What is the Effect of Income Tax Changes on US Economic Growth?

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The following article was written by Reem Aboul Hosn, Research and Market Analyst Officer at CFI Markets Ltd.

In a significant step that marks Donald’s Trump major achievement of his presidency, Republicans have passed US tax reform in an attempt to promote economic growth, create jobs and encourage US companies to invest more said Mitch McConnell, the Republican leader in the Senate.

In contrast, other economists’ bring up the issue that the tax cuts plan would cause the nation’s debt to rise significantly faster than the economy as deficit-financed tax cuts are widely believed to undermine growth; which was the main reason, Democrats opposed tax cuts.

However from a macroeconomic perspective; budget projections is affected by change in tax policy, not only as a function of economic growth, but also with interest employment and inflation rates. Given that the US economy is already close to full employment capacity, unemployment rate at 4%, is it a good idea to give a fiscal stimulus?

According to Tax Policy Center, United States has one of the highest corporate rates in the developed countries. Republican major plan is to provide deep tax cuts to corporations and wealthy business-owners to pump-up the economy and deliver more jobs and higher wages.

The dollar and the US stock market have made a strong move this week, following the passing of the tax bill in the senate. A preliminary assessment of the impact from a macroeconomic level, poses the question; will the largest tax cuts in the history of the country, modify the Federal Reserve strategy of tightening monetary policy? And the market expectations for increasing short-term interest rates?

Clearly, the Fed will increase rates at its next meeting on 13th and 14th of December. But expectation for 2018 increases are yet uncertain. Will the Fed clarify? This matters to all of us because the dollar rates will affect global rates.

At a microeconomic level, it is an important tax change because it will establish the 20% corporate tax rate as the “new” global standard.

Tax Cuts and the Economy:

In a market economy, reducing tax rates will spur economic growth since lower tax gives consumers more income to buy goods and services, boosts savings and investments, consequently, stimulate the economy.

Nevertheless, studies have shown that economic growth is not correlated with changes in marginal tax and capital gains rate. In other words, economic growth is largely unaffected by how much tax the wealthy pay. Growth is more likely to spur if lower income earners get a tax cut. It remains true that cutting taxes reduces government revenues, at least in the short term, creating either a budget deficit, or increased sovereign debt.

Stock Market Overview:

The Dow Jones Industrial Average reached a record high at 24,290 points on Monday, with banks and retailers surging as investors readjusted their portfolios in hopes of benefiting from expected corporate tax cuts.

The S&P 500 ended with a loss after hitting an intra-day record high earlier on Monday, while the technology-heavy Nasdaq dropped 1.05 % or 72 points to end at 6,775.

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