Some argue that cutting taxes will generate a level of economic growth sufficient to offset a substantial part, if not all, of the revenue lost. Under this theory, tax cuts do not cause deficits, but generate the growth necessary to reduce deficits. Yet, there is little historical or academic evidence from the past decades to suggest that tax cuts alone pay for themselves.
There is a healthy debate over the degree to which tax cuts, which allow taxpayers to spend a higher percentage of their income on goods and services, can spur additional economic growth. There have also been helpful attempts to refine how the official government scorekeepers account for revenue loss from tax cuts through so-called “dynamic scoring” which takes into account the budgetary impact of economic feedback.
However, two things have remained clear: 1) tax cuts don’t pay for themselves and 2) the revenue loss of tax cuts depends on what taxes are being cut, the state of the economy, and whether tax cuts are paid for by spending cuts.
During a recession, policymakers can design short-term tax cuts that get money into the economy quickly, boost economic growth, and wind up leading to less revenue loss than had the very same tax cuts been enacted during a period of economic growth. Policymakers could also enact less well designed tax cuts during a recession that have little to no impact on the economy.
Enacting longer term tax cuts, designed to increase the incentives for work and saving, can also lead to increased economic growth. However, if those tax cuts are not paid for by spending cuts, the economic effects of the increase in the deficit can blunt or even completely reverse any positive economic impact from cutting taxes.
When the George W. Bush administration tried to analyze the economic impact of making their tax cuts permanent, their best case analysis was that only 10 percent of the cost of the tax cuts would be offset through increased revenue due to heightened economic growth. Other analysis of the impact of tax cuts from conservative think tanks has found that at most one-third of tax cuts would be offset through increased growth.
Tax reform that doesn’t increase the deficit and makes the code simpler and more efficient could potentially increase economic growth. However, tax cuts themselves are not a free lunch.