This report summarizes the evidence on the relationship between tax rates and economic growth, referring in a number of cases to more-detailed CRS reports. Potentially negative effects of tax rates on economic growth have been an issue in the debate about whether to increase taxes to address the budget deficit and whether to broaden the base and lower the rates with tax reform. Short-Run Counter-Cyclical Effects Versus Long-Run Growth

Initially, it is important to make a distinction between the effects of policies aimed at short-term stimulation of an underemployed economy and long-run growth. In the short run, both spending increases and tax cuts are projected to increase employment and output in an underemployed economy, such as the United States today. These effects operate through the demand side of the economy. In general, the largest effects are from direct spending and transfers to lower-income individuals, whereas the smallest effects are from cutting taxes of high-income individuals or businesses. Long-run growth is a supply-side phenomenon. In the long run, the availability of jobs is not an issue, as an economy naturally creates jobs. Output can grow through increases in labor participation and hours, increases in capital, and changes such as education and technological advances that enhance the productivity of these inputs. Because much discussion is focused on the consequences of individuals in the top marginal tax rate brackets who provide much of the saving and entrepreneurial input in the economy, the following charts include examinations of the relationship between labor supply, savings, and growth rates for the top marginal rates. Over the same 60-year period, the top marginal income tax rate and effective tax rate of capital gains income has fluctuated. In general, however, tax cuts still lead to similar effects as wages because both income and substitution effects are small. Empirical evidence suggests a negligible and possibly negative savings response. This inflow would generally not be affected by individual income taxes but could be affected by corporate rate cuts. Sometimes the capital gains tax is singled out as being particularly important to savings. In summation, the evidence in this section suggests that changing tax rates is likely to have small effects on supply of labor and capital and on output. Dynamic Revenue Estimating

Claims that the cost of tax reductions is significantly reduced through feedback effects, because of increases in economic growth (and that gains from tax increases are significantly reduced) have been made. A series of studies providing direct relationships between tax rates and tax revenues designed to measure these responses initially found large effects. In any case, the evidence suggests feedback effects from 3% to 10%. More recent estimates, however, have suggested a feedback effect of about 20%. Any positive feedback effects would be much more than offset, for a stand-alone tax change, by the interest and crowding out effects of debt.
This report summarizes the evidence on the relationship between tax rates and economic growth, referring in a number of cases to other CRS reports providing more substance and detail. Potentially negative effects of tax rates on economic growth have been an issue in the debates about whether to increase taxes to reduce the deficit and whether to reform taxes by broadening the base to lowering tax rates.
Initially, it is important to make a distinction between the effects of policies aimed at short-term stimulation of an underemployed economy and long-run growth. In the short run, both spending increases and tax cuts are projected to increase employment and output in an underemployed economy. These effects operate through the demand side of the economy. In general, the largest effects are from direct government spending and transfers to lower-income individuals, whereas the smallest effects are from cutting taxes of high-income individuals or businesses.
Long-run growth is a supply-side phenomenon. In the long run, the availability of jobs is not an issue as an economy naturally creates jobs. Output can grow through increases in labor participation and hours, increases in capital, and changes such as education and technological advances that enhance the productivity of these inputs.
Historical data on labor participation rates and average hours worked compared to tax rates indicate little relationship with either top marginal rates or average marginal rates on labor income. Relationships between tax rates and savings appear positively correlated (that is, lower savings are consistent with lower, not higher, tax rates), although this relationship may not be causal. Similarly, during historical periods, slower growth periods have generally been associated with lower, not higher, tax rates.
A review of statistical evidence suggests that both labor supply and savings and investment are relatively insensitive to tax rates. Small effects arise in part because of offsetting income and substitution effects (which make the direction of effects uncertain) and in part because each of these individual responses appears small. Institutional constraints may also have an effect. Offsetting income and substitution effects also affect savings. Capital gains taxes are often singled out as determinants of growth, but their effects on the cost of capital are quite small. International capital flows also appear to have a small effect. Most expenditures that affect the productivity of labor and capital inputs (research and development, education, or infrastructure) are already tax favored or provided by the government. Small business taxes are also sometimes emphasized as important to growth, but the evidence suggests a modest and uncertain effect on entrepreneurship.
Claims that the cost of tax reductions are significantly reduced by feedback effects do not appear to be justified by the evidence, where feedback effects are in the range of 3% to 10% and can, in some cases, be negative. Because of the estimated realizations response, capital gains tax cuts have in the past been estimated to have a large revenue offset (about 60%), but more recent empirical estimates suggest one of about 20%. In general, for stand-alone rate reductions the additions to the deficit would cause tax cuts to have a larger cost both because of debt service and because of crowding out of investment, which would swamp most behavioral effects.