of tax cuts, and at the same time indicates the manner of countering the associated challenges and the potential long-run burden of budget deficit. Moreover, on a general scale, available information shows that that tax cuts have are getting their way to being adopted permanently. However, will this come with solutions to the present and foreseeable problems of such decisions? The dimensions the various literatures bring on the fore helps in finding a possible answer to this question. Economically, the idea of tax cuts can be said to begin and grow, which is based on the Say’s law as well as the Laffer’s curve. Say’s Law holds that production/supply of a commodity creates its demand and at same time demand for other products to the complete level of its own value (Atkinson 50). This was used by classical economists to explain the position of production (supply) in stimulating economic development. They argued that consumption (demand) was just a secondary outcome of economic development, but the primary source is production. This was followed by Laffer contribution that concentrates on the impact of marginal tax rates in terms of incentive to work as well as save those impacts the supply side growth or what is referred to by the Keynesians as potential output. Although Keynesians focus on the long run changes in the supply-side growth rate, the new supply-siders always promised short-term outcomes (Blinder 23-62). According to the Laffer curve, tax revenues and tax rates were different such that too low or too high tax rate may not cause high tax revenues. It was the feeling of the supply-siders that, in an environment of high tax rate, establishing the right level of tax rates through lowering the rate can result in high revenue by enhancing the economic growth. As a result, supply-siders advocated for bigger reductions in capital gains and marginal income tax rates as a way of encouraging allocation of assets to activities of investment that would lead to more supply. The increased aggregate supply in turn would cause increased aggregate demand. Moreover, to cater for inflation, the supply-siders suggested indexed tax rates of marginal income, as monetary inflation pushed wage earners into upper levels of marginal income that stayed static. Wages increased to keep purchasing power with prices, the levels of income tax were not adjusted simultaneously and, therefore, wage earners were moved into upper levels of income tax than the intention of the tax policy (Case and Fair 641-52). Based on the Laffer curve, the Kennedy administration reduced taxes to 65% from 95% in top marginal rate, which increased the government revenue. On the other hand, Reagan decreased taxes from 50% to 28% in top marginal rate, which increased the government revenue for approximately half a trillion dollars throughout his term. Doctors Peter Orszag and William Gale’s analysis of adoption tax policies by Bush Administration in 2001-2004 portrays a disturbing picture of the current tax policy. The policy is found to be fiscally irresponsible as well as decreasingly progressive. They conclude their analysis by suggesting that lawyers and economists work together to come up with a policy that will endeavor simultaneously for fiscal discipline and economic justice (Gale, Orszag and Shapiro 1-2). An analysis of the tax cuts of 2004 indicated a number of implications. First, the four bills would generally decrease federal tax revenues over the decade running 2004-2014, presuming that ATM relief is permitted to expire on schedule. Nonetheless this scenario was doubted because without relief, close to 30 million people would be subjected to the ATM by 2010. In essence, the four bills were capable of actually increasing the number of the people subjected to ATM compared to law without the tax cut, unless the government extended the temporary ATM provisions. However, permanently indexing the ATM would increase decade cost of tax measures up nearly $1 trillion. Because the entire provisions made permanent were intended to expire within 2010, the package cost grows radically after 2010. The cost, to the tune of 70 percent, is incurred in the last four years. The whole package’s costs decline moderately after 2011, as taxpayers increasingly get subjected to the tax (Burman 15). The AMT taxpayers receive zero benefit from the expansion of 10-percent bracket or the marriage penalty relief (nonetheless the child provision of credit is openly excused from the AMT and, therefore, goes on to augment the cost over time). However, if ATM relief becomes permanent, its cost becomes significantly bigger by the aid of other provisions. The AMT relief cost grows over time at a faster rate than the general economy due to ATM parameters not being indexed for inflation in the law without