Why Trickle Down Economic Works in Theory But Not in Fact

Does Trickle-Down Economics Work?

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The benefits of tax cuts for high income earners and businesses are supposed to trickle down to everyone. Photo by Spencer Platt/Getty Images

Trickle-down economics is a theory that says benefits for the wealthy trickle down to everyone else. These benefits are usually tax cuts on businesses, high-income earners, capital gains, and dividends.

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 business growth. Investors will buy more companies or stocks.

Banks will increase lending. Owners will invest in their operations and hire workers. The theory says these workers will spend their wages to drive demand and economic growth.

Trickle-Down Economic Theory

Trickle-down economic theory is similar to supply-side economics. That theory states that all tax cuts, whether for businesses or workers, spur economic growth. 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.

Both trickle-down and supply-side economists 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. That's because the 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 percent tax rate down to some hypothetical rate somewhere in the middle. If the tax rate falls below this range, then further cuts will only lower government revenue without stimulating economic growth.

Does It Work?

During the Reagan Administration, it seemed like trickle-down economics worked. His policies, known as Reaganomics, helped end the 1980 recession

Reagan cut taxes significantly. The top tax rate fell from 70 percent (for those earning $108,000+) to 28 percent (for anyone with an income of $18,500 or more). Reagan also cut the corporate tax rate from 46 percent to 40 percent. 

Trickle-down economics was not the only reason for the recovery, though. Reagan also increased government spending by 2.5 percent a year. It 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 theory to address the 2001 recession. He cut income taxes with EGTRRA. That ended the recession by November of that year. 

But unemployment rose to 6 percent. 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 JGTRRA in 2003. 

It appeared that the tax cuts worked. But, at the same time, the Federal Reserve lowered the fed funds rate. It fell from 6 percent to 1 percent.  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 in all income levels. Instead, the opposite occurred. Income inequality worsened. Between 1979 and 2005, after-tax household income rose 6 percent for the bottom fifth. That sounds great until you see what happened for the top fifth. Their income increased by 80 percent. The top 1 percent saw their income triple. Instead of trickling down, it appears that prosperity trickled up. 

Why Trickle-Down Economics Is Relevant Today

Despite its shortcomings, Republicans use trickle-down economic theory to guide policy.

In 2017, Republican President Donald Trump proposed cutting taxes for corporations and the wealthy. He suggested tax cuts on capital gains and dividends for everyone making less than $50,000 a year. Trump's tax plan would reduce the corporate tax rate to 20 percent. It cut income tax rates, doubled the standard deduction, and eliminated personal exemptions.The Tax Policy Center found that those earning in the top 1 percent would receive a larger percent tax cut than those in lower income levels. By 2027, those in the lowest 20 percent income levels would pay higher taxes.

He said it would boost growth enough to make up for the debt increase. But the Joint Committee on Taxation reported that the bill would add $1 trillion even after including the tax cut's impact on economic growth. It wouldn't spur growth enough to offset the cuts' loss in revenue.

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.