Why Trickle-Down Economics Works in Theory But Not in Fact
The Shortcomings of Supply-Side Economics
Trickle-down economics assumes investors, savers, and company owners are the real drivers of growth. It promises they’ll use any extra cash from tax cuts to expand businesses. Investors will buy more companies or stocks. Banks will increase lending. Owners will invest in their operations and hire workers. All of this expansion will trickle down to workers. They will spend their wages to drive demand and economic growth.
Trickle-Down Economic Theory
Trickle-down theory is more specific. It says targeted tax cuts work better than general ones. It advocates cuts to corporations, capital gains, and savings taxes. It doesn't promote across-the-board tax cuts. Instead, the tax cuts go to the wealthy. The benefits trickle down to everyone else.
Both trickle-down and supply-side proponents use the Laffer Curve to prove their theories. Arthur Laffer showed how tax cuts provide a powerful multiplication effect. Over time, they create enough growth to replace the government revenue lost from the cuts. The resulting expanded, prosperous economy provides a larger tax base.
But Laffer warned that this effect works best when taxes are in the "Prohibitive Range." This range goes from a 100% tax rate down to an unspecified rate of around 50%.
If the tax rate falls below the Laffer Curve's prohibitive range, then further cuts won't stimulate economic growth enough to offset the lost revenue.
When Trickle-Down Policies Work
Reagan cut taxes significantly. The top tax rate fell from 70% for those earning $108,000 or more to 28% for anyone with an income of $18,500 or more. Reagan also cut the corporate tax rate from 46% to 40%.
Trickle-down economics was not the only reason for the recovery, though. Reagan also increased government spending by 2.5% a year. He almost tripled the federal debt from $997 billion in 1981 to $2.85 trillion in 1989. Most of the spending went to defense. It supported Reagan's efforts to end the Cold War and bring down the Soviet Union.
Trickle-down economics, in its pure form, was never tested. It's just as likely that massive government spending ended the recession.
President George W. Bush used trickle-down policies to address the 2001 recession. He cut income taxes with the Economic Growth and Tax Relief Reconciliation Act. That ended the recession by November of that year.
But unemployment rose to 6%. That often occurs because unemployment is a lagging indicator. It takes time for companies to start hiring again, even after a recession has ended. As a result, Bush cut business taxes with the Jobs and Growth Tax Relief Reconciliation Act in 2003.
It appeared that the tax cuts worked. But, at the same time, the Federal Reserve lowered the fed funds rate from 6% to 1%. In this situation, it's unclear whether tax cuts or monetary policy caused the recovery.
Trickle-down economics says that the Reagan and Bush tax cuts should have helped people at all income levels. Instead, the opposite occurred. Income inequality worsened. Between 1979 and 2005, after-tax household income rose 6% for the bottom fifth. That sounds great until you see what happened for the top fifth. Their income increased by 80%. The top 1% saw their income triple. Instead of trickling down, it appears that prosperity trickled up.
Why Trickle-Down Economics Is Relevant Today
Republicans continue to use trickle-down economic theory to guide policy.
In 2010, the Tea Party movement rode into power during the midterm elections. They wanted to cut government spending and taxes. As a result, Congress extended the Bush tax cuts, even for those making $250,000 or more.
On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (TCJA). It cut the corporate tax rate from 35% to 21% beginning in 2018. The top individual tax rate dropped to 37%. Trump's tax plan cut income tax rates, doubled the standard deduction, and eliminated personal exemptions. The corporate cuts are permanent while the individual changes expire at the end of 2025.
The Tax Policy Center found that those earning in the top 1% would receive a larger tax cut percentage than those in lower income levels. By 2027, those in the lowest 20% income levels would pay higher taxes.
Though Trump said it would boost growth enough to make up for the debt increase, the Joint Committee on Taxation reported that the Act would add $1 trillion in debt even after including the tax cut's impact on economic growth. It wouldn't spur growth enough to offset the cuts' loss in revenue.
Why Trickle-Down Economics Fails
Critics believe that the trickle-down policy has done damage to the U.S. economy more times than it has helped. It has met with disastrous results when applied at the federal and state level.
Kansas is a case in point. Business taxes were cut by almost a third, which left the state’s income in the red. The benefits have gone to a handful of the wealthy, who did not invest much to spur the state’s economic growth. Because the state’s revenues are markedly decreased, Kansas’ education budget has been significantly curtailed as well.
The International Monetary Fund also rejects the trickle-down theory. In its report authored by five economists, it argues that “…increasing the income share of the poor and the middle class actually increases growth while a rising income share of the top 20% results in lower growth—that is, when the rich get richer, benefits do not trickle down.” The IMF’s fight against income inequality revolves around the fact that expenditures of middle-to-low-income sectors are the drivers of the economy. Even a mere 1% increase in wealth for 20% of low-income earners yields a 0.38% growth in gross domestic product (GDP). On the other hand, increasing the income of the top 20% high-income earners results in a 0.08% decrease in GDP.
The Bottom Line
The trickle-down theory postulates that the benefits from tax cuts, capital gains, dividends, and even looser regulations on corporations and wealthy individuals would eventually flow down to benefit middle- and low-income earners. The extra wealth accruing from the deductions would drive the wealthy to invest in or expand businesses, boosting economic growth.
The Laffer Curve supports its effect but only up to the point where the tax rates are at a prohibitive range. Out of this range, trickle-down theory is deemed infeasible.
Trickle-down economics generally does not work because:
- Cutting taxes for the wealthy often does not translate to increased rates of employment, consumer spending, and government revenues in the long term.
- Instead, cutting taxes for middle- and lower-income earners will drive the economy through the trickle-up phenomenon.
- The added income for the wealthy, resulting from tax cuts, will simply increase the growing income inequality in the United States.
President Trump’s Tax Cuts and Jobs Act has been a concern because this trickle-down policy is seen to exacerbate the income inequality already kicked into overdrive by Reaganomics. President Biden has pledged to dismantle aspects of the TCJA that benefit the wealthiest taxpayers and corporations.