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The Effect of Taxes on Businesses and the Economy

Posted on October 18th, 2020

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Do tax cuts work?  Critics say no, it only increases the deficit.  Proponents say yes, lower taxes enable individuals and businesses to spend more money which, in turn, also increases tax revenues and, therefore, reduces, not increases, the deficit.  To find out who is (more or less) right, let’s take a look at some historical government statistics.

First to be clear, the tax rates I am referring to in this article are the individual tax rates charged on the 1040 tax return. This is because, as I have discussed in previous articles, most small businesses are set up as either an LLC (i.e., sole proprietorship or partnership) or S-Corporation for tax purposes, both of whose taxes are “passed through” to the owner’s personal tax return at individual tax rates. (I will discuss corporate (C-Corporation) tax rates in a subsequent article.)

Of course there are a multitude of factors that affect the economy and deficit. But in terms of the government’s role, there are two primary policies it has at its disposal to affect the rate of economic growth, and in turn, unemployment and inflation: Fiscal Policy which is controlled by Congress and the President, and deals with tax rates, government regulation, and government spending; and, Monetary Policy which is managed by the Federal Reserve, and deals with interest rates and the supply and demand for credit through the banking system.

The Kennedy Administration was one of the first to advocate tax cuts as a means of stimulating the economy (chart-Kennedy)). Later during the Carter Administration, the economy was plagued both double digit inflation and unemployment, which President Carter described as “the misery index” and blamed it on a “malaise” on the part of the American people (chart-Carter). Doubting this, the Reagan Administration subsequently used tax cuts again to stimulate the economy, this time significant cuts, as well as reduced government regulations, which became known as “Supply-Side Economics” (dubbed by critics as “Trickle Down Economics”) (chart-Reagan).

Note the pattern between lower taxes and the declining unemployment rate between these three charts. There certainly would appear to be a correlation between those two statistical trends.

But did the lower tax rates actually stimulate economic growth, or was the lower unemployment rate just a coincidence?  In other words, what was the effect on the Gross Domestic Product (or GDP, the measure of the U.S. economy)?  The next chart is a comparison of tax rates to the GDP during the Reagan Administration (chart-Reagan GDP). It indicates there does seem to be a direct relationship between the two, especially in 1984 when GDP jumped 7.9% shortly after the tax cuts, and averaged nearly 5% through the end of the Reagan term.

Now, let’s look at the Obama Administration. Ignoring where the unemployment rate started (which is the topic of a whole different discussion), the unemployment rate steadily declined over the eight-year period, and despite a tax increase in 2013 (chart-Obama).  But what about the GDP during the Obama Administration? A comparison of tax rates to GDP indicates that the GDP was barely increasing as compared to the Reagan era above, hovering around 2 percent throughout most of the eight-year period (chart-Obama GDP). So it would seem based on this chart that there is a strong correlation between tax rates and the GDP.

In contrast, the increase in tax revenues under the Reagan Administration (see again above chart) ranged from 4.8% to over 11%, averaging 6.8% following the earlier tax cuts. And this included another jump in tax revenues in 1987 after additional tax cuts were enacted, reducing the top tax rate from 50% to 38.5%. So this increase in tax revenues can only be explained by economic growth.  And sooner or later, this also has to produce jobs.

Related Articles:

Big Government or Free Markets – Which Works Best?

How Does the 2017 Tax Cut and Jobs Act Affect YOU?

Which Type of Business Entity Should I Choose? 

Whose Income is K-1 Income Anyway, Mine or My Businesses’?

 


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