The Brookings Institution
I. Introduction
Policy makers and researchers have long been interested
in how potential changes to the personal income tax
system affect the size of the overall economy. Earlier
this year, for example, Representative Dave Camp (R-MI)
proposed a sweeping reform to the income tax system
that would reduce rates, greatly pare back subsidies in
the tax code, and maintain revenue- and distributional-
neutrality (Committee on Ways and Means 2014).
In this paper, we focus on how tax changes affect economic
growth. We focus on two types of tax changes—reductions
in individual income tax rates and “income tax reform.” We
dene the latter as changes that
broaden the income tax base
and reduce statutory income tax
rates, but nonetheless maintain
the overall revenue levels and
the distribution of tax burdens
implied by the current income
system. Our focus is on individual
income tax reform, leaving
consideration of reforms to the corporate income tax (for
which, see Toder and Viard 2014) and reforms that focus on
consumption taxes for other analysis.
We examine impacts on the expansion of the supply
side of the economy and of potential Gross Domestic
Product (GDP). This expansion could be an increase in the
annual growth rate, a one-time increase in the size of the
economy that does not affect the future growth rate but
puts the economy on a higher growth path, or both. Our
focus on the supply side of the economy and the long
run is in contrast to the short-term phenomenon, also
called “economic growth,” by which a boost in aggregate
demand, in a slack economy, can raise GDP and help align
actual GDP with potential GDP.
The importance of the topics addressed here derive from
the income tax’s central role in revenue generation, its
impact on the distribution of after-tax income, and its
effects on a wide variety of economic activities. The
importance is only heightened by recent weak economic
performance, concerns about the long-term economic
growth rate, and concerns about the long-term scal
status of the federal government.
We nd that, while there is no doubt that tax policy can
inuence economic choices, it is by no means obvious,
on an ex ante basis, that tax rate cuts will ultimately lead
to a larger economy. While the rate cuts would raise the
after-tax return to working, saving, and investing, they
would also raise the after-tax income people receive
from their current level of activities, which lessens their
need to work, save, and invest. The rst effect normally
raises economic activity (through so-called substitution
effects), while the second effect normally reduces it
(through so-called income effects). In addition, if they
are not nanced by spending cuts, tax cuts will lead
to an increase in federal borrowing, which in turn, will
further reduce long-term growth. The historical evidence
and simulation analysis is consistent with the idea that
tax cuts that are not nanced by immediate spending
cuts will have little positive impact on growth. On the
other hand, tax rate cuts nanced by immediate cuts in
unproductive spending will raise output.
Tax reform is more complex, as it involves tax rate cuts as
well as base-broadening changes. There is a theoretical
presumption that such changes
should raise the overall size of
the economy in the long-term,
though the effect and magnitude
of the impact are subject to
considerable uncertainty. One
fact that often escapes unnoticed
is that broadening the tax base
by reducing or eliminating tax expenditures raises the
effective tax rate that people and rms face and hence
will operate, in that regard, in a direction opposite to rate
cuts. But base-broadening has the additional benet of
reallocating resources from sectors that are currently
tax-preferred to sectors that have the highest economic
(pre-tax) return, which should raise the overall size of the
economy.
A fair assessment would conclude that well designed
tax policies have the potential to raise economic growth,
but there are many stumbling blocks along the way and
certainly no guarantee that all tax changes will improve
economic performance. Given the various channels
through which tax policy affects growth, a growth-
inducing tax policy would involve (i) large positive
incentive (substitution) effects that encourage work,
saving, and investment; (ii) income effects that are small
and positive or are negative, including a careful targeting
of tax cuts toward new economic activity, rather than
providing windfall gains for previous activities; (iii) a
reduction in distortions across economic sectors and
across different types of income and types of consumption;
and (iv) minimal increases in the budget decit.
Section II discusses the channels through which tax
changes can affect economic performance. Section
III explores empirical evidence from major income tax
changes in the United States. Section IV discusses the
results from simulation models. Section V discusses
cross-country evidence. Section VI concludes.
Effects of Income Tax Changes on
Economic Growth
1
We nd that, while there is no doubt that tax
policy can inuence economic choices, it is by
no means obvious, on an ex ante basis, that tax
rate cuts will ultimately lead to a larger economy.