Tax Cuts: Overview

Introduction

Income tax policy is one of the most debated topics in the United States, with Republicans and Democrats typically unable to come to agreement on the timing and extent of any proposed tax cuts. Research shows that most people do not mind paying taxes as long as their share is fair and the money contributes to the public good. What constitutes “fair” and “the public good,” however, is one of the issues central to the debate over tax cuts.

During the administration of President George W. Bush, income tax rates were cut. In the midst of a budget deficit and war, debate over Bush’s tax cuts was strong. Critics of the tax cuts approached the issue from different perspectives. Conservative Republicans, who strongly supported the cuts, were at odds with Bush because he did not decrease federal spending by cutting domestic programs and thus did not adhere to his platform to form a “smaller government”; instead, government spending increased by over 40 percent during the Bush administration.

Democrats also opposed cutting taxes without simultaneously cutting spending, but they disagreed with conservative Republicans over which, if any, programs to cut. Democrats were particularly vocal in pointing out that Bush added about $3 trillion to the federal deficit, including billions of dollars borrowed from the Social Security Trust Fund, negating the Clinton administration’s success in balancing the budget. They predicted that future generations would bear the brunt of the tax cuts and worried especially about the future of Social Security.

Arguments over the fairness of taxes can be heard from the lower and middle classes as well as the wealthiest taxpayers. Bush’s tax cuts provided relief for workers in all tax brackets, yet there was little disagreement that the cuts, as well as previous cuts made during other Republican administrations, primarily benefited the wealthy. Bush defended his tax policy by citing his belief in “supply-side economics,” the theory that wealthy people will invest their tax savings in business activity, thus stimulating the economy for the benefit of all.

The theory of supply-side economics also guided Ronald Reagan’s policies during the 1980s, and “supply-siders” credited Reagan’s tax cuts with ending a recession and building a strong economy. Critics of supply-side economics contend that the Federal Reserve, then under the direction of Alan Greenspan, deserves the credit for the economic improvements.

Understanding the Discussion

Capital gains: Profits earned by selling stock or real estate at a higher price than the original purchase price.

Federal budget: The federal government’s estimates of revenues and expenses for the coming fiscal year. Revenues are generated by taxes on income, payroll (Social Security and Medicare), estates, and corporate profits. The government incurs expenses for defense, education, entitlements, transportation and highways, the judicial system, and other public programs. When tax revenues exceed expenditures, a budget surplus occurs. When revenues are less than expenses, forcing the government to borrow money, a budget deficit results.

Income tax: A tax levied on employee salaries and wages for the purpose of funding the federal government. The US tax system is described as “progressive” because the percentage of income charged gradually increases with the income itself, so those with higher incomes must pay a higher percentage.

Recession: A period of economic decline generally defined by economists as two consecutive quarters (three-month periods) of decrease in the gross domestic product (GDP), which is the monetary total of all economic activity in the country. When consumer spending declines, it typically raises the threat of a recession, since consumer spending accounts for approximately 65 percent of the United States’ GDP.

Stagflation: An economic term that refers to stagnant growth plus high inflation and unemployment.

Supply-side economics: A term coined in 1975 by journalist Jude Wanniski to describe the theory that tax cuts for the wealthy will result in a stronger economy without the need to cut federal programs. This theory, expounded by Nobel Prize–winning economists Milton Friedman, Robert Mundell, and others, is based on the premise that wealthy investors will use tax cuts to begin new ventures that will provide more jobs and result in additional income tax and a stronger federal budget.

History

Prior to the Civil War, the United States government relied on capitation taxes, or taxes imposed on citizens regardless of income. These were often implemented during times of war, including the War of 1812, and then abandoned. In 1862, Congress enacted the first income tax as part of the Internal Revenue Act, which generated funds to help pay for the Civil War. The tax rates were progressive, in that 3 percent was levied on incomes between $600 and $10,000 (equal to about $13,548 to $225,805 in 2014) and 5 percent on any income over $10,000. Rates were raised again in 1864, but after the war, they were flattened to 5 percent for those with incomes $1,000 and higher. The income tax law expired in 1872, and attempts to reenact it were ruled unconstitutional by the Supreme Court.

The Sixteenth Amendment to the United States Constitution, which enables Congress to levy an income tax, was passed in 1913. President Woodrow Wilson implemented the first legal income tax at the rate of 1 percent for single incomes above $3,000 (equivalent to $70,621 in 2014), with progressive surtaxes on incomes above $20,000 ($470,806), the highest additional rate being 6 percent on incomes of $500,000 ($11.77 million) and above.

During World War I, the tax rate for those in the highest bracket climbed to 77 percent in order to help finance the war. Rates fell steadily during the 1920s but were raised during the Great Depression, then again during Franklin Delano Roosevelt’s administration to fund the New Deal. When Roosevelt enacted the Victory Tax during World War II, tax rates soared to 94 percent for those in the highest income bracket and 23 percent for the lowest.

Lyndon B. Johnson implemented the first major tax cuts in 1964. In addition to cutting corporate taxes, the Revenue Act of 1964 lowered income taxes from 91 percent to 70 percent for those in the top tier and from 20 percent to 14 percent for the lowest tier. It also introduced the standard $300 deduction. A period of economic growth followed, although economists are divided over whether the tax cuts were responsible.

The 1970s was a period of stagflation. In 1977, Jimmy Carter attempted to rejuvenate the economy by lowering the income tax rate from 70 to 50 percent for those in the top bracket and from 14 to 10 percent for those in the lowest bracket. Carter ended his term with a stronger economy and a budget surplus.

