Why Trickle Down Economic Works in Theory But not in Fact
It is the Social Contract that individuals submit part of their power to the Government because the Government is supposed to be better at distributing the resources of the nation in ways that will benefit the individual more than if they would do those investments themselves.
What happens when the resources are taxes, and it is questionable if the Government knows best or not? Worse, it is questioned why they are not taking the best decisions for the individuals, while they know full well their policy will not affect them for the better, but for the worse.
Trickle-down economics has long been the subject of arguments between political parties and experts. Read the article to learn why.
WHAT DOES TRICKLE-DOWN ECONOMICS MEAN?
By definition, trickle-down economics is a theory, the supporters of which believe that benefits for the wealthy will transfer, or trickle down, other actors in the economy. These benefits could take the form of tax cuts on corporations, high-income earners, tax relief for capital gains and dividends.
Trickle-down comes from the assumptions that agents in the economy such as investors, savers, and business owners are the ones that drive growth in an economy. It stipulates that they’ll use any extra wealth, generated from government regulations, such as tax cuts, to reinvest in businesses, thus expanding the economy.
Stockholders will act upon planned acquisitions or buy stocks. Banks will increase loan offering thus transferring liquidity to the spenders. Business owners will create jobs.
All of this growth is supposed to trickle down to employees, who, in their turn, will spend more and reinforce the economy. A rise in wages is supposed to further drive demand up and contribute to reinforcing the supply and demand cycle.
HOW DOES IT WORK?
In order to understand the theory of trickle-down economics, first you need to understand supply-side economics.
What is supply-side economics?
Supply-side is easy to understand when seen as a polar opposite of Keynesian theory. Keynesianism stipulates that it is consumer demand that drives the economy.
Consumers create need for products and services and offer money for them. That is supposed to be the factor that drives the decisions of the businesses (the supply) and thus, they are the original creator of growth.
Therefore the Keynesian fiscal policy will support consumerism, and not just workers – consumers will be important regardless of whether they work or not. Infrastructure, benefits and education will be subject of great investments.
Supply-side economics on the other side stipulates that increased supply is what will create economic growth. The drivers of that supply are capital, labor, entrepreneurship and land.
Supply-side tax policies focuses on industry. Tax cuts and deregulation will be employed by the government to support businesses. Companies that benefit from this government support are supposed to create jobs.
Hiring more workers overall is supposed to redistribute the wealth from the businesses, through the wages to the workers, and, through spending, create flows back into the economy.
The main course of action of supply-side economics is to create incentives for businesses to grow. Deregulation is supposed to eliminate restrictions to expansion and reduce the compliance costs. Businesses are then free to explore new fields and drive the economy up.
Two types of tax cut are created.
A corporate tax cut is supposed to free resources for businesses to hire more employees, invest in equipment and or increase their production of more goods and services.
An income tax cut is supposed increase the absolute wage per hour ratio. It incentivizes workers’ demand of employment. More workers hired in the economy means higher production and better quality of service.
What is the Laffer Curve?
In order to understand better why lower taxes on the wealthy are connected to a boost of the economy, it will be helpful to explain the concept of the Laffer Curve.
The concept is named after an economist called Arthur Laffer, who came up with the idea back in 1979.
The Laffer Curve draws a relationship between tax cuts and government revenues. And that relationship is twofold. Immediately, Laffer stipulates there will be an arithmetic effect. Every dollar in tax cuts means one less dollar in government from the government’s budget. The second effect is supposed to be more longer-term. And that is, according to Laffer, the ‘economic’ effect.
Lower taxes increase the budgets, and therefore the spending, of taxpayers. It allows for higher production on the side of businesses who can now meet consumer demand. That will decrease unemployment, and lead to additional average increase in the household budget.
More workers also means an increase in the tax base. Newly hired workers will be taxed, and that, in turn, will return the revenue to the government.
How does trickle-down relate?
Trickle-down theory is a special case supply-side economics, or a part of it. According to trickle-down, specific tax cuts are supposed to be targeted instead of just generally taking the side of businesses.
