Do Tax Cuts Create Jobs? If So, How?

Payroll Tax Cuts that Target New Hires Are the Most Effective

do tax cuts create jobs
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Tax cuts do create jobs, but the results vary widely. They depend on the type of tax cut, the recipient, and how high taxes were before the cut. The Congressional Budget Office did a comprehensive study of created by different government policies. It analyzed seven types of tax cuts. It found that the most cost-effective policy was payroll tax cuts targeted to new employees.

The CBO also compared that to the number of jobs created by other government programs. It included spending on infrastructure, increasing unemployment benefits, and aid to the states. The report found that extending unemployment benefits is more cost effective than any tax cut.

Income Tax Cuts

Income tax cuts stimulate demand by putting more money into consumers' pockets. That's important because consumer spending drives 68% of economic growth. It creates jobs when businesses ramp up production to meet the higher demand.

Across-the-board income tax cuts aren’t very cost effective. The CBO study found that, at best, they create 4 jobs for every $1 million in lost tax revenue.

Tax cuts for the middle class and poor do better. Middle-income families are likely to spend the tax cuts. During a recession, they need every dollar they can get. They pump the money directly into local shops, who hire more workers to meet the increased demand.

The CBO study found that providing tax credits for the households with low and middle incomes created 7 jobs per $1 million in credits.

Do tax cuts for the rich create jobs? High-income families are more likely to save their tax cut than spend it. During a recession, they don't need the extra money to maintain their standard of living. They already have savings and lines of credit to do that.

The CBO found that tax cuts for the rich would create 4 jobs for every $1 million in cuts. It reviewed the impact of maintaining higher exemption amounts for the Alternative Minimum Tax. The AMT gets triggered when taxpayers make more than the exemption. It’s more likely to catch those in higher tax brackets. Keeping the exemption higher would benefit wealthy households.

Corporate Tax Cuts

Across-the-board corporate tax cuts don't do much to create jobs. That's according to a by the Institute for Policy Studies. It compared 92 publicly-held corporations who paid less than the 35% corporate tax rate. It found that, between 2008 and 2015, these corporations lost jobs while the overall economy increased jobs by 6%. Instead of paying taxes or hiring, these companies bought back their own stocks. They also increased CEO pay at a higher rate than the average for companies listed on the S&P 500.

This was a similar finding to a . It compared companies in low-tax states to those in high-tax states. They found the tax rate didn't affect job creation unless tax cuts were offered during recessions.

Payroll tax cuts are the to increase jobs because they lower the cost of labor. These cuts create jobs in four specific ways:

  1. Companies with popular products immediately use the savings to hire more workers.
  2. Other companies use the savings to reduce prices. That increases demand, which necessitates hiring more workers. 
  3. Some firms use tax savings to allow them to buy more goods. This benefits manufacturers.
  4. Many businesses use the cuts to raise wages to retain good workers. The workers spend more, increasing demand.

According to the CBO, every $1 million in payroll tax cuts creates 13 new jobs.

The payroll tax cuts specifically targeted for new hires is the most cost-effective tax cut. Every $1 million in targeted payroll tax cuts creates 18 new jobs. It lowers the cost of new employees when compared to existing workers or investment in new equipment. That changes employers’ decision-making in favor of new hires.

How Tax Cuts Create Jobs

Supply-side economics is the theory that says . Tax cuts do provide a boost, but only in the short term. In an economy that was already weak, tax cuts served an immediate lift.

The Laffer Curve states that tax cuts reduce government revenue dollar-for-dollar. It argues that the government will recoup that loss over the long term by boosting economic growth and the tax base. But the National Bureau of Economic Research found that from corporate tax cuts.

One reason for this discrepancy could be the tax rate before taxes were cut. According to Laffer's model, the tax rate must be in the "Prohibitive Range," which is above 50%, for the cuts to stimulate the economy enough to recoup all the losses.

For example, the President George W. Bush tax cuts boosted the economy in the short-term. But increased growth wasn't enough to recoup the revenue lost. In 2001, the percentage of federal revenue to gross domestic product went up to 20.9%. This value is higher than the norm because the economy shrank. After the Economic Growth and Tax Reconciliation Relief Act, federal revenue fell to 18% of GDP. In 2004, the percentage of revenue to GDP fell to 16%. By 2006, the percentage of revenue to GDP rose a bit to 18%.

Even though the percentage of government revenue to GDP decreased, the total revenues increased because GDP increased.

To avoid increasing the federal debt, Congress should also reduce spending. Investors see the excessive debt as a tax increase on the future generations who must pay it off. That occurs when the ratio of debt-to-gross domestic product is near 77%. The World Bank found that if the debt-to-GDP ratio exceeds this for an extended period of time, it slows the economy. Every percentage point of debt above this level costs the country 1.7% in economic growth.

What's Better Than Tax Cuts at Creating Jobs?

If tax cuts aren't great at creating jobs, what about government spending? The CBO study found that extending unemployment benefits works better than any tax cuts. It creates 19 jobs per $1 million spent. Benefits create jobs because the unemployed wind up spending every dollar they receive on essentials such as food, clothing, and housing. 

A found that every dollar spent on unemployment benefits stimulates $1.73 in economic demand. For example, the Obama benefit extensions cost taxpayers $10 billion every month. But they generated $17.3 billion in economic growth per month.

The best way to create jobs is not through tax cuts, government spending, or any fiscal policy at all. Instead, it's through monetary policy, one that expands the money supply, making more liquidity available for businesses to invest. Fiscal policy is only necessary when monetary policy is already as expansionary as possible. That happened in 2009 and 2010 after the Great Recession forced the fed funds rate to zero.

The Bottom Line

Although tax cuts do add more jobs, how effective these are depends on where and when these cuts are applied. Tax cuts are best applied on individual income rather than on corporate income. Tax cuts work well to boost employment and GDP only if the previous taxes were high enough to have dampened economic growth.

Their application must also be weighed against their propensity to add to government debt. For these reasons, tax cuts are not the most favored solution for significant job creation. The best way is through an expansionary monetary policy. This allows a lot of money to be available to increase consumer demand, business investments, and consequently, employment rates.