Income tax cuts stimulate demand by putting more money into consumers' pockets. That's important because consumer spending drives 70% of economic growth. This create jobs when businesses ramp up production to meet higher demand. A study by the Congressional Budget Office(CBO) found that the Bush tax cuts would create 4.6 jobs for every $1 million, if extended into 2011-2012.
However, there is some debate over whether tax cuts to higher income families create as many jobs as tax cuts to low- and moderate-income families. The theory is that lower income families must spend the tax cuts, driving demand, while higher income families will save their tax cut. Furthermore, higher income family spending is less influenced by tax cuts because they families can maintain their spending by cutting into their savings, or getting loans or credit. Their tax cuts are more likely to be used to pay back loans.
Payroll tax cuts are one of the most cost effective ways to increase jobs. According to the CBO, every $1 million in payroll tax cuts creates 13 new jobs. Payroll tax cuts create jobs in four ways. First, some companies use the savings to reduce prices, increasing demand, which would necessitate hiring more workers to meet the demand. Second, other companies increase wages to retain good workers, who would then spend more, increasing demand. Third, some firms keep the tax savings, allowing them to buy more and increase demand. Fourth, companies that already had products in demand would use the savings to hire more workers. This fourth method is the most cost effective way to create jobs. In fact, if the payroll tax cut is only given for new hires, then every $1 million in payroll tax cuts creates 18 new jobs.(Source: CBO, "The Economic Outlook and Fiscal Policy Choices," September 28, 2010)
By the way, the most cost effective way to increase jobs is not a tax cut at all. The CBO study found that unemployment benefits create jobs because the unemployed are most likely to spend these tax dollars. Every $1 million in unemployment benefits creates 19 new jobs.
However, fiscal policy through government spending is not a really good way to create jobs. Think about it. If $1 million creates 19 jobs, that's still over $50,000 of your tax dollars needed to create one job. The CBO didn't analyze what type of jobs, or the income from the jobs. The best way to create jobs is through monetary policy that expands the money supply, making more liquidity available to businesses to invest. Fiscal policy is only necessary when monetary policy is already as expansionary as possible. This happened in 2009 and 2010, after the Great Recession forced the Fed funds rate to zero. (For Calculations, see Google Docs)
