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 operations and hire workers. These workers spend their wages, driving demand and economic growth.

Trickle-Down Economic Theory

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

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 any lost government revenue. 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." Otherwise, tax cuts will only lower government revenue without stimulating economic 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 percent (for those earning $108,000+) to 28 percent (for anyone with an income of $18,500 or more). The corporate tax rate was also cut, from 46 percent to 40 percent.

 Reaganomics ended the 1980 recession. It suffered from stagflation, which is both double-digit unemployment and inflation.

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 percent a year. He almost tripled the Federal debt. It grew from $997 billion in 1981 to $2.85 trillion in 1989. Most of the new spending went to defense. It supported 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: William A. Niskanen, "Reaganomics," Library of Economics and Liberty.)

To end the 2001 recession, President George W. Bush cut income taxes with JGTRRA. That ended the recession by November of that year. But unemployment rose to 6 percent, 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 percent to 1 percent during this same period.  It's unclear whether tax cuts or another stimulus were what worked.

Trickle-down economics says that 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 percent for the bottom fifth. That sounds great until you see what happened for the top fifth -- an 80 percent increase in income. The top 1 percent saw their income triple. Instead of 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 2017, Republican President Donald Trump proposed cutting taxes for the wealthy.

He also wants to end taxes on capital gains and dividends for everyone making less than $50,000 a year. Trump would lower the corporate tax rate to attract more corporations. 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.  They wanted to cut government spending and taxes. As a result, Congress extended the George Bush tax cuts, even for those making $250,000 or more.