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Benefits and costs of a tax cut in the United States

by Uneeb Khan

In preparing to change the nation’s tax code, US lawmakers must answer a fundamental question: What are the priorities for tax reform? Looking for faster growth? Lower income inequality? A tax cut that doesn’t raise the budget deficit? A recent working paper note that depending on how that tax cut is targeted, some progress toward the first two goals may be possible. Personal income tax cuts can help support growth and, if well-targeted, can also help improve income distribution. However, we observe that lowering rates does not boost growth sufficiently to offset the loss of tax revenue caused precisely by the tax cut itself.

The Fortress Tax Relief reform debate is ongoing as the US economy is experiencing one of the longest booms in its history. In the medium term, however, growth prospects are constrained by weak productivity growth, declining labor force participation, an increasingly polarized income distribution, and high levels of poverty. These trends have reduced labor’s share of national income by about 5 percent over the span of 15 years, reduced the middle class to its lowest percentage of the population in 30 years, and—apart from what happened in the immediate aftermath to the financial crisis—have given rise to the lowest potential growth rate since the 1940s.

To find solutions to these problems it is necessary to take measures in multiple fields, such as trade, education, and health. In the latest assessment of the US economy, the IMF and the US authorities also mentioned tax policy as an important instrument. Our paper takes a closer look at the notion that tax reforms—and personal income tax cuts in particular—can go a long way toward solving these challenges. But how much can a cut really help? Can a Personal Income Tax Cut Boost Growth? And if so, can you raise it high enough so as not to put a burden on the budget? More importantly, will the benefits of reform trickle down to low- and middle-income households?

In our paper, we assess the dynamic effects of a reduction in the effective personal income tax rate on income distribution and the US economy. To do this, we use modern quantitative macroeconomic analysis tools, based on a model that includes the most outstanding characteristics of the United States that are essential for the subject in question, namely, different types of households (differentiated by educational level), different productive sectors ( manufacturing and services) interrelated through a realistic input-output structure, and international trade. In addition, and unlike conventional incidence analyses, our approach incorporates dynamics and prospective behaviors,

Our analysis yields three fundamental conclusions.

First, although we were able to determine that tax cuts provide a one-time boost to GDP, consumption, and investment, these effects are never powerful enough to prevent a loss of tax revenue. Thus, cuts would have to be financed either by increasing public debt, lowering spending, or raising revenue through other taxes. Since our objective is to obtain better distributional results while preserving the possibility of achieving some modest increase in growth, we focus on the shift from personal income taxes to consumption taxes as a means of financing the cut. , combined with an expansion of the earned income tax credit to protect the poor.

Second, we find that personal income tax cuts can benefit lower-income groups, even when those at the bottom of the income scale do not directly receive the cut. Our economic model predicts that when cuts are targeted at middle (or high) income groups, these groups will spend part of their savings on (non-tradable) services, which are commonly provided by lower-income people. The wealthiest groups, on average, devote a higher proportion of their consumption spending to services. Consequently, when the wealthiest pay less in taxes, their spending on services increases, thus raising the demand—and wages—for low-skill labor.

Third, our analysis reveals a fundamental trade-off between growth and income inequality, depending on who gets the cut. In our simulations, while tax cuts in favor of higher income groups may be more beneficial to GDP by increasing investment and labor supply, they also exacerbate polarization and income inequality, variables that are already found. at their all-time highs. Even taking into account that the rich could consume more goods and services produced by people at the bottom of the income distribution, and even considering an increase in the earned income tax credit to protect the poor, the gap in income would still be substantially expanded if taxes were reduced for higher income groups.

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