Spending Choices

Why Tax Cuts Fail to Create Jobs

Last Update April 2011


In a previous study, we observed that tax cuts to the rich do not stimulate the economy. Tax cuts to the rich may actually harm the economy. Initially this finding seems counterintuitive. We believe that a person who has more money (less taxes) will spend it on goods and services. From this spending jobs are created. However, we see a hint in the historical data. The tax cuts of the 1920s and the Bush tax cuts of the 2000s were followed by investment bubbles. If we go back to our review of the opportunity costs of taxes, we will see that an investment bubble after tax cut to the rich is not at all surprising. Perhaps it should be expected.

Let's take a brief review of the opportunity costs of taxes.

When the poor pay taxes they must give up some necessities. That is all they have to give up. They can't afford anything else. It doesn't matter how the tax is implemented, income tax, flat tax, consumption tax. If the poor have to pay a tax, their opportunity cost will be necessities.

blue represents money spent, red represents potential spending lost to taxes.

The middle class will keep their necessities when they pay taxes. Taxes will not cause them to go hungry or homeless. But they will have to reduce their comforts and their investments. If they are lower middle class, they will have few investments. They will pay their taxes by giving up comforts.
The wealthy can pay a rather large tax rate without giving up any necessities or comforts. The very thing that makes them wealthy is that they have more money than they can spend. So they invest the rest. For the rich the opportunity cost of taxes is investments only. Taxes do not impact their necessities or comforts.

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Introduction to this discussion



From the above review, we can proceed to discuss how increases in take home pay, resulting from any cause such as a tax cut, may initially impact the economy. A pay increase (e.g.: tax cut) to the poor will result in more money going into basic necessities - food, apartments, etc. A pay increase to the middle classes will result in more money towards comforts, and some into investments. But a pay increase (e.g. tax cut) to the rich will result in more money going into investments. Thus, the investment bubbles that occurred after the tax cuts of the 1920s and the 2000s might have been predicted simply from the top heavy nature of those tax cuts.

This carries broader implications. If we want to create jobs by inserting money into the economy (e.g.: tax cuts), we can not just insert the money anywhere. Where we insert the money totally determines what will be created. Tax cuts to the rich would more likely create investment bubbles than jobs. Money to the poor will increase money needed to build apartments, grow food, and other necessities. (It may also increase money going to acts of desperation - e.g.: gambling.) Money to the middle class (pay increases, tax cuts, etc.) would likely have the most diverse impact.

On the other side, rapid increase in the wealth of the rich will contribute to investment bubbles and may occur as a result of investment bubble. Thus, rapidly increasing wealth of the rich would be one of the first indicators of investment bubbles.



Similar observations may be made when subsidies or tax incentives are given to businesses. Businesses may use their moneys in various manners. Some uses produce jobs, goods, or services. Some don't. Let's look at some typical ways that businesses will use their funds, and how those uses effect jobs and consumers.
Use of funds Jobs Impact Consumer Impact
executive compensation zero zero
dividends on stocks zero zero
mergers & takeovers negative negative
exporting jobs negative possibly cheaper goods
machines to replace workers negative faster production
expanding and training positive *
worker salaries positive *
research & development positive better more diverse goods

Each of these have been in the news in the last 20 years. A rather large portion of the $700 billion bailout of 2008 (the billionaires bailout) was used for executive bonuses and dividends. Many companies have used tax incentives to close American plants and relocate overseas. Many have used mergers for tax incentives. Some have used subsidies for research and development. A few have raised workers salaries. What we see is that many of the tax incentives have been used in ways that either fail to create jobs, or destroy jobs. Tax incentives are not always good for the economy.


Although we would expect tax cuts to bolster the economy, empirical evidence shows that they typically don't. Tax cuts to the rich are more likely to promote investment bubbles than job creation. Tax incentives to corporations frequently promote job destroying choices, or simply become handouts to the executives and the investors.


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