Tax Cuts Don't Work the Way Free Marketers Expect
Economists who lean toward the free-market side of the ideological spectrum often say that tax cuts help the U.S. economy by encouraging people to work more. Greg Mankiw, a Harvard economist who earns a very high income from his famous textbooks, has repeatedly claimed that higher taxes will discourage him from working more. The supposed mechanism is simple -- tax cuts raise the amount of money you receive for an hour of labor, making people want to put in more hours.
Others are more skeptical. They point out that the top marginal federal income tax rate has fallen from more than 90 percent in the 1950s and ’60s to less than 40 percent today, but instead of rising, the hours worked by employed people has actually fallen:
Of course, it might have fallen even more if tax cuts hadn’t encouraged people to keep working. But careful research by economists has shown that taxes tend to have little effect on labor supply. One reason is that as taxes go down, people feel wealthier, and so don’t feel as much pressure to work. By the same token, when taxes go up, people feel they need to put in more hours to make ends meet. These are what economists call income effects. A second reason taxes might have little impact is that most people don’t get to choose how many hours they work -- their boss chooses for them.
So it looks as if Mankiw and others exaggerate the effects of tax cuts. But new research is finding that there’s a big, important exception. When taxes go down for the poor, they really do work more.
A recent paper by the University of Chicago Booth School of Business professor Owen Zidar demonstrates the differences between cutting taxes for the well-off and cutting them for those of modest means. He writes:
Tax cuts that go to high-income taxpayers generate less growth than…cuts for low and moderate income taxpayers. In fact, the positive [overall] relationship between tax cuts and employment growth is largely driven by tax cuts for lower-income groups and the effect of tax cuts for the top 10%...is small.
Zidar looked at what happened to different states when federal taxes went up or down. Some states, such as Connecticut, have a lot of rich people, while others, like Mississippi, have a lot of poor people. Also, some federal tax cuts are weighted more toward the poor than others. Zidar found that tax cuts boosted employment in poorer states more than in richer ones, and the effect on those states was greater when those tax cuts favored the poor more.
Why do tax cuts for the poor help more than cuts for the rich? One reason is that rich people just aren’t that likely to change how much they work in response to changes in tax rates. Most high earners receive a salary rather than getting paid by the hour, so they can’t adjust how much they work. Nor are most executives, doctors, lawyers and financiers going to quit working because taxes went up. On top of that, it’s possible that many top earners work because they like it, or because work itself brings them status, or because they need to maintain a wealthy lifestyle for social reasons. Middle-class people, on the other hand, are more likely to work because they need to buy things for their families -- tax cuts help them buy more necessities per hour worked, giving them reason to work more. And for poor people, a tax cut might make the difference in their decision whether to get a job or go on welfare, sponge off family or sell drugs.
A second reason is that tax cuts have an effect on aggregate demand. Rich people save most of their money, so when you cut their taxes they tend to stick the extra money in the bank. But if you give poor or middle-class people a tax cut, they tend to go out and spend it, which increases demand via a multiplier effect. That tends to raise employment.
So if you want to boost the economy through tax cuts, give them to the middle class and the poor rather than the rich. That raises an interesting question -- how do you cut taxes for the poor? Low earners pay little if any income tax, but they do pay payroll taxes and sales taxes.
A large portion of payroll taxes in the U.S. go to pay for Medicare. The U.S. could cut payroll taxes and shift Medicare funding toward income taxes. At the state level, shifting from sales taxes to income taxes could have similar effects.
Another way to cut taxes for the poor is to raise the level at which welfare benefits are phased out, or make phase-outs more gradual. When benefits disappear as income rises, it acts like a tax, because it effectively takes away some of each additional dollar earned. Raising the income cap for government benefits, or making the benefits disappear more slowly, acts like a tax cut for the poor.
Higher earners certainly are not going to like the idea of shifting more of the tax burden onto their shoulders. But it’s probably good for the economy, and for keeping the working class working.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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