Econ 101: How do Tax Cuts Work?

     The recent economic expansion in the United States bolstered by news of 2 million jobs created in 2005 and an unemployment rate below 5 percent is in large part due to the 2003 tax reduction. Tax cuts create economic growth. There is little doubt that this is the case, both at the national and local levels. Lets look at how theyve worked through history.

A Short History: Tax Cuts Work
     If we look at the U.S. economy, three historical examples are the Harding-Coolidge tax cuts of the 1920s, the Kennedy-Johnson tax cuts of the 1960s, and the Reagan cuts of the 1980s. The U.S. federal income tax, established with the enactment of the 16th amendment in 1913, began with a top marginal rate of 7 percent. This quickly escalated to 77 percent by 1918. During the Harding-Coolidge administrations the top marginal rate was reduced to 25 percent by 1925. Economic output nearly doubled over the following four years, and unemployment fell sharply.

     During the Depression and World War II tax rates rose steadily, with the top marginal rate reaching 94 percent by the end of the War and remaining at 90 percent or more well into Kennedy's term. Kennedy pushed for tax cuts, which were enacted in 1964 after his assassination. The top marginal tax rate was reduced from 91 percent to 70 percent by 1965. What followed was a major expansion in the economy. Real gross domestic product rose in the four years after the tax cut by an average of 5.1 percent per year. Unemployment averaged 3.9 percent, compared to a 5.8 percent average in the four years prior to the tax cut.

     The Reagan tax cuts of 1981 dropped the top marginal rate from 70 percent to 50 percent, with additional cuts in the tax on capital gains. The top marginal rate was further reduced to 28 percent by 1988. The result was again an increase in growth in the economy. Real GDP grew by .9 percent per year between 1978 and 1982, and grew by 4.8 percent per year from 1983 to 1986. The unemployment rate was 9.7 percent in 1982. It fell to 7.0 percent by 1986, and was 5.3 percent in January of 1989.

Tax Cuts for the Rich?
     This is a history of tax breaks for the rich resulting in economic growth for everyone, especially for the poor. Just as an example, in 1920, 26 percent of Americans owned automobiles. The Harding-Coolidge tax cuts were enacted and by 1930, 60 percent of Americans had a car. Electric lighting was in 35 percent of Americans homes in 1920 and 68 percent by 1930. When the top marginal tax rate was 91 percent in 1920, only one in five people lived in a household with a flush toilet. By 1930 more than half of Americans would have flush toilets.

     Why does a reduction in the highest marginal tax rates improve the living standards of all of us? It does not occur due to some trickle-down theory that rich people will spend more money on goods and this will create jobs for the rest of us. There simply arent enough rich people for this to make sense. The real answer lies in an understanding of how markets work.

     A market economy is based on voluntary exchange. I cannot force you to buy something that I produce, and you cannot force me to produce something for you. The only way you can get rich in a market economy is to produce something that others want and are willing to pay for. Since there are not a lot of rich people, you are more likely to get rich producing something for the poor and middle class that they will want and at a cost that they can and are willing to pay.

     The marginal tax rate is the one that affects your incentive to do this. It tells you how much of the next dollar the government will take and how much of the next dollar you get to keep. Lowering the marginal tax rates creates a greater incentive for people to find a way to produce things for the poor. This is what happens in any market economy, be it the United States or Estonia (which is growing rapidly after reducing its top marginal tax rates). It also makes it easier for people who are poor to become rich, thus increasing their willingness to work hard and risk their assets to produce what others will want.

     If the government taxes away 90 percent of each additional dollar you earn, there will be little incentive for you to risk your life's earnings in a new venture that has an uncertain payoff, and it will be very difficult for you to move from poverty to wealth. On the other hand, if you get to keep 75 percent of each dollar that you earn, you will have an incentive to risk your capital, work hard, and produce goods and services that others want at a cost they can afford.

     Democrats try to chide Republicans for offering tax breaks for the rich. Republicans, unfortunately, seem not to be willing to claim credit for doing so. It is by creating tax breaks for the rich that the poor in America become wealthy. Today 60 percent of all poor households in America own their own car. Nearly half own their own home. This situation has occurred because of the workings of the market system of voluntary exchange and incentives that reward those who produce for others. Once the average person understands how the market system works, attempts to confuse voters through what Ludwig von Mises called the politics of envy will fail, and we will be able to maintain economic growth for all.