How Do Tax Cuts Spur Economic Growth?

It is widely believed, with plenty of evidence to support the hypothesis, that tax cuts spur economic growth. Over the past six decades, tax cut legislation has been implemented by elected officials of both political parties. The Kennedy tax cuts in 1964, Reagan’s tax cuts in 1981, the Clinton/Gingrich tax cuts in 1997, the Trump tax cuts in 2017, and more locally North Carolina’s tax cuts and reforms in 2013 all did what their advocates said the tax cuts would do: they increased economic growth rates and secondarily enhanced government revenues.

So, what is the economic logic that leads us from cutting taxes to greater economic growth?

If you listen to pundits and some economists (both conservative and liberal), you will frequently hear that it’s all about increased spending. Because the cuts “put more money in people’s pockets,” they spend more. And it’s the increased spending that ultimately “stimulates” the economy. While this sounds plausible, it is essentially wrong. Increased spending on the part of consumers/taxpayers, as opposed to the government, is an effect of economic growth, not its cause. The fact is that that the money from the tax cut would get spent with or without the cut. If the taxpayer didn’t have it to spend, the government would.

Spending is not what drives economic growth; earning is.

No one can spend income that they haven’t first earned either through work, entrepreneurial activity, or investment. And tax cuts of any form, particularly if they come in the form of rate reductions on income, enhance the incentive to earn or, more accurately, reduce the disincentive to earn. And how do people earn the money that ultimately translates into the spending that so many would-be economic analysts focus on? It is through the production of goods and services that other people want. In other words, increased production is what drives economic growth and increased consumer demand. And it is the drive and effort to increase one’s earnings that ultimately increase production.

Taxation is a disincentive to earning. The higher the marginal tax rate on any form of income, the less one is allowed to keep from any additional dollar earned. This means that it is less likely that the income-earner will do what it takes, i.e., work more, invest more, build more, hire more people, etc., to earn an extra dollar. The higher the tax, the lower the production and therefore earnings.

It is much more likely that a person will pursue and earn an extra dollar if they can keep 80 cents of it (a 20 percent marginal tax rate) than if they can only keep 40 cents (a 60 percent marginal tax rate). This is true for all kinds of income. A lower tax rate on regular income increases the incentive to work harder, acquire more skills, log overtime hours, and the like. A lower tax rate on interest and capital gains income encourages people to invest in both existing and new entrepreneurial ventures. Reduced corporate income taxes also encourage investment by increasing returns to shareholders and leaving more earnings available for business expansion. One or more of these forms of tax reductions were part of all tax cut plans mentioned above. For example, the recent Trump tax cuts focused on corporate and individual rate cuts, while the capital gains tax was the primary focus of the Clinton/Gingrich cuts in the 1990s.

In North Carolina, the successful changes passed in 2013 saw dramatic tax reductions in all three of the income generators mentioned above. Over time, the top income tax fell from 7.75 percent to a flat rate of 5.25 percent. But because there is no distinction between regular income and capital gains and investment income in the North Carolina tax code, this meant that there was a dramatic tax cut for all income, regardless of how it was earned. Corporate income, which is treated separately, was reduced in several stages from 6.9 percent to 2.5 percent.

What all this means is that the incentive to earn more income, i.e., be more productive, in North Carolina has increased, not just internally but relative to other states in the region and nationally. On average, every year since the passage of these cuts, North Carolina’s economy has grown at nearly twice the rate of the national economy. This has occurred, not because of how much consumers in the state have been spending as a result of the tax cuts, but how much productive effort has been committed to the pursuit of earning.