Do tax cuts stimulate an economy?

Question

Every election cycle, I keep hearing that tax breaks stimulate the economy.

Are there any well-known studies or scientifically-backed examples from history that shed light on whether or not this claim is true or false?

Answer 1

Taxes do affect economic growth, but not equally. From the OECD paper, Do tax structures affect aggregate economic growth? Empirical evidence from a panel of OECD countries:

The results of the analysis suggest that income taxes are generally associated with lower economic growth than taxes on consumption and property. ... Property taxes, and particularly recurrent taxes on immovable property, seem to be the most growth-friendly, followed by consumption taxes and then by personal income taxes. Corporate income taxes appear to have the most negative effect on GDP per capita. These findings suggest that a revenue-neutral growth-oriented tax reform would be to shift part of the revenue base towards recurrent property and consumption taxes and away from income taxes, especially corporate taxes.

However, upon doing a review of the economic growth literature in 2002 (15 Years of New Growth Economics: What Have We Learnt?), Xavier Sala-i-Martin concluded that:

The size of the government does not appear to matter much. What is important is the “quality of government” (governments that produce hyperinflations, distortions in foreign exchange markets, extreme deficits, inefficient bureaucracies, etc., are governments that are detrimental to an economy).

In other words, a government that focuses on the right tax mix (high consumption and property tax, low corporate income tax, and reasonable personal income tax), such as Sweden, will have a tax system that has little negative effect on the economy in spite of having a large public sector.

In summary:

• If they're talking about reducing corporate income tax, they are usually right.
• If they're talking about personal income tax, it depends.
• If they're talking about consumption tax or property tax, they're usually wrong.

Answer 2

The question regards the effects of tax cuts, not distortions created by taxes generally. The shortest answer to the question 'do tax cuts stimulate the economy' is yes, they have to.

Basic (principles level) supply/demand analysis describes a 'dead weight loss' associated with a difference between the price paid by consumers and the price received by producers. Economic activity in the affected market must decrease; maintaining the original quantity requires consumers to pay the original price plus the entirety of the tax (perfectly inelastic demand), or producers must be willing to sell at a price equal to the original less the entire tax (perfectly inelastic supply).

Absent one of these (theoretically possible, but empirically very rare) conditions, the tax reduces economic activity. Thus, any tax cut which reduces the size of a 'dead weight loss' must 'stimulate the economy'

Borror0's post discusses various tax design schemes, correctly noting taxes on inelastic goods (land, almost perfectly inelastic) distort the economy less than taxes on elastic goods (labor). This discussion omits one key point; no matter how well designed a tax system is, the tax changes relative prices. This change in relative prices has efficiency implications.

Beyond relative prices, in practice taxes may reduce economic activity due to - administrative costs associated with collecting taxes and punishing fraud - allocative issues associated with how tax revenue is spent

Either of these issues warrant their own threads. The current question simply asks whether tax cuts stimulate the economy. The answer is unequivocally yes. Whether the size of the stimulus provides ample justification for the cut is a political question. Tax cuts may 'stimulate the economy' but also result in cuts to important programs.

for a detailed explication of microeconomic principles, please see a quality text book. The wikibook on this topic is useful. Also, Mankiw writes a popular text.