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

Definition: 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. They use any extra cash from tax cuts to expand business growth. Investors buy more companies or stocks.

Banks increase business lending. Owners invest in their business operations and hire workers. These workers spend their wages, driving demand and economic growth.

Trickle-Down Economic Theory

Trickle-down economic theory is similar to supply-side economics. That states that all tax cuts, whether for businesses or workers, spur economic growth. Trickle-down theory is more specific than supply-side theory. It says tax cuts targeted to corporate, capital gains, and savings work better than general tax cuts.

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 so much growth that make up for any lost government revenue. That's because the expanded, prosperous economy provides a larger tax base. 

Most proponents ignore Laffer's warning that this effect works best when taxes are in the "Prohibitive Range." If taxes are already low, then tax cuts will only lower government revenue without stimulating extra growth.

Did It Work?

During the Reagan Administration, it seemed that trickle-down economics worked. Reagan cut taxes significantly. The top tax rate fell from 70% (for those earning $108,000+) to 28% (for anyone with an income of $18,500 or more). The corporate tax rate was also cut, from 46% to 40%. Reaganomics ended the 1980 recession.

That was amazing since the recession suffered from both double-digit unemployment and inflation. (A dreadful situation known as stagflation.)

Trickle-down economics was not the only reason for the prosperity. Reagan not only cut taxes, but he also increased government spending by 2.5% a year. He nearly tripled the Federal debt. It grew from $997 billion in 1981 to $2.85 trillion in 1989. This spending went primarily to defense, in support of Reagan's successful efforts to end the Cold War and bring down the Soviet Union. Trickle-down economics, in its pure form, was never tested. It's more likely that massive government spending ended the recession. (Source: Library of Economics and Liberty, Reaganomics, William A. Niskanen)

To end the 2001 recession, President George W. Bush cut income taxes with JGTRRA, which ended the recession by November of that year. However, unemployment rose to 6%, so Bush cut business taxes with (EGTRRA) in 2003.

It appeared that the tax cuts worked. At the same time, the Federal Reserve lowered the Fed funds rate from 6% to 1% during this same period.

Just like during the Reagan Administration, it's unclear whether tax cuts or another stimulus were what worked.

If trickle-down economics worked, then Reagan's lower tax rates should have helped all income levels. In fact, the exact opposite occurred. Income inequality worsened. Between 1979 and 2005, after-tax household income rose 6% for the bottom fifth of income earners. That sounds great until you see what happened for the top fifth -- an 80% increase in income. The top 1% saw their income triple. Instead trickling down, it appears that prosperity trickled up! (Source: Steven Greenhouse, The Big Squeeze, pp.6-9)

Why Trickle-Down Economics Is Relevant Today

Despite its shortcomings, Republicans use trickle-down economics to guide policy. In 2016, Republican Presidential candidate Donald Trump ​proposed cutting taxes for the wealthy. He also wants to eliminate taxes on capital gains and dividends for everyone making less than $50,000 a year. He would lower the corporate tax rate to induce global corporations to invest more in the United States instead of overseas.  He said it would boost growth enough to make up for the debt increase.

In 2010, the popular Tea Party movement rode into power during the mid-term elections based on cutting government and taxes. As a result, the George Bush tax cuts were extended even for those making $250,000 or more.

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