Monday, November 5, 2007

The Power of Tax Cuts

Tax cuts are commonly misunderstood. Many new commentators and politicians refer to tax cuts as "costing" the country money or say that the country is not able to "afford" tax cuts. This view is overly simplistic and is not supported by economic data.

First, the money from the tax cuts is viewed as government money being given back to the taxpayers. In reality, tax cuts allow taxpayers to keep money that they government would have otherwise appropriated. People get to keep what they earn instead of giving it to the government.

Second, it is usually not realized that tax cuts often generate more revenue that tax increases. Presidents Reagan and Bush (41) both cut taxes. In both cases, tax revenues increased. Also in both cases, the economy grew much more strongly after the tax cuts than before. During both periods, inflation and unemployment fell to very low levels and the economy recovered from recessions.

To understand why tax cuts work, consider a tax as a punishment for something. For example, a tobacco tax is a punishment for smoking. It is assumed that if the price of tobacco rises, then fewer people will smoke. While that theory does not take addiction into account, it is true to some limited extent.

Taxes on income work the same way. If the government takes an increasingly large share of your take-home pay when you earn more money, some of the incentive to earn more money is lost. Similarly, dividend taxes encourage people to do something other than invest their money in stocks and mutual funds. Capital gains taxes discourage capital investment and entrepreneurship.

On the other hand, if taxes are decreased, then you keep more of the money that you make. By keeping more of every dollar that you earn, you have the incentive to work more to earn more. Low dividend taxes encourage more savings and investment. Lower capital gains taxes encourage people to invest in the economy.

Increased investing is probably one of the most important facets of tax cuts. Investing isn't just for the wealthy. If you have a 401k or a mutual fund, you are an investor. By putting more money into the nation's businesses, the economy grows. As businesses grow, they earn more profits and have to hire more workers. The government reaps the benefits of taxes on the profits and the income of the new employees.

If this doesn't sound right to you, ask yourself what a local government does when they try to attract a business to their area. Often they give the business a package of incentives that includes a lower tax rate. When a business pays lower taxes, they have more money to hire workers, research new ideas, market new products, pay their stockholders, or give to charities within the community.

Tax increases do the opposite. Money that could be invested in private industry is instead sent to the government. This causes the economy to contract and growth to slow. An example of this was when President George Herbert Walker Bush agreed with Congress on a tax increase in 1990. This led to a recession and ultimately cost the first President Bush his re-election campaign.

Does that mean that the rich and the corporations are not paying their fair share of the nation's tax burden? Not at all. According to the most recent data available (2005), the top 1% of taxpayers pay 39% of all taxes. The top 5% pay 59%. The top 10% pay 70% and the top 50% of taxpayers pay over 96% of all taxes. That means that the bottom 50% of taxpayers pay only slightly more than 3% of taxes.

History has proven time and again that raising taxes slows the economy and can often lead to a recession and lost tax revenues and jobs. Cutting taxes does the opposite. It spurs the economy and helps create jobs. Most importantly, tax cuts keep more money in our pockets instead of the government's.

Our tax code is complex and badly in need of a complete overhaul. Until it can replaced with something simpler, easier to understand, and more friendly to business and investment, and ultimately, the taxpayers, keeping the tax cuts in force is the next best thing.

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