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Trickle-Down Economics and Its Effects

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Trickle down economics

Trickle-down economics says what's good for the wealthy is good for the economy.

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Trickle-Down Economics Definition:

Trickle-down economics does exactly what it says -- the benefits of economic policies that help the wealthy trickle down to everyone else. For the most part, these policies mean tax cuts. Trickle-down economics assumes that the real drivers of economic growth are those who are successful in society -- business owners, investors, and savers. The extra cash they get from tax cuts is used to expand companies directly, investing in business, or adding savings (liquidity) that can be used for business lending.

According to trickle-down economics, the first thing businesses do with extra money is hire workers. These workers spend their wages, driving demand. The net result is a faster growing economy.

Trickle-Down Economic Theory:

Trickle-down economic theory is based upon supply-side economics. This theory states general tax cuts, to businesses and workers, will translate to increased economic growth. Businesses will invest, as in trickle-down economics, but workers will also spend the extra cash, further stimulating demand. Trickle-down theory is more exclusive than supply-side theory, in that it states that specific types of tax cuts -- corporate, capital gains, and savings -- work better than general tax cuts.

Trickle-Down Economics Is Based on the Laffer Curve:

Proponents of both trickle-down and supply-side economics point to the Laffer Curve for their proof of how well tax reductions can stimulate the economy. Economist Arthur Laffer showed how tax cuts provide a powerful multiplication effect. Over time, tax cuts drive business growth and additional hiring so much that eventually the government revenue lost from the cuts is replaced. That's because the expanded, successful economy provides a larger tax base.

However, Laffer points out that this effect works best when taxes are in the "Prohibitive Range." If taxes are already low, then tax cuts will do nothing more than reduce government revenue -- without stimulating additional economic growth.

Trickle-Down Economics and Reaganomics:

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 48% to 34%. Reaganomics was successful in ending the 1980 recession. This was amazing, since the recession was marked by both double-digit unemployment and inflation, a dreadful situation known as stagflation.

Did Trickle-Down Economics Work?:

However, it's difficult to say whether trickle-down economics was the only reason for the prosperity. That's because, while Reagan cut taxes, he also increased government spending -- by 2.5% a year. Reagan nearly tripled the Federal debt, which went 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. Therefore, trickle-down economics was never really tested, since government spending is also a spur to economic growth. (Source: Library of Economics and Liberty, Reaganomics, William A. Niskanen)

Did Tax Cuts End the 2001 Recession?:

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.

Apparently, the tax cuts worked. On the other hand, the Federal Reserve lowered the Fed funds rate from 6% to 1% during this same time period. Just like during the Reagan Administration, it's unclear whether tax cuts, or another stimulus, were what worked.

Trickle-Down Hasn't Actually Trickled Down:

If trickle-down economics worked, then lower tax rates during the Reagan Revolution should have increased the lowest income levels. In fact, the exact opposite has occurred. Income inequality has 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:

Despite its shortcomings, trickle-down economics is still being used to guide policy recommendations. 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.

Most 2012 Republican Presidential candidates also proposed some form of cutting taxes. For example, Mitt Romney proposed cutting all taxes on capital gains and dividends for everyone making less than $250,000 a year. He also wanted to lower the corporate tax rate to induce multi-national corporations to pay more taxes in the U.S. instead of overseas. Article updated August 27, 2013

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