A tax cut is often thought of as the magical solution to our economic problems, but a tax cut is not always what it seems. On June 7th President Bush has signed into law the biggest reduction in federal taxes since 1981. Some Democrats say the tax cut will divert revenues that the federal government needs to spend on education, prescription drugs and other priorities, but Bush says it will supply a timely stimulus to the economy. The Bush proposal would including reducing income-tax rates, easing the marriage penalty, phasing out the estate tax and boosting tax breaks for charitable contributions.
In evaluating the impact of tax cuts on the economy, one must include both any potential positive effects from reducing marginal tax rates and the negative effects from reducing national saving. The overall impact of a tax cut on the economy thus is not necessarily positive. To determine whether tax cuts would raise or lower national productive capacity, one must look at estimates of the size of these offsetting effects.
The Bush tax plan would reduce the average statutory marginal tax rate (that is, the average tax rate applying to the last dollar earned in the economy) by roughly three percentage points relative to the current distribution of tax rates. Estimating the impact on the economy of this reduction in marginal tax rates is subject to substantial uncertainty. Marginal tax rate reductions could affect a variety of activities important to the economy, including work behavior, saving and investment, and risk-taking. A reduction in marginal tax rates may discourage work, by increasing the after-tax income of workers and therefore potentially inducing them to reduce their work effort (since they can achieve the same amount of after-tax income with less work effort). A reduction in marginal income tax rates could encourage you to save less, since the rate of return you earn would be higher and thus you could accomplish your goal with a lower saving rate.
