How Tax Cuts Work

Okay, the following is the best explanation I’ve ever seen as to why giving tax breaks to the wealthy makes sense:

Why does cutting taxes (for the wealthy) result in MORE tax money being collected? The short answer is that by reducing tax rates (the percent of tax collected on each dollar of income) the government encourages people to work and earn more. Just as a business will often opt to reduce the price of its goods in order to increase the amount sold, the government is basically reducing the cost of working and thereby encouraging people to work and earn more. While it takes less in taxes on each dollar taxpayers earn, it collects the smaller amount from a much larger base of income thereby raking in a larger amount of tax dollars from a larger volume of taxable income.

The longer explanation has to do with the progressive nature of our tax system. Our Federal income tax has a series of rates rather than one rate. Basically, what the government does is set a schedule of tax brackets, say $1 -$20,000 worth of income is taxed at 10%; 20,001 – $30,000 at 20%; and $30,001 and above at 50%. In this scenario , everyone, from the poorest to the richest taxpayer pays 10% of the first $20,000 worth of income. A wealthy person earning $100,000 per year pays 10% of the first $20,000 she earns while the high school student with a part-time job earning $10,000 pays 10% of his income. While the high school student just pays his $1,000 in taxes (10% of $10,000); the wealthy person also has to pay 20% or $2,000 on the income earned between $20,001 and $30,000 and another $35,000 in taxes on the income between $30,001 and $100,000 (50% of the remaining $70,000 of income).

By reducing the top bracket rates, the government provides more incentive to work (prior to Ronald Regan, the top rate in the U.S. was about 90%, while in England the top rate at that time was something like 101% which resulted in the taxes on the income in the last bracket being more than the amount earned). Once a person earns enough to pay their basic living expenses (food, clothing and shelter) they can afford to choose between work and leisure. The higher the marginal tax rates (the taxes on the marginal or last amount of income earned) the less incentive one has to work. The idea behind the high rates is that the high marginal rates apply only to rich people who can afford the taxes because it does not deprive them of the money needed for life’s basic needs. This is true, However, since they have already earned enough in the lower brackets to pay for their basic needs, they now have a choice between working all day and having the government tax most of the recent income away or quit work for the rest of the year and play golf. When people stop working, they stop stop producing (meaning there are fewer goods being produced for the rest of us to buy) but they are also not making any money that the government can tax. If the tax on income in excess of, say $30,000 is 90% and people stop working as soon as their income for the year reaches $29,999 then the government gets to collect taxes at the rate of 90% of nothing.

Most of us can’t stop working when our income reaches a certain figure. However, higher income people are often professionals who have some control over the hours they work. Thus, people like doctors, lawyers, stockbrokers, etc. can usually control their hours and cut back as their income rises. Former President Regan himself experienced this while he was an actor. As a star actor he was in a position to accept or reject a script. He calculated that making five pictures per year put his income just below the highest bracket. So, if he did a sixth picture, most of the income would go to Uncle Sam. As a result he limited himself to 5 pictures per year and spent more time with his family. With other actors doing the same, the public had fewer shows to watch. However, this did not stop with star actors working less and the public making do with fewer new movies. With fewer shows being made, there was less work for lower paid actors who were below the star level as well as all the other behind the scenes people who help to make a movie. Not only did the government lose taxes on the extra money that the star actors would have made if they had not voluntarily left the workforce but it also lost the taxes the larger group of lower paid actors and other workers would have made if they had not been laid off involuntarily due to lack of work.

While people making lower incomes usually cannot temporarily stop working on their regular job in order to avoid being pushed into a high rate tax bracket, they can keep their income down by turning down extra work. The factory worker who accepts less overtime because additional overtime will throw him into a higher tax bracket. The person working a part-time job in addition to their full time job who quits the part-time job because most of it goes to taxes. Finally, the working spouse. In many cases one spouse, due to education and experience, will have a considerably higher income than the other spouse. With high marginal taxes, couples in this situation will find that the income from the lower income spouse is not worth the effort because most of it goes to taxes. How is this so? Well, for most households income taxes are calculated on the combined incomes of the husband and wife. Let’s assume a 90% tax on incomes in excess of $40,000 and assume that the husband earns $39,999 and the wife earns $20,000. With a 90% tax the $20,000 being brought in by the wife works out to an additional income for the household of $2,000 because $18,000 of her income is taxed away. Unless the husband is able to cut his hours and reduce his income by $20,000 to keep the household income at $39,999 it does not make sense for the wife to continue working.

By reducing high marginal tax rates more people have the incentive or opportunity to work and more people have the incentive to work longer hours and this not only generates more goods and services but a much larger income base on which to levy taxes.
So, why do deficits increase every time the government cuts taxes? While reductions in tax rates begin immediately, which causes a temporary drop in government revenues, the adjustment process takes a while as people slowly realize that their paychecks are suddenly larger and could be even larger if they worked more. Along with this realization process, there is also a lag between people deciding to work more and actually finding that work. The other, more important, reason why deficits initially balloon when taxes are cut is that Congress not only refuses to cut spending but continues increasing spending.
How Tax Cuts Work (Source)

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Categories: Money, Politics

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