As explained earlier, tax cuts will be provided to businesses, tax relieve will be applied to capital gains, and savings. Across-the-board tax cuts will not be a part of the strategy. Tax cuts will be provided to the more well-off, who are supposed to reinvest in the businesses and, with that, transfer funds to the less wealthy.
Both trickle-down and supply-side economy can be explained via the Laffer Curve. It shows the exact relationship between the tax cuts, the economy growth, the rise of employment and the increase in the tax base – which is supposed to prove the wealth multiplication effect.
Have in mind Arthur Laffer himself warns that this effect works is mostly applicable when taxes are in the Prohibitive Range.
This is the tax range that starts from 100% taxation, down to a theoretical rate in the middle of the curve where taxes will not affect the businesses decision. In other words, an across-the-board tax cut for the wealthy is not necessary.
An initial analysis is needed to establish if the current tax rate prevents businesses from actions that would grow the economy.
WHO CREATED TRICKLE-DOWN ECONOMICS?
There have been several times in history when regulations have been imposed by the government that provide tax cuts or tax relief to wealthy businesses and corporations in expectation to boost the economy in result. There is an argument to be made that those regulations were necessary at the time and those worked.
Presidents Nixon and Reagan
Ronald Reagan is often named the creator of the trickle-down economy.
President Reagan was, after two unsuccessful attempts to win the Republican Presidential nomination, elected for the president in1980, inheriting an economy that had just went through a very tough recession in the 1970’s marked by the worst stagnation America had ever experienced.
Stagflation is a combination of three harmful economy factors – a stagnation in the economic growth, high level of unemployment, and inflation. The average price of consumer good raises while at the same time the economy growth is limited. Usually demand decreases enough to halt inflation.
Stagflation basically got its name during the 1973 – 1975 recession.
Early signs of the recession were visible early into the presidential term of Richard Nixon. Nixon famously froze all wages and prices for 90 days. The Pay Board and Price Commission was appointed to approve any increases after afterwards – up until the 1972 presidential campaign. A 10% tariff on imports followed. Finally, Nixon removed the States from the Gold Standard.
Raising the import prices caused GDP growth to slow down.
By 1975 there had been five quarters when gross domestic product growth had been negative.
In the beginning of summer in 1975, two months after the recession had ended unemployment peaked at 9%. Inflation was another issue when it raised from 3.5% to 9.5%.
The Federal Reserve’s made several attempts to stop the stagflation but those attempts had the opposite effect. Between the years 1971 and 1978, they manipulated the price of fed funds rate to by raising it to fight inflation, then later lowering it to fight recession.
That created an unstable climate for investors which meant the prices stayed high, even when the rates were low. Inflation skyrocketed to 13.3% by the end of the 1970’s.
Paul Volcker put an end to stagflation by raising the rate to 20% in the beginning of the 1980’s. And that created the 1980-82 recession.
The economics of the Reagan administration, known as Reaganomics, is supposed to fight the recession by reducing the government’s influence on the economy. It is a laissez-faire approach to economics. Reagan believed capitalism and the free market will create growth.
The government’s role would be diminished so that businesses, led by the principle ‘greed is good’ would have the freedom to save the economy.
Reagan’s position is noticeably different his predecessors. Johnson and Nixon had trusted the government’s role should lead to growth.
On the contrary Reagan vows to decrease the growth of government spending, to cut income taxes and capital gains taxes, to decrease regulations on the industry and to halt the expansion of the money supply.
President Reagan provides results on each of the four goals of his platform, although not fully. To a large extent they overcame inflation, but that should be mostly attributed to Reagan’s monetary policy, not his fiscal policy. At the same time Reagan’s tax cuts do end the recession.
It is important to point out government spending isn’t lowered. Instead of spending more on domestic programs where the government would support the population, the budget is eaten up by the military. As a result the debt rises threefold, from about a thousand billion in the beginning of the 1980’s to $2.857 trillion the end of the 1980’s.
