A decline in taxes is what is referred to as a tax cut. A tax cut automatically has an instantaneous effect on both the pertaining government and the taxpayers, which are usually a reduction in the government’s income and an increase in tax payer’s income.
However, in the long term, a tax cut is speculated to have macro-economic benefits if the taxpayers use the supplementary income they get wisely, and at the same time, the governments adjust well to its reduced income. For instance, if the tax cuts are beneficial enough, they are likely to give an incentive to both individuals and corporations to invest hence stimulating economic activity and eventually, this generates more income which is taxable and as a result more revenue for the government.
After the ‘Bush Tax Cuts’ of 2001 and 2003 signed by President George W. Bush, the US economy began ailing as it underwent the worst recession ever felt since the 1930s. The incoming President, Obama thus inherited a $1.3 trillion deficit, rising unemployment, and unparalleled crises in the US banking system (Larson 2003).
As a result, he had the colossal duty of putting the economy back on its feet again and at the same time, set a strong foundation for future economic growth. At his inaugural address, President Obama stated that “Our economy is badly weakened, a consequence of greed and irresponsibility on the part of some but also our collective failure to make hard choices and prepare the nation for a new age” (Singletary 2009).
Before that, Obama had indicated that he had a robust plan oh how he would revive the economy in the shortest period possible rather than lay long term strategies that would take long to heal the economy. This short term plan consisted of a stimulus package which he guaranteed the American citizens that under the plan; he would inject billions of dollars into the economy through tax cuts and direct spending.
“Obama’s tax cut plan would give $500 to individuals and $1,000 to couples per year and in the form of credit. It would be a payroll tax credit that would see employers reducing the amount of tax that is withdrawn from the paychecks of employees. This cut he estimated would cost $150 billion” (Singletary 2009).
Budget deficit usually occurs when the income that is being spent by the government is more than the received tax income from taxpayers. Therefore due to demand in the economy, which increases during the recession, the government returns fall as expenses are raised. This is usually caused by unemployment benefits given out and a constant swell of people who have lost their jobs and need welfare. It also affects the economy in terms of investment spending, which decline steadily since people do not have the money to invest.
Tax cuts in such a situation add even further to the economy demand. However, with the introduction of the stimulus package, President Obama also signed legislation known as the American Recovery and Reinvestment Act that would help jumpstart the economy. As it gave working Americans a tax cut, this is a plan that also created new jobs and made significant investments in the infrastructure of the country.
Further, private investments normally collapse during the recession, and thus the money in the economy that would be borrowed for these private investments is left unborrowed and unused. When the government takes this opportunity to create a program and borrow this money for investing, it crowds out investment, causing what is known as the “crowding out” effect. This effect is characterized by lower employment, lower money multiplication, and lower overall GDP (Baumol & Blinder 2008).
When the government takes measures to influence and stabilize the economy, especially by adjusting the levels and allocations of taxes and government expenditure, this is known as fiscal policy. On the other hand, a contractionary fiscal policy arises when the government decreases its spending or increases the taxes causing the economy to contract.
According to the Keynesian theory, the expansionary fiscal policy works best during the recession. (Baumol & Blinder 2008) notes “this is because if a deficit is run through increasing government expenditures by a small amount, it causes the aggregate demand to shift upward to the necessary amount of restoring the economy to the natural GDP level.”
Conversely, the contractionary fiscal policy can be used during a booming economy. When the economy is already at the natural GDP level, but the collective demand is estimated to continue increasing, then the GDP level is also expected to rise. As a result, prices will also rise, as well as wages and the prices of other resources. Eventually, there will be inflation in the level of prices but no change in the GDP. This can, however, be combated by increasing taxes or decreasing expenditure by a small amount which will reduce the collective demand. (Hemming et al. 2002)
In conclusion, cutting taxes at this time of recession, which amounts to an expansionary fiscal policy, is bound to be beneficial to both the government and individual citizens of the United States. Additionally, there is the economic effect which acknowledges the positive impact that lower tax rates have on work, output, and employment as it gives the motivation to increase performance in these activities. In this way, the tax base, in general, is also positively affected.
Reference List
Baumol, W. J., & Blinder, A. S. (2008). Economics: Principles and Policy. Stamford, CT: Cengage Learning.
Hemming, R. et al (2002). The effectiveness of fiscal policy in stimulating economic activity: a review of the literature, Issues 2002-2208. Pennsylvania Ave NW, Washington: International Monetary Fund.
Larson, J. S. (2003). Tax cuts: issues and analyses. Main St, Huntington, NY: Nova Publishers.
Singletary, M. (2009). Obama’s proposed tax cut not what Americans need now. The Washington Post, pp. 23, 25.