The Benefits and Costs of a U.S. Tax Cut
IMF Blog, September 1, 2017
Source details
- Canonical URL
- The Benefits and Costs of a U.S. Tax Cut
Other formats
Bibliographic details
- Authors: Sandra Lizarazo, Adrian Peralta-Alva, Damien Puy
- Published: September 1, 2017
Overview
- Title and authors: "The Benefits and Costs of a U.S. Tax Cut" by Sandra Lizarazo, Adrian Peralta-Alva, Damien Puy.
- Publication date: September 1, 2017.
- Central question: Can lowering effective personal income tax rates boost growth, improve income distribution, and avoid increasing the budget deficit?
Context and motivation
- The U.S. economy is in one of its longest expansions in history, but medium-term prospects are constrained by:
- weak productivity growth;
- falling labor force participation;
- increasingly polarized income distribution;
- high levels of poverty.
- Observed historical trends cited:
- labor share of national income reduced by about 5 percent in 15 years;
- the middle class shrunk to the smallest share of the population in 30 years;
- aside from the immediate aftermath of the financial crisis, the lowest potential growth rate since the 1940s.
- Tax policy is considered an important lever among other policy areas such as trade, education, and health.
Model and approach
- The paper assesses dynamic effects of lowering effective personal income tax rates on income distribution and the U.S. economy using a quantitative macroeconomic model that includes:
- heterogeneous households differentiated by education level;
- different productive sectors (manufacturing and services) linked through a realistic input-output structure;
- international trade;
- dynamics and forward-looking behavior to capture medium-term effects beyond standard static incidence analyses.
Three key results
- First:
- Personal income tax cuts provide a one-time boost to GDP, consumption, and investment.
- These effects are never strong enough to prevent a loss of revenue.
- Therefore, tax cuts would need to be financed by either increasing public debt, cutting spending, or raising revenues from other taxes.
- The paper focuses on financing cuts via a shift from personal income taxes to consumption taxes, combined with an expansion of the earned income tax credit to protect the poor.
- Second:
- Personal income tax cuts can benefit lower-income groups even if bottom earners do not directly receive a tax cut.
- Mechanism: tax cuts targeted at middle (or high) income groups increase spending on non-tradable services, which are typically provided by lower-income people.
- Wealthier groups, on average, dedicate a larger share of their consumption expenditures to services; when they pay less in taxes their spending on services increases, raising demand for—and the wages of—low-skilled labor.
- Third:
- There is a fundamental tradeoff between growth and income inequality, depending on who receives the tax cut.
- Tax cuts for higher income groups may generate greater gains in GDP through higher investment and labor supply but also exacerbate income polarization and inequality, both already at historical highs.
- Even with richer households' consumption benefiting lower-income producers and with an increase in the earned income tax credit, the income gap would still widen substantially if taxes were cut for higher income groups.
- A tax cut targeted at middle-income groups would help reduce income disparity and polarization but might provide smaller growth dividends.
Policy implications
- A personal income tax cut alone will not sufficiently raise growth to offset revenue loss.
- Financing choices matter: shifting from personal income taxes to consumption taxes plus expanding the earned income tax credit is analyzed as a strategy to preserve modest growth upside while seeking better distributional outcomes.
- Targeting of tax cuts determines the balance between growth benefits and distributional consequences:
- Cuts favoring higher-income groups: larger GDP gains, larger increases in inequality.
- Cuts favoring middle-income groups: reduced inequality, smaller growth gains.
Source: The Benefits and Costs of a U.S. Tax Cut, Sandra Lizarazo, Adrian Peralta-Alva, Damien Puy, September 1, 2017.