policy. This implies that more and more people get subjected to AMT as well as the average tax rate within the AMT increases as inflation forces more people into top levels AMT tax. The policy has also distribution effects. Analysis shows that calling the four bills a middle-class tax relief was a misnomer. A part from the expansion in the 100percent tax level, the entire provisions would result into more than 50% of middle-class benefits to the households (20 percent) with the highest incomes. The ATM relief is one of the most skewed elements especially towards the top 20 percent. The group would receive more than 95% of the benefits and more than 71% of relief from marriage penalty because a 15% tax level expansion for married couples just assists those in higher levels. Even though increasing from $700-$1,000 substantially benefits the middle-class households, the largest beneficiaries on per capita basis belong to high earners who become newly eligible to the $1,000 credit. Because of this, more than 50% of the benefits from child credit increase accrue to top 20 percent. Primarily, the 10-percent level expansion is the only one that the middle-class families benefit from. Nearly two-thirds of the provision’s benefits would go to the income distribution’s middle three-fifths (Urban Institute And Brookings Institution 1-2). These estimates of distribution absolutely presume that even if $1 trillion might be forgone throughout the next decade, there would be no impact on the supply of the citizen valued government services or level of future taxes. Indeed, the tax cuts should be paid for, meaning that, in the long run, winners and losers will exist. The real occurrence of the net benefits change relies on exactly the way the lost revenues are constituted. Nonetheless, many clear beneficiaries of this package that would be the fourth main tax cut could become worse off in the long run. These policies also cause some economic effects. The tax cuts have always been rationalized on the basis that they would promote long-run economic growth. However, that argument does not make sense in this package. A few taxpayers would relatively see a decrease in their rate of marginal tax after 2005 when the provisional AMT relief is planned to end. Due to these, there would be insignificant effect on incentives to save, work, or invest in unproductive shelters of tax (Burman, Gale and Rohaly 105-117). Furthermore, by adding the tax cuts to the growing budget deficits, interest rate rises and discourages firms from investing (businesses) as well as consumers from purchasing cars and homes. Such responses would have a tendency to stifle economic growth. Generally, even if there were no tax cuts, the deficits that was facing the federal government was well over $400 billion yearly, or approximately 20% of the federal spending (Friedman and Shapiro 1-3). With the proposed tax cuts, revenues would be reduced by more than $530 billion over the subsequent decade. In case this is not paid for, either via offsetting tax increases or spending cuts, they would augment the deficit by $637 billion, which consists of the extra interest on the public debt. This cost nonetheless is a considerable underestimate of the actual cost (Friedman and Shapiro 1-3). Presuming that the provisional AMT relief is extended consisting of indexing for inflation, overall revenue cost would be nearly $1 trillion, and nearly $1.2 trillion consisting of interest. Tables 1: Tax Cuts and the 2004 Deficit (excluding economic effects) As Percentage of GDP 2004 deficit with tax cuts 4.20% Cost of tax cuts 2.60% 2004 deficit without tax cuts 1.60% Source:  CBPP calculations using data from the Congressional Budget Office and the Joint Committee on Taxation. Tax –cuts greatly influences the budget of a nation by creating deficit in the long-run, even though it is thought to have short-term results on the economy. In fact, the tax cuts contribution to the present deficit goes beyond the contributions that are attributed to other factors like the economic downturn. A study by CBO discovered that the direct impact of the business cycle explains just six percent of the deficit in 2004. To address this problem, the administration proposed reductions in the domestic discretionary spending. The cost of tax-cuts, nonetheless, remained 18 times the augmentation in domestic discretionary expenditures. Tables 2: Historically Low Revenues, Behind Current Deficit, Not High Spending As Percentage of GDP Average, 1980-2003 2004 Spending 21.1% 20% Revenue 18.5% 15.8% Deficit 2.6% 4.2% Source: The Congressional Budget Office. Methodology The subject of tax cuts has attracted several studies since the proposal of 200-2003 house tax cuts under the Bush administration. As a result, various quantitative and qualitative