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A "tax cut" is an umbrella term to describe a government unit decreasing any of its tax rates. For example, the Bush tax cuts were cuts that reduced income tax rates of upper-income, capital-owning households.
In the short term, tax cuts have the effect of lowering the government's revenue and raising the real income of those affected by the cut. Economists debate the validity and applicability of hypotheses like the Laffer curve, which holds that when the stars are right, tax cuts can result in raising the government's revenue because of increases in economic activity. When looking at the US, there is little evidence for this assertion: During the Clinton years, tax increases went along with a booming economy; under Bush, a substantial tax cut failed to achieve even remotely similar growth and government revenue stayed well below the 2000 projections. President Obama not only extended the Bush tax cuts, but added additional tax cuts claiming the boost was necessary to keep the recovery going.
Another problem is that government spending levels can't be as easily adjusted, and spending cuts seldom go along with lagging revenue. Tax-funded social and welfare programs are popular, education and infrastructure spending is crucial for a country's long-term economic outlook, and many people (especially on the right) also favor high levels of military spending. Thus, tax cuts tend to result in staggering deficits - Presidents Reagan and George W. Bush are among the worst offenders here, while the "tax-and-spend liberal" Clinton left office with a budget surplus.
Effects on corporations
Essentially, lower tax rate increases the effect of debt in the overall cost of capital, from Modigliani–Miller theorem. Thus, as taxes are lowered, the weighted average cost of capital increases, creating a disincentive for the corporations to expand. As a result, whatever money the corporation has left over that isn't used to pay taxes are usually distributed in the form of dividends.[note 1] To be fair, some of these amounts go to people's retirement funds through ownership by investment funds that owns these company. However, there is one significant issue here: most of these funds do not own a significant portion of the company to determine how much, when to distribute, or whether to distribute in the first place.[note 2]
Effects on investments
Given all else equal, lowering tax rate generally[note 3] increases investment risk. You heard it right. It causes investments to be riskier. That is because the losses can be used to reduce taxable income in most jurisdictions.
Perpetual tax-cutting mechanism
Republicans tend to believe, for some odd reason, that you can keep reducing the level of taxation repeatedly, indefinitely.[note 4] This may be due to the notion that one of their economic advisers invented the Laffer curve, which makes the assertion that if you drop taxes, tax receipts will actually go up. Unfortunately, the
church of tax cuts Reagan Administration interpreted the curve wrong: the taxes were too low for maximum revenue at that time, not too high, so when they cut taxes, the revenue went down. While some of this loss was indeed recouped through economic growth, tax receipts grew much more slowly after the Reagan tax cuts than after increases under Bill Clinton.
Still, nowadays a Republican who wants to get anywhere in his career will pretty much have to sign Grover Norquist's pledge never to raise taxes, and invariably, their proposed response to economic downturns will be new rounds of tax cuts. It doesn't take a math genius to figure out that even if the Laffer Curve were correct, the combination of these principles would steadily drive tax rates and revenues towards the 0% point, inevitably resulting in bankruptcy.
- Apart from amount spent through management malfeasance, such as empire building or pet projects that has no significant value to the company or shareholders in general.
- Growth funds, for example, prefers the company they own to save the money for expansion.
- Obvious exceptions exist, such as the investments held in tax-exempt accounts.
- Otherwise, why would every last one of those Republican-nominated presidential candidates since Ronald Reagan candidate talk about tax cuts?
- Paul Krugman: Invincible Ignorance, NYT
- The CBO's handy graph of revenues
- A Time article compiling various sources
- From the "Center on Budget and Policy Priorities"
- Americans for Tax Reform: Current List of Taxpayer Protection Pledge Signers for the 112th Congress