Trickle down effect

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In economics the trickle-down effect is believed to be central to conservative economic theory, despite the fact that, according to laissez-faire economist Thomas Sowell, no conservative economist has ever advocated such a theory [1].

Trickle-down theory is promulgated by right-leaning newspapers such as The Wall Street Journal editorial page and libertarian and conservative think-tanks such as the American Enterprise Institute and the Cato Institute. This theory does not say that benefits given to the upper classes will "trickle down" to those below them on the social hierarchy due to the benevolence or generosity of the rich; rather, its proponents maintain this will occur mostly as a result of the normal workings of unfettered markets.

The concept is hard to define, while the validity of the concept depends on the definition. For example, one online magazine defines trickle-down theory as an "economic theory which advocates letting businesses flourish, since their profits will ultimately trickle down to lower-income individuals and the rest of the economy" [2]. Another defines it as being the same "as Supply Side Economics. ... An economic theory that the support of businesses that allows them to flourish will eventually benefit middle- and lower-income people, in the form of increased economic activity and reduced unemployment" [3]. One economist defines it as "A theory of economic development that claims higher standards of living for the poor will develop gradually [with economic growth] and not at the overt expense of the more affluent." [4] Other economists define it as simply the economics of President Ronald Reagan, known as "Reaganomics."

However, following the two definitions above, it seems to be a more general theory applied by President George W. Bush in economic policy-making, and perhaps by most of recent U.S Republican Party policy proposals, hearkening back to those of Calvin Coolidge and Warren G. Harding, if not William McKinley. There are at least three different ways of looking at the trickle-down effect.

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Upper income and corporate tax rate reductions

In this view, it is a central tenet that government policies which benefit upper-income taxpayers and corporations (through tax cuts, subsidies, deregulation, etc.), will indirectly benefit the middle classes and even the poor. These benefits will trickle down. This tenet is central to Supply-Side economics, a version of laissez-faire economics, and it was a highly charged issue during the Reagan Administration. In fact, at some times, pro-Reagan economists, such as Arthur Laffer, were arguing that the benefits of supply-side rate reductions were so large that total tax revenues would actually rise, helping to pay for the Reagan administration's increased spending on the military and the like, so that the government deficit would not rise.

Note that it is also part of Keynesian economics to see the possibility that reductions in the tax rate will stimulate increases in tax revenue, though usually not enough that the tax cut "pays for itself". Of course, the mechanism by which Keynesian economics sees revenues increasing differs too: while Supply-Siders see changes in marginal tax rates as stimulating the incentive to supply, the Keynesians see increases in aggregate demand as allowing increased revenues to be realized.

Instead in standard theory, rate reductions can bring about increases in revenue when the distance between "marginal" and "actual" tax rates is quite large, and the reason for the difference is the amount of income being "sheltered" from taxation. According to this argument, rate reductions, because they make inefficient tax shelters less compelling, free capital for more productive uses, or even for consumption. More generally, the argument is that decreased marginal tax rates increase the incentive for individuals to work and save their income.

Rate reductions, when they raise personal disposable income, increases aggregate demand until it reaches potential output, while Supply-Side economics sees their policies as increasing potential output. There is no evidence that potential output increased at faster than trendline during the 1980s after "Supply-side" tax cuts were instituted. Further, Supply-Side economists often see the positive effects on potential as happening very quickly, almost immediately, which, given the severity of the 1981-1982 recession does not seem to be the case. Keynesian policies that affect the supply side, such as government investment in infrastructure, education, public health, and the like are seen as taking years to pay off. Compared to these Keynesian "supply-side" policies, those of the Supply-Side economists are criticized for promising a "free lunch" that cannot be delivered.

Trickle-down theory is often seen a major rhetorical variant of "what's good for business and the rich is good for the country." In this form it was ridiculed by Franklin Delano Roosevelt as "toryism". While many believe this is generally true, others argue that trickle-down economics simply helps the special interests of business and its owners. David Stockman said Supply-Side rhetoric was used during the Reagan Administration as a "trojan horse" for lowering taxes on the wealthiest individuals. One economist critical of this theory, John Kenneth Galbraith, has summarized trickle-down theory as "horse and sparrow" economics: "if you feed enough oats to the horse, some will pass through to feed the sparrows." Before he became Vice-President under Reagan, George H.W. Bush had referred to this theory as "voodoo economics."

