The tax bill President Trump signed into law has provisions we like and others we don’t. What we like the best is that it reduces marginal tax rates for almost all taxpayers, both individual and corporate. So just what are marginal tax rates, and why do economists think they are so important? Here is a simple example that makes the point.
Linda and Connie are both caterers living in different jurisdictions. Both cater 100 events a year and clear $1,000 per event, so each makes an annual income of $100,000. They both pay $20,000 in income taxes to their respective governments. On the surface, the two businesswomen appear identical.
However, in Linda’s jurisdiction, the income tax is a flat 20 percent on all income earned; whereas, in Connie’s jurisdiction, the first $50,000 in income is subject to zero tax, while all income earned above that is subject to a 40 percent tax rate. Although Linda and Connie both pay on average a tax of 20 percent, Linda faces a marginal tax rate of 20 percent while Connie faces a marginal tax rate of 40 percent. A fundamental proposition of economics since at least the 1880s is that decisions are made at the margin.
To see why this matters, suppose each woman is offered an opportunity to cater one more event that yields $1,000 in pre-tax income. Accepting the job gives Linda an additional $800 in after-tax income while it gives Connie only $600. It doesn’t take a doctorate in economics to surmise that Linda is much more likely to accept the additional job than is Connie. Nor does one need to be a rocket scientist to realize that, if Connie’s marginal tax rate were reduced, she would be more likely to engage in additional economic activity.
This is why economists theorize that cuts in marginal tax rates will boost economic growth and lead to rising real wages. In the fall of 1982, after much political wrangling, cuts in marginal tax rates were finalized and implemented. The next 16 quarters saw average annual GDP growth of 5.1 percent. It had averaged a meagre 1 percent in the 16 previous quarters.
We should not make too much of these statistics, as monetary policy in the early 1980s was quite different from today. In addition, federal debt was much lower as a percentage of GDP than now. Nevertheless, there is reason to hope reduced marginal tax rates will increase economic growth.•
Bohanon and Curott are professors of economics at Ball State University. Send comments to firstname.lastname@example.org.