do tax cuts help the economy?

A new study by Ernst & Young concludes that increasing taxes on higher-income Americans will hurt economic growth and lead to 710,000 fewer jobs being created.

The study was commissioned by four business groups that are opposed to this tax increase, which will go into effect Jan. 1 under current law.

This study should give these groups more ammunition in their fight to ward off this tax hike. They have an uphill battle as far as public opinion is concerned: A new Pew Research Center poll found that 44 percent of Americans think raising taxes on households with more than $250,000 in income would help the economy, while only 22 percent said it would hurt the economy.

Most small businesses are flow-through entities, where profits are taxed at the individual owner. The study found that taxpayers in the top two brackets earn more than $576 billion in flow-through business income, through S corporations, partnerships, limited liability companies and sole proprietorships.
Subjecting this business income to higher taxes is a bad idea if we want to encourage economic growth, business groups argue.

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The one idea that is almost certain not to jump-start this economy is a tax cut.

Why can we be sure of this? Because that is what we have done for the past three years. For those who think President Obama’s policies have done little to produce growth, keep in mind that the single largest piece of his policies — in dollar terms — has been tax cuts. They actually began before Obama, with the tax cut passed under the George W. Bush administration in response to the financial crisis in 2008. Then came the stimulus bill, of which tax cuts were the largest chunk by far — one-third of the total. The Department of Transportation, by contrast, got 6 percent of the total to fix infrastructure.

That wasn’t the end of it. There was the payroll tax cut, the small business tax cut, the extension of the payroll tax cut, and so on. The president’s Twitter feed boasted: “President Obama has signed 21 tax cuts to support middle class families.” And how has that worked out?

In the wake of a financial crisis caused by excessive debt, tax cuts are highly unlikely to lead to increased economic activity. People use the money to pay down their debts rather than shop for cars, houses and appliances.

- Fareed Zakaria, MidWeek, 6/13/12

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One of the most pernicious economic falsehoods you'll hear during the next seven months of political campaigning is there's a necessary tradeoff between fairness and growth. By this view, if we raise taxes on the wealthy the economy can't grow as fast.

Wrong. Taxes were far higher on top incomes in the three decades after World War II than they've been since. And the distribution of income was far more equal. Yet the American economy grew faster in those years than it's grown since tax rates were slashed in 1981.

This wasn't a post-war aberration. Bill Clinton raised taxes on the wealthy in the 1990s, and the economy produced faster job growth and higher wages than it did after George W. Bush slashed taxes on the rich in his first term.

If you need more evidence, consider modern Germany, where taxes on the wealthy are much higher than they are here and the distribution of income is far more equal. But Germany's average annual growth has been faster than that in the United States.

You see, higher taxes on the wealthy can finance more investments in infrastructure and education, which are vital for growth and the economic prospects of the middle class.

Higher taxes on the wealthy also allow for lower taxes on the middle -- potentially restoring enough middle class purchasing power to keep the economy going.

As we've seen in recent years, when disposable income is concentrated at the top, the middle class doesn't have enough money to boost the economy.

What we should have learned over the last half century is that growth doesn't trickle down from the top. It percolates upward from working people who are adequately educated, sufficiently rewarded, and who feel they have a fair chance to make it in America.

-- Robert Reich (see article comments for opposing views)

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Many are convinced that tax increases have little or no damaging impact on the economy. We hear over and over again that notions of damaging effects from higher taxes are merely based on “trickle down” theory, which has been proven false.

This is not true. There exists robust empirical evidence that taxes impede economic activity. In conventional economics, only the magnitude of the negative impact of taxes on economic output is debated, not the existence of such an effect.

Let us focus on one such negative impact, the effect of taxes on the activity of business owners, an important segment of the economy. Business owners account for 40 percent of American capital, while firms with less than 500 employees employ half the private sector workforce.

The argument that taxes do not negatively affect small and medium-size business tends to rely on a number of fallacies. One example is an article by Berkeley economics professor Laura Tyson, a member of Obama’s advisory board, which was published in the New York Times. In the article, she claims that “the relationship between tax rates and economic activity, even though it has superficial appeal, is not supported by the evidence.”

The most common fallacy repeated by Tyson is that taxes do not matter because the economy was booming during the Clinton years even though taxes went up. But tax increases are not the only economic event associated with the Clinton years, and therefore cannot be claimed to cause all events that took place in his presidency. The Clinton years also contained entry into NAFTA, welfare reform, and recovery from the 1992 recession. Most importantly though, the Clinton years included the IT boom, which dramatically raised productivity growth in the United States as well as in other developed countries. It would strain the imagination to believe that Clinton’s moderate marginal tax increase somehow caused the PC and Internet Revolution.

Instead of picking one historic event that happens to fit your preferred theory, a more reasonable approach is to investigate all historical periods where taxes increased or decreased. This has been done by former Obama advisor Christina Romer and her husband David Romer. They also take into account the causes of tax increases.¹ They find that tax increases tend to reduce economic growth, stating that “tax increases appear to have a very large, sustained, and highly significant negative impact on output,” as “an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent.” Similar results have been obtained by Harvard economist Alberto Alesina using a different methodology.