In Robert J. Gordon's Macroeconomics (9th ed, 2003, p. 393) he points to three elements behind the idea of supply-side tax reductions:

1. Taxes on income reduce the after-tax rewards for working and saving. Therefore, reducing taxes (i.e., increasing the after-tax rewards) would be an example of providing incentives.
2. An increase in this reward would cause a big and significant increase in both working and saving. These are seen as raising potential output. This is called improving the supply side.
3. In the Laffer variant, the increase in work and saving would allow the government to collect more extra revenues than was lost due to the tax reductions. That is, there is a "free lunch" for reducing marginal tax rates.

While Gordon sees the first as valid, the second and third do not pass the test of empirical data, in his survey. One problem is that a rise in after-tax income does not always mean a rise in work or saving as predicted in (2). In economics jargon, the supply-side argument incorporates the incentive or substitution effect but ignores the income or wealth effect. To put this in more concrete terms, an individual who enjoys the benefit of a tax reduction could decide to work more, because the marginal value of his or her labor is higher, or decide to work less, because the value of time off is greater to him or her than more money would be. Getting greater after-tax income due to the tax cuts, she or he can actually work fewer hours and get more income.

In its defense, the economy did improve in the later Reagan years, after supply-side economics was implemented. Many economists would reject this history as a justification of supply-side economics; instead, they apply an eclectic version of Keynesian economics. Paul Volcker, the Fed chief appointed by Jimmy Carter, had already begun implementing contractionary monetary policies to solve the problem of severe inflation by raising unemployment (see Phillips Curve). Once inflationary expectations were squeezed out of the system, by the recession of 1980 and the much more severe 1981-1982 recession, the Reagan policy of deficit spending by "across the board" rate reductions and military spending increases can be seen as sparking the prosperity of the late 1980s through demand-side fiscal stimulus. This expansionary effect was helped by the rapid fall in oil prices, especially around 1986. Contrary to supply-side promises, the government deficit rose from 1.6 percent to 2.8 percent of GDP from 1979 to 1989. The government debt rose from 25.6 percent of GDP in 1979 to 40.6 percent in 1989.

If the 1980s expansion had been a classic, demand-driven Keynesian recovery, however, nominal demand should have grown rapidly in the 1980s. The rate of nominal demand growth actually fell over the course of the decade.

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Laissez-faire

Second, there is the related view that granting more freedom to the market benefits all members of the society. In the trickle-down theory, competitive markets make it good not just for the rich and powerful but for the poor and powerless.

To many conservatives the unfettered and competitive market is synonymous with the "free market". This is linked to the first version of trickle-down economics because free-market rhetoric was often used to justify tax reductions for upper income brackets and corporations. However, there is a fundamental difference between the cut on personal income tax and the reduction of taxes on corporate dividends (the reader can find more information on the effect of a cut on personal income tax in the previous section). In general, the latter form of tax cut tends to be much more effective in stimulating economic growth, and is particularly beneficial to the small and middle-sized companies, which often face more financial constraints than the bigger corporations, and which can often take advantage of the extra money generated by the tax cut to re-finance themselves or open up new business opportunities.

David Stockman, one of President Reagan's economic advisors, placed supply-side economics in a long tradition in economics, and maintained that laissez-faire will benefit not just those well-placed in the market but also the poorest. The general principle is argued in Bernard de Mandeville, The Grumbling Hive (1733): "private vices are public virtues." As mentioned in the previous paragraph, entrepreneurs respond to the economic stimulus (i.e. a cut in corporate dividend taxes) by infusing new investments into the economy, hence creating new job opportunities and contributing to economic growth. The benefit of the tax cut "trickles down" in the sense that a booming economy benefits all market participants — millionaires and average joes alike. Supply side economic policies like this are essentially a form of expansionary fiscal policy, as Keynes readily acknowledged (a more detailed exposition can be found in any introductory macroeconomics textbook). In addition, some interpret the following quote from Adam Smith in this light.