Ronald Reagan’s administration saw the passage of the Economic Recovery Tax Act of 1981, which cut the top tax rate from 50 to 28 percent. Reagan embraced the new and then-unpopular theory of supply-side economics, much to the dismay of traditional Republicans and economists. His conviction that large tax cuts for the wealthy would encourage investors to begin new initiatives that would strengthen the economy may have played a key role in ending the stagflation of the 1970s, although his second presidential term ended with the largest budget deficit in US history to date.

Bill Clinton raised taxes and succeeded in balancing the budget. During his presidency, the economy boomed, and a bull market provided the wealthiest Americans with generous profits. Unfortunately, the income among the middle and lower classes changed much less, and the gap between the rich and poor widened considerably.

Tax cuts were high on the list of priorities for George W. Bush when he took office in 2001, despite a poll conducted in 2000 by ABC and the Washington Post that said more than 75 percent of Americans cared less about tax cuts than they did about the solvency of Social Security, reducing the federal debt, lowering health-care costs, or providing more money for education.

In 2001, the Bush administration implemented its first tax-cut package, the Economic Growth and Tax Relief Reconciliation Act, which was projected to reduce the federal budget by $1.35 trillion over a ten-year period. Bush also introduced a tax rebate with the hope of stimulating the sluggish economy.

Bush’s next initiatives were the Job Creation and Workers Assistance Act of 2002, estimated to reduce the federal budget by $41.6 billion over a ten-year period, and the Jobs and Growth Tax Relief and Reconciliation Act of 2003, projected to reduce the federal budget by $340 billion over ten years. The 2003 tax cuts expanded the child tax credit to $1,000, cut the income tax rate by 3 percentage points for all but the two lowest tax brackets, decreased tax rates for stock dividends and capital gains, and eliminated the “marriage penalty,” by which married taxpayers paid a higher tax than if they filed individually as single taxpayers.

Bush worked diligently to make his tax cuts permanent. Some cuts expired in 2005 and 2008, including a $4,000 deduction for college students. Other cuts were slated to expire after 2010. To prevent this, Congress passed the Tax Increase Prevention and Reconciliation Act of 2005, which extended the cuts on dividends, long-term capital gains, and other measures for a total of $70 billion over ten years.

Tax Cuts Today

In December 2010, President Barack Obama signed into law legislation that extended the Bush-era tax cuts, which were set to expire in 2011, for another two years. Although many in the Democratic Party were against the extension, Obama said that it was a compromise with Republican legislators to protect tax benefits for the middle class.

Two years later, on January 1, 2013, Congress passed the American Taxpayer Relief Act of 2012. This legislation maintained Bush’s tax cuts for individuals with incomes below $400,000 ($450,000 for married couples) but allowed them to lapse for incomes above that threshold, raising the highest individual rate from 35 percent to 39.6 percent. Altogether, the act provided for $600 billion in new tax revenue over the next decade—less than the $800 billion hoped for by Obama and fellow Democrats, and approximately one-fifth of the tax revenue that would have been generated had all of the cuts been allowed to expire.

In late December 2017, the Republican Congress under President Donald Trump passed the Tax Cuts and Jobs Act. This legislation eliminated individual income tax deductions for state and local taxes, as well as all itemized deductions except charitable donations; reduced the amount of mortgage debt eligible for interest deductions to $750,000 from $1,000,000; increased the standard deduction; changed the income levels within each tax bracket; and more than doubled the exemptions for estate tax. Rates were lowered for each tax bracket, effective for a decade. At the same time, the law discontinued the corporate alternative minimum tax, cut the top corporate income tax rate permanently from 35 to 21 percent, and changed the system to a worldwide tax system. Businesses and other supporters believed the act would simplify tax filing for individuals and families, reduce taxes for most Americans, and encourage business growth, which would in turn result in wage increases and new jobs. Critics maintained that the tax cut benefited the wealthiest Americans and big business at the expense of the middle and lower classes and small business owners. Others objected to the increase in the federal budget deficit that the tax cut would likely bring.

In the first quarter of 2018, companies responded by making capital expenditures and giving workers one-time wage increases, fringe benefits, or bonuses. Numerous job losses and stock buybacks were also announced, however. In June 2018, the Congressional Budget Office predicted a deficit of over $2.3 trillion over the next decade as a result of the tax cut. Research in 2024 revealed that the corporate tax cuts enacted by Trump did not help American workers as much as promised, though they did cause many to receive small pay increases. Further, the cuts added over $100 billion per year to the national debt.

To help counteract the economic effects of the COVID-19 pandemic on American households, the Congress under President Joe Biden passed the American Rescue Plan in 2021. The legislation expanded the Child Tax Credit from $2,000 to $3,600 for children under the age of six and to $3,000 for children under the age of eighteen (previously, only children under the age of seventeen were eligible for the credit). In addition to raising credit amounts, the credits were distributed to families in advance payments during the second half of 2021. Studies later showed that the expanded tax credit greatly benefited families during the pandemic, especially those who experienced job loss or illness at that time. However, despite reducing rates of poverty and food insufficiency, the legislation was not extended in late 2021, thus returning credit amounts to pre-pandemic levels in 2022.

These essays and any opinions, information or representations contained therein are the creation of the particular author and do not necessarily reflect the opinion of EBSCO Information Services.

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