analysis of the relevant data provided by the budget office have been done over the last decade. All these studies have arrived at more or less similar conclusions on whichever side of the coin they chose to focus. Based on the same primary and secondary data, this study undertakes a meta-analysis of the data as gathered by these studies. Because these studies have already been done using the right empirical methods, it would be appropriate to combine these data for a better analysis. These will consider the framework identified in the literature review which includes getting data on the effects of the proposed tax including revenue generation, distribution effect and economic effects. Data and Analysis Data analysis will be conducted on the basis of statistical findings of the existing analyses and reports on the legal and economic implication of tax cuts. The results of the analysis come in form of tables and graphs. The Congressional Budget estimated that the federal revenues would fall to their minimal level as a portion of GDP. 15.8 percent from 1950. As a portion of the economy, the revenue base would be minimal than it was prior to programs such as Medicaid, Medicare, as well as the interstate highway s were there. On the other hand, sum of federal spending in FY2004 is not approximated to be at especially high levels as a portion of the economy. According to CBO, federal spending was 20% of GDP in FY2004, a level which is lower compared to the 22 years, running from 1975 to 1996. Table 3: Distribution of Tax-Cut Benefits in 2004 (shows/reflects tax-cuts enacted since 2001) Income class Average tax cut %age increase in after-tax income %age Share of tax cut Middle 20 percent $647 2.3 % 8.9% Top one percent $34,992 5.3 % 24.2% Over $1 million $123,592 6.4% 15.35 Source:  Urban-Bookings Tax policy center. In the same manner the distribution of tax-cuts recorded in FY2004 are, it is likely that the distribution will become even more biased over time. This results from the fact that tax-cuts are more useful to the middle-class, whereas some of the tax-cuts are more useful to the high-income households. The situation is such that if implemented, the middle fifth households would get the same tax-cut which they are scheduled to get within 2004 law, whereas the top level’s one percent would get tax-cuts significantly larger than within the 2004. Table 4: Average Value of Tax-Cut Benefits 2004 Income class Three “Middle class” Provisions All other Tax-cut provisions Middle 20 percent $547 $1000 Top one percent $1,320 $33,672 Source: Urban-Brookings Tax Policy Center From table 4, the distribution of the “middle-class provisions” is in bleak contrast, though to the tax benefits distribution within the outstanding tax-cut provisions. The higher one percent, according to amount of income, will get an average tax-cut of nearly $33, 700 from the entire tax-cut provisions in 2004, whereas the middle fifth households will get an average tax-cut of only $100. Another group of tax cuts offer those top income scale with an average tax profit greater than 300 times bigger than the profits, which those in the middle income bracket are getting. This gap will broaden even more over time. Specifically, the three “middle-class provisions” explain only one third of the entire tax-cuts cost over time. Table 5: President’s 2003 Stimulus Proposal %age of Proposed tax-cut that: Possess high “bang for buck” 19% After economy in the Short run 21% Are effective stimulus 4% Having been enacted in 2003, the stimulus bill was moderately more efficient in offering short-term incentive to the economy as compared to the original proposal by the president, because it consisted of state fiscal relief. However, only 8 to 14 percent of the cost incentive legislation enacted within 2003 had encompassed high “bang-for-the-buck” short-term incentive proposals. The information, here, shows that the purpose of the 2003 legislation was neither for job creation nor growth in the short-term (Friedman and Shapiro, Tax Returns: A comprehensive Assessment of the Bush Administrations Record on Cutting Taxes.). Figure 1 deficit pattern The administration justifications do not eventually reduce the budget deficit, but enhances it. With reference to Congressional Budget office (CBO) data at the beginning of 2001, the 10 years cost of extending the entire tax-cut measures within the law, which had a provisional status was $22billion. On the other, if the provisional tax-cut provisions that operates in law were entirely extended, their cost within a decade (in 2014) stands at $431 billion. Figure 2: Job from summer 2003 to December 2004 The first three years, which were expected to conform to the projections of tax cuts stimulating employment, fell short. For instance, the Institute of