How Do Tax Cuts Affect the GDP?

Gross domestic product (GDP) measures the total output of the economy. It is the sum of four components: personal consumption, private sector investments, government expenditures and net exports (exports minus imports). Some argue that cutting taxes means more consumption and investment, while others believe that the resulting reduction in government revenues leads to higher deficits and reduced spending on important social programs.

Facts

Tax cuts mean more disposable income for individuals and more retained earnings for businesses. The impact on the GDP depends on what individuals and businesses do with the extra cash. If households buy more goods and businesses increase hiring and capital equipment purchases, the GDP will increase. A reduction in taxes also means less revenue for the government at all levels, which generally leads to lower government spending, higher deficits or both.

Significance

Berkeley professor J. Bradford DeLong writes on his website that how consumers and businesses spend the extra money determines the effect of a tax cut. Households are likely to buy goods and services they need the most with the savings, which would increase demand for those goods. Businesses would react to this increased demand by increasing production and hiring more people, which would generate additional consumer spending. Increased personal consumption and business investments mean higher GDP. Proponents of tax cuts argue that this increased level of consumer and business activity generates more tax revenues over the long term. However, detractors argue that tax cuts, especially when governments are running large budget deficits, compound the problem by increasing deficits and reducing fiscal policy flexibility.

Tax Cuts vs. Government Spending

Tax cuts and government spending projects take time to implement because of the delays inherent in the legislative process. However, DeLong notes that targeted tax cuts to people who are likely to spend the money quickly are a better policy option than stimulus programs. For example, if a tax cut targets low-income families, they are likely to spend the tax savings on groceries and other household necessities, which would increase the GDP. Infrastructure projects may also have the same effect because they reduce unemployment in the short term, thus increasing personal consumption and GDP. However, increased government spending could increase deficits and interest rates, which would crowd out private-sector investments and negatively affect GDP.

Impact on Budget Deficits

The U.S. Congressional Budget Office and others have cautioned lawmakers repeatedly that long-term budget deficits are unsustainable. In the context of the 2011 budget negotiations, the CBO projected that extending certain tax-reduction provisions would reduce revenues as a percentage of GDP over the long term. This would mean difficult choices in terms of spending on the elderly and other important government programs.

References

About the Author

Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.