The tax cuts Reagan imposes do manage to bring up consumer demand. By the last year of Reagan’s mandate, the maximum tax rate became 28% for the unmarried individuals with a yearly income of $18,550 or more. Citizens making less money paid no taxes at all. There was a drop in the tax rate of more than 40% for individuals earning $108,000 or more.
The tax brackets for inflation were indexed. Reagan moved these tax cuts to tax increases in other directions. Social Security payroll taxes as well as some excise taxes went through an increase. The corporate tax rate was dropped from 46% to 40%. The taxation of investments was changed.
Government spending was supposed to be stopped. Instead, there was growth, although not as fast as the growth in spending during the predecessor’s term – President Carter. During Reagan the growth was 2.5% a year, caused mostly be raising costs for the military.
Social Security or Medicare payments were not changed. In fact, Reagan’s budgeted spending for the two programs was 22% of GDP. That’s higher budget than the usual 20%.
In the beginning of his term Reagan removed the Nixon-imposed price regulations on domestic oil and gas. Those were considered to introduce an imbalance in free-market self-regulation that would have prevented inflation. Reagan deregulated other industries including the financial institutions and, by that, he contributed Savings and Loan Crisis in 1989. Reagan increased import barriers.
When Reagan came to power, the measures imposed by Chairman Paul Volcker against inflation were already in place. Volcker used a brave monetary policy – he began raising the fed funds rate by a historic 20%. While these measures were beneficiary to fight off inflation, economic growth was affected. Unemployment went as high as 10.8% and stayed above 10% for the large part of the year.
Watch this Crash Course video to get an interesting perspective of the Reagan presidency:
Reagan is not the only President to employ trickle-down economics. President George W. Bush used similar tools to fight off the 2001 recession. The income taxes were cut by introducing the Economic Growth and Tax Relief Reconciliation Act. The measures turned out to be successful in ending the recession by November of 2001.
However unemployment was still an issue – it went as high as 6%. It is not rare that unemployment will linger at high levels after a crisis. Businesses will be unwilling to create jobs a long time after the unfriendly economic environment has changed. Bush then introduces another Act in 2003 – the The Jobs and Growth Tax Relief Reconciliation Act.
Temporarily the overall impression is that the tax cuts worked. However, the fact that the Federal Reserve lowered the fed funds rate could have contributed. It fell from 6% to 1%. It is a significant change and leaves it unclear if tax cuts caused the recovery or monetary policy did.
According to trickle-down economics, presidents Reagan and Bush introduced tax cuts which should have affected the wealthy immediately, and citizens of all income levels, gradually.
What happened in reality is the opposite. The income gap worsened. In the years between 1979 and 2005, household income after taxes for the bottom 20% of the population rose by 6%. That means there was growth. However, if we compare that to the top 20% of the population, we see the increase there reached 80%. The top 1% saw their budgets triple for the same period.
That means the wealth created by trickle-down policies never did trickle down to less well-off parts of the population. Or, at least, by judging the wealth that did trickle down, too much was retained.
WOULD TRICKLE-DOWN WORK TODAY?
Recently, the idea that Reaganomics-like policies must be taken up once again are becoming popular. The ‘America great again’ campaign, popularized by President Donald Trump, Tea Party followers, and other Republicans advocate for further tax cuts on the wealthy as a way to fix the economy. But many say that while it could be argued that trickle-down worked in the 1980’s it could be very harmful today.
One example is the effect tax cuts have on the federal budget – they would decrease the dollar-for-dollar tax to budget flow immediately. But businesses are supposed to get richer, higher more people, and when their salaries are taxed, that would increase the tax base and, with that, reimburse taxes to the budget.
However, that theory does not factor in the lag between the tax cuts and job creation. Additionally, The Laffer Curve proves that cutting taxes only increases government revenue up to a point – after a certain threshold cutting taxes will harm the budget. During Reagan’s term the higher taxes were at 70%, the effects would be much different when the taxes are under 50%.