"It is the great multiplication of the productions of all the different arts, in consequence of the division of labour, which occasions, in a well-governed society, that universal opulence which extends itself to the lowest ranks of the people." (An Inquiry into the Nature and Causes of the Wealth of Nations, ch. 1. Emphasis added.)

It is important to pay attention here to the crucial assumption of a "well-governed society." In other words, the economy in question must have strong and effective institutions in place to safeguard the well-being of the free market. Free market policies alone do not guarantee sustained economic growth or a healthy pattern of income distribution.

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The Growth of the GDP Benefits All

A third variant centers on Kuznets' "Law", which says that increases in income inequality that occur in the early stages of industrialization are followed by increases in income equality. A more general version argues that increases in real gross domestic product are almost always good for the poor. This is linked to the previous version of trickle-down because GDP is best seen as a measure of market activity, the buying of goods and services produced for sale. As many critics have noted, it does not measure well-being very successfully. (One effort to replace GDP as a measure of well-being is the Genuine Progress Indicator.)

One difference between Kuznets' "Law" and the other two trickle-down arguments is that the narrowing of the income distribution could reflect government action: after a period of increasing inequality leads to greater total wealth per person, people may decide that they can "afford" greater equality of distribution and then push the government for this result. However, this is not the standard interpretation.

Though Kuznets' "law" seems to describe the process of industrialization in the U.S., at this point it has expired: since the 1970s, the U.S. has seen steady increases in inequality in wealth and income. Rises in gross domestic product have usually coincided with increases in inequality.

However, it is not true that the gains by the wealthiest Americans have come at the expense of low-income Americans. From 1981 to 1989, every income quintile—from the richest to the poorest—gained income in real terms according to the Census Bureau economic data. The reason the wealthiest Americans saw their share of total income rise is that they gained income at a faster pace than did the middle class and the poor.

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Criticism of the term "trickle down"

In his book Basic Economics: A Citizen's Guide to the Economy, economist Thomas Sowell fleshes out his criticism that the term "trickle down" is a mischaracterization of conservative economic views:

"There have been many economic theories over the centuries, accompanied by controversies among different schools of economists. But one of the most politically prominent economic theories today is one that has never existed among economists - the "trickle down" theory.

"People who are politically committed to policies of redistributing income and who tend to emphasize the conflicts between business and labor, rather than their mutual interdependence, often accuse those opposed to them of believing that benefits must be given to the wealthy in general or to business in particular, in order that these benefits will eventually "trickle down" to the masses of ordinary people. But no recognized economist of any school of thought has ever had any such theory or made any such proposal. It is a straw man. It cannot be found in even the most voluminous and learned histories of economic theories.

"Proposals to reduce taxes on capital gains, for example, are often opposed politically by saying that those who make such proposals believe in a "trickle down" theory of economics. In reality, economic processes work in the directly opposite way from that depicted by those who imagine that profits first benefit business owners and that benefits only belatedly trickle down to workers.

"When an investment is made, whether to build a railroad or to open a new restaurant, the first money is spent hiring people to do the work. Without that, nothing happens. Even when one person decides to operate a store or hamburger stand without employees, that person must first pay somebody to deliver the goods that are going to be sold. Money goes out first to pay expenses and then comes back as profits later - if at all. The high rate of failure of new businesses makes painfully clear that there is nothing inevitable about the money coming back.

"Even with successful and well-established businesses, years may elapse between the initial investment and the return of earnings. From the time when an oil company begins spending money to explore for petroleum to the time when the first gasoline resulting from that exploration comes out of a pump at a filling station, a decade may have passed. In the meantime, all sorts of employees have been paid - geologists, engineers, refinery workers, truck drivers. It is only afterwards that profits begin coming in. [...]

"In short, the sequence of payments is directly the opposite of what is assumed by those who talk about a "trickle-down" theory. The workers must be paid first and then the profits flow upward later - if at all." (Basic Economics, pp. 388-389)

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See also

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External links

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