The Benefits And Costs Of A U.S. Tax Cut

from the International Monetary Fund

— this post authored by Sandra Lizarazo, Adrian Peralta-Alva, and Damien Puy

U.S. lawmakers getting ready to rewrite the nation’s tax code have a fundamental question to answer: What are the priorities for tax reform? Do you want faster growth? Less income inequality? A tax cut that doesn’t increase the budget deficit? In a recent working paper, we find that, depending on how a tax cut is targeted, it is possible to make some progress toward the first two objectives. Personal income tax cuts can help support growth and, if well targeted, can also help improve income distribution. However, we find that lowering personal income tax rates does not raise growth enough to offset the revenue loss that is caused by the tax cut itself.

The tax reform debate is unfolding, with the U.S. economy in one of its longest expansions in history. In the medium term, though, growth prospects are constrained by weak productivity growth, falling labor force participation, increasingly polarized income distribution, and high levels of poverty. These trends have reduced the labor share of national income by about 5 percent in 15 years, have shrunk the middle class to the smallest share of the population in 30 years, and – aside from the immediate aftermath of the financial crisis – have resulted in the lowest potential growth rate since the 1940s.

Finding solutions to these issues requires action in multiple areas, among them trade, education, and health. In the latest economic assessment of the U.S. economy , the IMF and U.S. authorities have also mentioned tax policy as an important lever. Our paper looks more closely at the notion that tax reforms – and individual income tax cuts in particular – can go a long way in solving these challenges. But how far can a tax cut really take you? Can a personal income tax cut boost growth? And if it does, can it boost it enough to not weigh on the budget? More importantly, will the benefits of the reform reach low and middle-income households?