Increase in Pretax Earnings After a 10 Percent Tax Cut: Tax cuts have relatively small effects on the amounts people work.
May 2, 2012
A key concern among would-be tax reformers is that high tax rates are holding back the U.S. economy and that lower tax rates would not only spur more economic activity, but also help pay for themselves. Fortunately, the question of how individual tax rates influence economic activity is among the most richly studied in the economics of taxation. The simple answer is that individual taxes do affect economic decisions such as how much to work, but only to a modest extent, and that the primary effect of tax cuts is to reduce revenues. This chart uses the economic evidence from twenty-three published studies cited in Chetty (2011) to illustrate how a 10 percent cut in individual income tax rates might increase the pretax earnings of the typical tax-paying family earning about $70,000 per year. Most studies find that such a tax cut would have essentially no effect on employment or earnings. The average estimate of all twenty-three studies predicts that the typical family would increase pretax earnings by roughly $450, or 0.7 percent. Even using the highest estimated response, the increase in earnings is about $1,500, or about 2.2 percent. While the household described above would work slightly more, the same evidence also implies that it would pay much less in taxes. Using the fifteen studies that focus specifically on how taxable income (income after subtracting items like mortgage interest or dependent exemptions) responds to changes in tax rates, the same 10 percent tax cut is predicted to reduce federal income taxes paid by 8.6 percent. Far from paying for itself, this tax cut would add to the deficit.