What Effect Does Income Tax Have On The Growth Of The U.S. Economy?

by CherrellT on June 16, 2012

In the current economy, income tax cuts seem to make great sense. Although Presidents have little genuine influence on the American economy, nevertheless, economic policies and plans will dominate discussion in the 2012 Presidential election. Democrats inevitably will advocate tax increases on wealthy Americans, and they will propose a variety of government-funded initiatives to “jump-start the sluggish economy.” Republicans naturally will propose across-the-board cuts in income and payroll taxes with corollary reductions in government spending. Expect early and often to hear the refrain, “Let’s put the money into the hands of American consumers.” Those same American consumers will morph into voters on November 6, and they will vote with their paychecks and wallets. Therefore, as the campaign heats up and the vitriol flows more freely, ordinary Americans will wonder, “What are the economic consequences of income tax cuts?”

Tax cuts drive consumer spending, which drives economic growth. Right?

Consumer spending generates approximately two-thirds of the nation’s Gross Domestic Product (GDP), and tax cuts historically have triggered sharp spikes in sales of big-ticket consumer goods. In 1964, the government’s eighteen percent cut in federal income tax rates drove Americans to their shopping centers like a tiny tsunami, laying the foundation for American prosperity through the end of the decade. Economists concede that Vietnam War spending and the space race also contributed to prosperity in the ’60s, but conservatives among them persistently credit the tax cuts for the boom. Tax-cut advocates also point to economic rebounds triggered by tax-rate reductions in the early 1980s and in 1991 and 1992.

In 2012, however, the sad answer bucks the conventional wisdom and long-standing historical trends. In the 2012 economy, even radical reductions in federal income tax rates probably will do very little to spur economic growth.

America suffers a Great Recession hang-over

According to the National Bureau of Economic Research, the Great Recession “officially” ended in June, 2009, but its effects linger: the housing market remains seriously depressed as new-home starts languish, retail sales of new homes steadily decline, housing values continue falling, and foreclosure rates stay frighteningly high. Although unemployment declined during the economy’s short-lived 2012 growth spurt, it rose again at mid-year. Resigned to the fact that American manufacturing jobs have taken-up permanent residence in emerging nations, politicians and economists look to American corporations and industries for innovations that will spawn new employment opportunities for highly skilled American workers. Their optimism flags, however, as private sector job creation fails to offset massive furloughs and lay-offs among government works, especially among teachers, firefighters and police officers. Persistent signs and symptoms of economic malaise take their toll on consumers’ confidence, and they cut spending. In May 2012, retail spending dropped sharply, taking wholesale prices down with it. Perhaps most revealing, since 2007, the average American family’s net worth has fallen to what it was in 1990, wiping-out twenty years’ growth as if quintillions of dollars simply evaporated.

Nursing their Great Recession hang-overs, American families have reprised their grandparents’ and great-grandparents’ Depression-era ways, displaying unprecedented prudence, frugality, and outright stinginess.

Current conditions set the conventional wisdom on its ear

Because they have learned, in Christine Romans’ inspired phrase, “smart is the new rich,” American families aggressively are paying down their consumer debts, and they know they must next turn their attention to saving. Most thirty-something workers have no emergency savings, no independent retirement savings, and no college savings plan for their children.

If, despite the deficit and debt service, Congress and the President agreed to a generous ten percent tax cut, the average American worker would find an extra $191 in his or her half-monthly paycheck. Asked what she would do with an extra $191 per check, Megan Himes, a young Denver professional who makes “the national average right to the penny,” replied exactly as most middle class workers have responded to reliable pollsters, declaring, “I would increase my payments on my credit cards and student loans, and I finally would open a savings account.” Asked specifically if she would increase her spending, Himes responded, “Well, I might buy a pair of new shoes…if they were on sale, like a lot on sale.”

Multiply Megan Himes’ reaction by millions of American families and the conclusion becomes painfully clear: in 2012, even an unrealistically robust ten percent tax cut would have negligible benefits for the American economy. Consequently, the majority of economists at universities and high-powered think tanks agree the feds should leave tax rates unchanged and redouble their initiatives to balance the budget, reduce the deficit, and restore the nation’s once-exemplary credit rating.

Rachel Bosner is a finance-savvy freelance blogger who writes about taxes. Rachel highly suggests visiting this site to learn how to claim tax back, without having to hire a professional.

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