The Tax Foundation has released an excellent new book which details various options for reforming America’s tax code and their consequences for government revenues and economic growth. While the book analyzes more than 80 options for reform, two in particular stick out: cutting marginal income tax rates by 10 percent, and allowing businesses to fully deduct the cost of new investments. Both options would cost roughly the same amount ($2.2 trillion over 10 years, on a static basis), but full expensing would expand GDP at five times the rate of the income tax cuts. All tax cuts, it seems, are not created equal.
Tax reformers have often had great success with cutting marginal income tax rates. In the 1960s, President John F. Kennedy’s tax cuts (signed into law after his death by President Lyndon B. Johnson) are partially credited with the economic boom of the 1960s. President Ronald Reagan’s tax cuts helped the economy recover from a deep recession in 1981 and 1982. As a result, this year’s Republican presidential candidates, including the presumptive nominee, Donald Trump, proposed several tax plans which center on reductions in marginal income tax rates, often at great fiscal expense.
Can the next president repeat the successes of Kennedy and Reagan through another round of marginal rate cuts? Not exactly. To understand why, it is important to consider how taxes affect economic growth. There are two major effects. First, tax cuts put more money in the pocket of consumers, who spend it and grow the economy. The second effect—and arguably the more important one—is that tax cuts increase the incentive to produce more.
For instance, a business which files taxes as an individual may require a certain rate of return to make a new investment worthwhile. When tax rates are high, returns are lower, and new investments are not as profitable. When tax rates are low, however, returns are higher, and the business is more likely to pursue those new investments.
The problem is that as tax rates fall, the benefits of additional tax cuts diminish. For example, if the top marginal tax rate starts at 90 percent and gets cut to 80 percent, a business or individual in the top tax bracket will go from being able to keep 10 cents of every additional dollar to 20 cents. In other words, this tax cut has just doubled marginal disposable income. However, cutting the top rate from 30 percent to 20 percent means that marginal disposable income rises from 70 cents on the dollar to 80 cents, an increase of only 14 percent. While both of these reforms may be considered a “10 percent tax cut,” one offers a lot more bang for the fiscal buck than the other.
The chart below demonstrates how this phenomenon works for various levels of taxation. When tax rates are high, the benefits of cutting them are gigantic. But when tax rates are low, there is little more that can be gained from cutting them further.
This is why the Kennedy and Reagan tax cuts were so successful. Kennedy cut the top marginal rate from 91 percent to 70 percent, increasing marginal disposable income for the top bracket by 233 percent. Reagan’s first round of tax cuts slashed the top marginal rate from 70 percent to 50 percent, increasing these taxpayers’ marginal disposable income by a still-respectable 67 percent.
However, modern reformers will not easily be able to replicate their success. For instance, Donald Trump’s plan to cut the top rate from 39.6 percent to 25 percent would increase marginal disposable income for the top bracket by just 24 percent, and even less for the lower brackets. Eliminating the income tax entirely would raise marginal disposable income for the top bracket by 66 percent—a smaller bounce than Reagan’s 1981 tax reform.
While no one wants to give nearly 40 percent of their marginal income to the federal government, tax rates are still fairly moderate by historical standards. For this reason, the additional incentives for businesses and individuals to invest and produce more will be limited should Congress pass another round of marginal rate cuts.
This logic works the other way, too. The economic harm of tax increases swells when marginal tax rates are higher. Democrats often claim that President Bill Clinton’s 1993 tax hike (which raised the top rate from 31 percent to 39.6 percent) had little effect on the economy. That is debatable—the boom of the 1990s may have masked some negative effects—but there is absolutely no reason to believe that another tax hike of similar magnitude, starting at today’s top rate of 39.6 percent, would have comparatively limited economic ramifications.
While Congress may consider cuts to marginal income tax rates as part of its economic toolkit, reformers who want to replicate the successes of Kennedy and Reagan will be disappointed. To boost the economy through tax policy, it is far better to prioritize cuts to the corporate rate or full expensing of investments, both of which offer more growth for a similar price. President Reagan’s economic policy has certainly earned the reverence modern Republicans give it, but that does not mean that today’s policymakers should repeat the Gipper’s reforms to the letter.
Preston Cooper is a policy analyst at the Manhattan Institute. You can follow him on Twitter here.
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