Why we should consider reducing income tax
It has been nearly four months since Russia and Ukraine have gone to war, massively affecting the cost of living: from sunflower cooking and oil to wheat, Russian and Ukraine's lack of exports has had dire consequences on the global food supply chain.
I don't even have to mention the petrol price rising as your pockets must already feel it. However, there is a potential solution to our expenses, burning a hole in your wallet: reducing income tax.
Reductions in income tax rates affect the behaviour of individuals and businesses through both income and substitution effects. The positive impact of tax rate cuts on the size of the economy arises because lower tax rates raise the after-tax reward for working, saving, and investing. These higher after-tax rewards induce more work effort, saving, and investment through substitution effects. This is typically the "intended" effect of tax cuts on the size of the economy.
Another positive effect of pure rate cuts is they reduce the value of existing tax distortions and induce an efficiency-improving shift in economic activity (even holding the level of economic activity constant) away from currently tax-favoured sectors, such as health and housing. We must consider this: pure rate cuts may also provide positive income (or wealth) effects, which reduce the need to work, save, and invest.
For example, an across-the-board cut in income tax rates encompasses all these factors. It raises the marginal return to work, increasing labour supply through the consumer switching to cheaper alternatives, i.e. the substitution effect.
It reduces the value of existing tax subsidies and thus would likely alter the composition of economic activity.
The substitution effect also raises a household's after-tax income at every level of labour supply, which in turn reduces labour supply through the income effect.
The net effect on labour supply is ambiguous, with no definitive outcome. Similar results also apply to the impact of tax rate cuts on saving and other activities.
Tax rate cuts may encourage individuals to work, save, and invest.
In the long-term, it will reduce national savings and raise interest rates. But, if immediate spending cuts do not finance the tax cuts, they will likely also result in an increased federal budget deficit.
The net impact on growth is uncertain, but many estimates suggest it is negligible or negative.
Base-broadening measures can eliminate the effect of tax rate cuts on budget deficits.
At the same time, they also reduce the impact on labour supply, saving, and investment, reducing the direct effect on growth.
However, they also reallocate resources across sectors toward their highest-value economic use, resulting in increased efficiency and potentially raising the overall size of the economy. The results suggest that not all tax changes will have the same impact on growth, leaving many with concerns for our future.