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 extending unemployment benefits are the best way to boost economic growth. Benefits create jobs because the unemployed wind up spending every dollar they receive on essentials like as food, clothing and housing. . Every $1 million in unemployment benefits creates 19 new jobs. A study by Economy.com found that every dollar spent on unemployment benefits stimulates $1.73 in economic demand. Although extended benefits cost taxpayers $10 billion every month, they generate $17.3 billion in economic growth, creating jobs and additional tax revenue.
Do Tax Cuts Boost Economic Growth?Supply-side economics is the theory that says tax cuts increase economic growth. A study by the Treasury Department showed that, in the short-term and in an economy that is already weak, tax cuts provided an immediate boost. The cuts must ultimately be balanced with a reduction in spending to avoid increasing the Federal debt.
Left unchecked, the Federal debt would eventually slow the economy. If the debt-to-GDP ratio is too high (near 90%), it's perceived as a tax increase on future generations, who ultimately must pay it off. (Source: U.S. Treasury Department, A Dynamic Analysis of Permanent Extension of President's Tax Relief, July 25, 2006)
Effect of the Bush Tax CutsDuring the 2001 recession, the percentage of Federal revenue to GDP went up to 20.9% -- higher than the norm. That's because the economy shrank. To stimulate growth, the government cut taxes in 2001 (JGTRRA) and 2003 (EGTRRA). After the tax cuts of 2001, Federal revenue fell to 18% of GDP. The tax cuts of 2003 reduced the revenue percentage even further, to 16% of GDP in 2004. However, these tax cuts were initially a success. The economy recovered. Even though the percent of government revenue to GDP decreased, the total revenues increased because GDP increased.
Supply-side proponents said the growth in GDP was because of the tax cuts. Other economists pointed out that interest rates were also lowered during the same time period. The Federal Reserve lowered the all-important Fed funds rate from 6% to 1% between 2001 - 2003. (Source: New York Federal Reserve, Historical Fed Funds Rate)
The Tax Increase Prevention and Reconciliation Act of 2005 extended lower tax rates for long-term capital gains and dividends through 2010. This did not significantly impact government income, and the percentage to GDP returned to 18% by 2006.
Can Tax Cuts Increase Federal Budget Revenue?The Laffer Curve states that tax cuts reduce government revenue dollar-for-dollar, but recoup that loss over the long term by boosting economic growth, and the tax base. However, the National Bureau of Economic Research found that only 17% of the revenue from income tax cuts was regained, and 50% of the revenue lost from corporate tax cuts. One reason for this discrepancy could be the tax rate before tax were cut. According to Laffer's model, the tax rate must be in the "Prohibitive Range" -- above 50% -- for the cuts to stimulate the economy enough to recoup all the losses. (Source: NBER, Dynamic Scoring:A Back of the Envelope Guide, December 2004)
Best Way to Create JobsIf tax cuts aren't great about creating jobs, what about government spending is not a really good way to create jobs either. It takes $1 million in spending to create 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 not through tax cuts, government spending or any kind of fiscal policy at all. Instead, it's through monetary policy. This 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)Article updated February 20, 2012