How Can Tax Cuts Revive the Economy?

Tax Cuts

How Tax Cuts Stimulate the Economy

There are two basic economic theories competing in America today: Keynesian and Classical. Keynesian economic theory calls for the government to influence the economy through government expenditures and collecting of taxes. Classical economic theory asserts that market forces keep the economy in balance and the government should not interfere. However in a strange way, both theories claim tax cuts can stimulate economic growth, the only difference is who gets the tax cuts. Tax cuts for the ordinary American, according to the Keynesian supporters, will put more money into the economy, stimulating economic growth. On the other hand, Classical economists claim that tax cuts for the wealthy will stimulate investment, create jobs, and stimulate economic growth.

Many Classical economists assert that an "Expansionary Fiscal Policy" can, through the lowering of taxes, increase the productivity of the economy, if the tax cuts are aimed at those with the resources to make major investments in economic growth. While many may claim that this would give tax breaks for the rich, it is the rich who have excess capital with which to invest, and investment in companies increases production and the number of jobs. The more people working, the more money in the economy and the better the economic growth. (Lacker, 2007)

Followers of the Keynesian school of economics, while mainly promoting "Discretionary Fiscal Policy" of increasing or decreasing government spending in order to influence major economic shifts, also believe that decreasing taxes for the ordinary Americans will stimulate "Aggregate Demand" in the general population. In other words, the more money the average American has, the more disposable income they have, the more they will spend, increasing production demand and stimulating economic growth. Fiscally conservative Keynesians have in the past advised the president to turn to "…simulative tax cuts, rather than public spending, to stimulate the economy…" (Zelizer, 2000)

In the second half of the 20th century, both individual and corporate tax rates for Americans have been much higher than in the first half. It has been established that there is a "negative relationship between economic development and corporate income tax rates…" ( Campbell. 1994) As the government tries to collect more taxes to cover the increase in spending, there is less capital left over for the businesses to build new factories, hire more workers, or increase their pay and benefits. The "Tax Multiplier" is a good way to measure how the changes in government tax rates can trigger a change in the aggregate production. When there are lower taxes, companies can produce more, using more workers, transportation, supplies, etc., while lowering the price of the product. This is meant to be an incentive to increase the demand by the public at large to spend more (aggregate demand). And the increase in workers, as well as the other businesses tied to the production, will allow for more people to have more money to spend, stimulating the economy even further.