This paper examines how changes to the individual income tax affect long-term economic growth.
The structure and financing of a tax change are critical to achieving economic growth. Tax rate cuts
may encourage individuals to work, save, and invest, but if the tax cuts are not financed by immediate
spending cuts they will likely also result in an increased federal budget deficit, which in the long-term
will reduce national saving and raise interest rates. The net impact on growth is uncertain, but many
estimates suggest it is either small or negative. Base-broadening measures can eliminate the effect of tax
rate cuts on budget deficits, but at the same time they also reduce the impact on labor supply, saving, and
investment and thus reduce the direct impact on growth. However, they also reallocate resources across
sectors toward their highest-value economic use, resulting in increased efficiency and potentially raising
the overall size of the economy. The results suggest that not all tax changes will have the same impact on
growth. Reforms that improve incentives, reduce existing subsidies, avoid windfall gains, and avoid deficit
financing will have more auspicious effects on the long-term size of the economy, but may also create
trade-offs between equity and efficiency.