Economic policy from summer 2003 has been making comparisons of actual job creation to the job creation forecasted by the administration after enacting 2003 tax-bill. In this sense, 5.5 million Jobs were predicted to be created between summers 2003 to December 2004, but only 689000 jobs were created, accounting for only 13 percent of the prediction by the Administration. Generally, difference between the predicted and actual shows a big gap in the policy. Discussion and conclusion By October 2005, it was noted that changes in tax law since 2001 had cost the federal government to the tune of $929 billion consisting of $860 billion in direct cost as well as $69 billion in interest. Those who engineered the tax cuts had promised greater economic gains than it was usual, but that did not happen. Unfortunately, for most Americans, approximately every wide measure of economic activity-jobs, GDP, business investment, and personal income amongst others fared badly over the period of 2001-2005 than in the previous business cycles. At the time, there was only one bright point in the economy, which was residential investment. However, that sector registered a decrease in tax incentives since lower income tax rate decreases the value of deductions for the real estate taxes and mortgage interest. For an individual with a mortgage bearing $10,000 in interest, there is a $3,500 reduction in taxes, with about 35% tax rate as well as by $3,000 bearing a 30% rate (PEW Economic Analysis Group 1-4). Although the tax cuts failed in stimulating the economy, they considerably reduced revenues. In the FY2005, the cost of the entire tax cuts passed from 2001 combined amounted to $260 billion (out of which $35 billion stood for interest), a total that would pay off most of the FY2004’s Unsustainable $317 billion deficit. With the extension of the tax cuts and acceptance of reasonable assumptions concerning future spending, the deficit would indefinitely stand at approximately 3% of the GDP (or greater) (Price 3). A better solution, in this case, was to let the top income tax cuts expire and use the revenue to finance additional cost-effective job creation policies. The idea is to allow the economy to stimulate while at the same time decreasing the deficit over the long-term. This means that the cost of the extension of the upper-income tax cuts by the Bush administration in terms of both lost opportunities and dollars is inappropriately high. This can be explained by looking at the 10 economic expansions that have occurred from 1949. The most recent expansion of 2001 via the end of 2007 is very low compared with others in terms of stimulating economic growth, employment, national investment and employee pay (Fieldhouse and Irons 35-41). Thus, the Bush-era tax policies were far from causing economic progress. This means that policies in this line should be designed in such a way that they permits appropriate governance and revive the economy without causing a negative outcome. Works Cited Atkinson, Robert D. Supply-side Follies: Why Conservative Economists Fails, Liberal Economics Falters, and Innovation is the Answer. Lanham: Rowman and Littlefield, (2006): 50. Print. Blinder, A S. "Can fiscal policy improve macro-stablization". In Kopcke, E.; Tootell, G. M. B.; Triest, R.K. The Macroeconomics of fiscal policy. Cambridge, MA: MIT Press, (2006): 23-62. Print. Burman, E Leonard. An Analysis of the 2004 House Tax Cuts. Policy Analysis. New York: The Urban Indtitute and The Tax Policy Center, 2004. Print . Burman, E Leonard, G William Gale and Jeffrey Rohaly.""The AMT:Projections and Problems," ." 7 July 2003. Tax Notes. 12 February 2014 . Case, K E and R C Fair. Principles of Economics. Upper Saddle Rive, NJ: Prentice Hall, (2007): 641-52. print. Fieldhouse, Andrew and John Irons. "Let the tax cuts for the rich expire." MIlwauke Journal Sentinel (2010): 1-3. Print. Friedman, Joel and Isaac Shapiro. ""Who Would Pay for the Houses "Free Lunch" Tax Cuts?"." 18 May 2004. Center on Budget and Policy Priorities. 12 February 2014 . —. "Tax Returns: A comprehensive Assessment of the Bush Administrations Record on Cutting Taxes." Center on Budget and Policy priorities (2004): 1-13. Gale, G William, Peter Orszag and Isaac Shapiro. ""The Ultimate Burden of the Tax Cuts"." 2 June 2004. Center on Budget and Policy Priorities. 12 February 2014 . PEW Economic Analysis Group. "Adendum: Decision Time: The Fiscal Effects of Extending the 2001 and 2003 tax cuts." Fiscal Analysis Initiative (2010): 1-4. Print. Price, Lee. Economy pays price for Bushs tax cuts. 26 October 2005. 12 February 2014 . Urban Institute And Brookings Institution. A preliminary Anaysis of the 2008 Presidential Candidates Tax Plans (Full Report). Full Report. New York: The Tax Policy Center, 2010. Print. Read More