An average person, asked to explain the impact of cutting taxes, might well reason:
I have represented this argument in flow chart form to give it a spurious air of logical coherence. Yet any flow chart is only as good as the reasoning that underlies it. In this case, that reasoning is seriously incomplete.
A tax cut has two immediate impacts on government revenue. First, less revenue is raised from the existing tax base, from the firms, consumers and workers who are presently paying taxes. In the diagram below, the loss in revenue is shown in the two pink-ish rectangles labelled "Revenue loss." Second, a tax cut may reduce the gap between before tax and after tax wages. If it does, people may supply more labour, putting downwards pressure on the the before-tax wage rate, encouraging firms to hire more workers. The tax revenue gained from new workers, and from people working longer hours, is shown in the purple rectangle labelled "Revenue gain" below.
Notice that the benefits of the tax cut are shared between employees, who pay lower taxes, and employers, who are now able to offer lower wages. This division of benefits, as well as the relative magnitude of the revenue loss and revenue gain rectangles depends upon how firms and workers respond to the tax cut.
Most empirical research suggests that people do not usually change their work hours much when their after-tax wage rate changes. There are even studies that have found 'backwards bending' labour supply curves. People sometimes respond to an increase in their after-tax wage rate by reducing their work hours, because they do not have to put in so many hours to pay the mortgage. In sum, based on what economists know about labour supply, one would expect tax revenues to fall when tax rates are reduced.
Recent experience with tax cuts - the reduction in the federal GST in Canada, for example, or the Bush tax cuts or the US, for example - supports that intuition. As GOP policy adviser Bruce Bartlett put it, "Few people remember that a major justification for the 2001 tax cut was to intentionally slash the budget surplus....In this regard, at least, the Bush-era tax cuts were highly successful."
The reason why hours worked are fairly unresponsive to wage rates is that many people do not have much control over their work hours - a nine to five job requires a fixed number of hours per week. It can be argued that the rich are different from you and me - they have more options, are more free to choose when and where they work, and thus their labour supply is more elastic. Perhaps tax cuts for footloose and fancy free jet setters have some revenue raising potential?
High tax rates on the rich can cause an erosion of the tax base and reduce tax revenue - though the size of this effect is debated. The Rolling Stones' Mick Jagger, Keith Richards and Charlie Watts, for example, fled Britain's high tax rates for the Netherland's less onerous tax regime decades ago.
But, as the NY Times reports "over the last 20 years, according to Dutch documents, the three musicians have paid just $7.2 million in taxes on earnings of $450 million that they have channeled through Amsterdam — a tax rate of about 1.5%, well below the British rate of 40%." There is no way that the British could lure the Rolling Stones back without providing even more generous tax treatment.
So far I have been taking it for granted that cutting taxes will increase incentives to work and to save. Yet even this is not obviously the case. Economic decisions are made at the margin. Unless a tax cut changes incentives on the margin, it will usually create little or no behavioural response.
Take, for example, a $1000 increase in the basic exemption or personal amount tax credit, the amount of income that a person can earn without paying income tax. For every person who is currently earning more than the basic exemption, an increase in that exemption is just like getting a cheque in the mail. It means the person has more money in her pocket, but her incentive to work longer hours, to put extra effort in at her job, is unchanged. If anything, she might feel as if she can afford to take a day off, and cut back on her work hours.
For students of economics, the impact of an increase in the basic personal amount on work incentives looks something like this:
Except for individuals who are just to the left of the kinked point on the red budget constraint, the increase in the tax exemption will act like an increase in income. It increases the amount of leisure the individual can afford to consume, and thus would be expected to decrease the hours the individual works.
There are many good reasons to increase the basic tax exemption. It is a progressive way of reducing taxes, as the benefits as a percentage of income are greatest for low income people. It can be an important part of a strategy to reduce "welfare walls" and encourage people to enter the labour force. But it is unlikely to produce any kind of behavioural responses that lead to a significant increase in tax revenues.
The basic lesson of economics is that people - including governments - aren't stupid. If it was possible to generate an immediate increase in tax revenues by reducing tax rates, taxes would be cut instantly. Taxes are what they are in part because reducing taxes creates an immediate revenue short-fall.
The ultimate impact of a tax cut depends upon how that revenue short-fall is met. Are basic government services, such as transportation infrastructure or the legal system, cut? Inadequate infrastructure is an obstacle to doing business, just like high taxes, and can impede economic growth. Does the government borrow to maintain spending levels? High levels of government debt are hardly good for the economy. Is redistributive spending, such as social security and medicare, scaled back? It might promote economic growth, but it would be political suicide.
[Update] But what about the argument that Ryan makes in the comments below, "You can't create a low-tax regime in the long run without first cutting at least one tax in the short run"? It is true that circumstances change. If other countries cut corporate tax rates, the country that tries to stick with its existing regime may face a loss of revenue. The internet makes it easier to run a business from a Barbados beach house than it was 20 years ago. The first question to ask someone who proposes cutting taxes is: "What has changed? Why is the previous tax rate no longer optimal?" The second question to ask is: "What is a reasonable estimate of the likely behavioural response?"
Take, for example, the case of Amazon UK as described in a recent article in the Guardian:
The UK operation avoids tax as the ownership of the main Amazon.co.uk business was transferred to a Luxembourg company in 2006. The UK business is now owned by Amazon EU Sarl and the UK operation is classed only as an "order fulfilment" business. All payments for books, DVDs and other goods go directly to Luxembourg. The UK business is simply a delivery organisation.
The latest 2010 accounts for Amazon EU Sarl show the Luxembourg office employed just 134 people, but generated turnover of €7.5bn (£6.5bn). In the same year, the UK operation employed 2,265 people and reported a turnover of just £147m. According to the SEC filings, UK sales that year were between £2.3bn and £3.2bn. Amazon in the US has earned an average 3.5% profit margin over the past three years.
The only way to persuade Amazon to unwind these lucrative arrangements would be to reduce UK corporate income taxes to a level lower than Luxemburg's. Any smaller reduction would be unlikely to produce any behavioural response.
There are no twenty dollar bills lying on the sidewalk. Cutting taxes has consequences, and not all of them are pleasant.
Update: for an explanation of the Laffer curve, see this interview with Arthur Laffer on Icelandic television.
Update: this backgrounder from the Center on Budget and Policy Priorities makes the point that tax avoidance and evasion strategies, while they impact tax revenues, do not necessarily have significant impacts on the real economy. Also gives references.