As the situation is today in the world, the wealthiest 85 people around the globe have just as much as the poorest 3.5 billion of the population – that is roughly half the world’s entire population. This is the stark headline of a report from Oxfam ahead of the World Economic Forum at Davos:
‘Globally, the richest individuals and companies hide trillions of dollars away from the tax man in a web of tax havens around the world – it is estimated that $21 trillion is held unrecorded and off-shore;
In the US, financial deregulation directly correlates to the increase in the income share of the top 1 per cent which is now at its highest level since the eve of the Great Depression;
In India, the number of billionaires increase tenfold in the past decade, aided by a highly regressive tax structure and the wealthy exploiting their government connections, while spending on the poorest remains remarkably low;
In Europe, austerity has been imposed on the poor and middle classes under huge pressure from financial markets whose wealthy investors have benefited from state bailouts of financial institutions;
In Africa, global corporations – particularly those in extractive industries – exploit their influence to avoid taxes and royalties, reducing the resources available to governments to fight poverty.’
It appears the wealthier no longer reinvest back into jobs. Tax cuts appear to have the opposite effect. The gap between the rich and the poor is rising.
The model of trickle-down economics is unsustainable because the effects cannot be measured or controlled.
While the wealthier are becoming more resourceful than they were during the Reagan Era, the poor lack the funds to pay for food, health care, housing, education and other important assets that could help bridge the equality gap.
At the same time governments are continuing play with the idea of supply-side levers in order to revive the economy, when there is abundant proof the lower class has to be supported instead.
The reason is twofold. Partially, it is the unwillingness of politicians to consider new ideas. It is a habit, a status-quo, to always consider the needs of businesses and corporations first. And the second reason is, governments are set on pursuing numbers, economic growth and high competitiveness regardless of the social impact a policy could have for the citizens.
Individuals’ success is measured by their income, their purchasing power and other numeric values. Economic success of governments is also measured in numbers. GDP, GNP, unemployment, inflation, debt…
It is alarming that the disregard of the government is giving rise to populist politicians with questionable strategies.
WHY ARE WE TALKING TRICKLE-DOWN AGAIN?
The issue of trickle-down economics is once again gaining traction because of some of President Trump’s political decisions.
On the side of the Republican party, the idea of trickle-down economics is still solid. In fact, it is gaining popularity.
On December 22, 2017, President Donald Trump acts upon his campaign promise to ‘Make America Great Again’ by signing the Tax Cuts and Jobs Act. By signing the Act, Trump essentially cuts the corporate tax rate from 35% to 21% since the beginning of 2018. For individuals, the tax rate drops to 37%. Trump’s tax plan includes a complex set of measures, including cuts in income tax rates, doubling the standard deduction, and removing the personal tax exemptions. There are different rules when it comes to deadlines, too. The corporate cuts are supposed to last while the changes for the individuals have an expiration date – they will last until the end of 2025.
Watch here a Vox video that explains the tax cut via a cereal metaphor. It is worth seeing.
According to the Tax Policy Center the earnings of the top 1% would enjoy a larger tax cut percentage than individuals with lower income. By the year 2027, those in the lowest 20% of income levels will end up paying higher taxes.
According to the president, the tax cut is supposed to create growth to compensate for the debt increase. However, according to the Joint Committee on Taxation the Act will cost $1 trillion to the budget even after the compensation is factored in.
It all boils down to this question: Who truly drives the economy?
While it sounds like trickle-down makes sense, there is data to support the fact that the wealthy do not allow the extra funds, left over from tax cuts, to trickle down to the low-income citizens. They retain the wealth.
There are arguments to support the theory, that if the support is forwarded to those who need cash the most, they will spend that, out of necessity, and will, in fact, boost the economy, by driving transactions up.
Still, for various reasons, the question about trickle-down economics is brought up again and again.
History has the bad habit of repeating itself. It is up to society to put pressure on the decision makers to make the right decision.