Since personal income tax remains inevitable in all economies, the adjustments of tax rate have certain long-run and short-run effects that determine financial decisions of taxpayers. From a macroeconomic perspective, changes in tax policies play a significant role to acquire successful tax structures that influence economic growth.
In the United States, changes in personal income tax are heavily dependent on the regulations in the Revenue Act of 1964 (RA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (TRRA). While the RA decreases the marginal tax rates of personal income, the TRRA increases tax expenditures and decreases the marginal tax rates of personal income, capital gains, and dividends. Both legislative regulations create an average cut of 2% in personal income tax (Mertens and Ravn 1223). The US government designs income tax codes to ensure a wide variety of capital income ownership, thus generating a large amount of taxable income (Saez and Zucman 528).
Although the reduction in personal income tax in the US seems beneficial for taxpayers, there are also consequences in income equality. In 2012, the annual incomes of taxpayers were $84,000 (90%), from $660,000 to $4 million (9%), from $4 million to $20 million (1%), and above $20 million (0.1%) (Saez and Zucman 541). Hence, the wealth distribution in the US formed a larger gap in income equality despite the efforts from personal income tax policies.
To improve living standards based on the long-run impacts of personal income tax cuts, the adjustments in personal income tax need to acquire positive economic growth, thus indicating an increase in Gross Domestic Product (GDP). In fact, the cuts in personal income tax may acquire economic growth with a balance between after-tax returns and incomes. While the after-tax returns increase decisions of taxpayers to work, save, and invest, the after-tax incomes decrease those decisions. Specifically, 1% of the personal income tax cut would increase the real GDP per capita from 1.4% to 1.8% after nine months (Mertens and Ravn 1213). In this way, adjustments in tax policy lead to changes in equilibrium values, thus generating the transitory growth effects of the economy. Although personal income tax cuts have positive impacts on living standards, the economic growth takes decades for practical implications because of adjustment costs of new investments and limited elasticity of saving rates, thus constituting a long-run effect (Lee and Gordon 1029).
Moreover, personal income tax cuts also have a long-run effect of interest rates. According to the Federal Reserve System (FED), interests from mutual funds, business partnerships, and holding companies are in the interest line of the personal tax returns and incomes in forms of directly-owned stocks and bonds. Based on the income tax codes of the US government, these stocks and bonds are taxable because they are wealth-holding intermediaries and exotic financial instruments (Saez and Zucman 528). Thus, adjustments in personal income tax have a direct, yet long-run connection with the interest rates. While the personal income tax cuts create the impulse responses to the money supply, there is not strong evidence of a short-run effect of interest rates. In fact, although the reductions in personal income tax are dis-inflationary and inflationary, the corresponding effects are not important to 95% of taxpayers (Mertens and Ravn 1231). The long-run effect of interest rates derived from the significant wealth inequality in society. With reference to 0.01% of the population with 5.4% of total household wealth in 2012, the increase in wealth concentration was the consequence of the increased interest rate between top wealth-holders and other taxpayers (Saez and Zucman 543).
Furthermore, personal income tax cuts influence short-run employment rate. Reductions in personal income tax decline the unemployment rate and enhance the productivity of each employee (Mertens and Ravn 1214). Although high personal income tax may affect the employees, it does not cause serious consequences for the self-employed, thus encouraging entrepreneurial activities (Lee and Gordon 1031). In fact, a 1% reduction of personal income tax increases from 0.3% to 0.8% of employment per capita after fifteen months (Mertens and Ravn 1239). Therefore, reductions in personal income tax only have short-run impacts on employment rates.
With regard to the inflation rate, the US government considers inflation as a financial source to raise the costs to new entrants and facilitate large existing companies that are heavily dependent on financial intermediaries. In this way, the large gap between new entrants and large existing companies limits the economic growth, thus indicating a reduction in personal income tax (Lee and Gordon 1032). Still, personal income tax cuts do not have clear long-run impacts on the inflation rate. The inflation rate is dependent on the expansionary effects of personal income tax cuts, which originate from the increased demand or supply for final goods (Mertens and Ravn 1231).
While appropriate cuts in personal income tax inspire the decisions of taxpayers to work, save, and invest, impractical tax rate cuts result in the high federal budget deficit, thus constituting high interest rates and low living standards. In other words, adjustments in personal income tax also acquire further practical implications for living standards, interest rates, unemployment, and inflation. Hence, inappropriate changes in personal income tax do not acquire a positive contribution to economic growth.
Part II – Research Questions
What Are the Impacts of Additional Personal Income Tax Reductions on Income Equality? The research question relates to the long-run impacts of personal income tax cuts on living standards, thus providing the solutions for increasing wealth inequality. The topic is promising to research as it focuses on a serious social issue in the US. The research question may employ primary and secondary data resources from personal tax documents and surveys of the FED with regard to changes in capital distribution after tax cuts.
How Do Additional Personal Income Tax Reductions Determine Entrepreneurial Activities? The research question focuses on the investment decisions of taxpayers to increase after-tax returns, thus explaining the roles of personal income tax cuts as an economic strategy. The topic relates to macroeconomics as it suggests solutions to increase the employment rate without changes in tax policies. The collection of primary and secondary data resources for personal and corporate tax documents would provide information of investment decisions.
What Are the Impacts of Additional Personal Income Tax Reductions on Corporate Income Tax? The research question is topical as the answer to it will provide the controls for interest and inflation rates based on the analysis of long-run and short-run effects. The research question emphasizes the balance between personal and corporate tax reductions, thus indicating a long-run solution for positive economic growth. The data collection process may employ the secondary resources from the tax documents and surveys of FED to construct the theoretical framework for the mutual relationship between personal and corporate income tax reductions.
Lee, Young, and Roger H. Gordon. “Tax Structure and Economic Growth.” Journal of Public Economics, vol. 89, no. 5-6, 2005, pp. 1027-1043.
Mertens, Karel, and Morten O. Ravn. “The Dynamic Effects of Personal and Corporate Income Tax Changes in the United States.” American Economic Review, vol. 103, no. 4, 2013, pp. 1212-47.
Saez, Emmanuel, and Gabriel Zucman. “Wealth Inequality in the United States since 1913: Evidence from Capitalized Income Tax Data.” The Quarterly Journal of Economics, vol. 131, no. 2, 2016, pp. 519-578.