Trickle-Down Economics: Does It Work?

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Trickle-down economics is the idea that decreasing taxes, especially on businesses and the upper classes, will stimulate the economy and lead to long-term growth. Trickle-down economics is a descendant and occasionally derogatory term for supply-side economics, which campaigns for tax cuts and deregulation of the financial sector.

Today, let’s take a look at trickle-down economics as a synonym for the economic
policies used by Ronald Reagan, which especially championed tax cuts for the upper and upper-middle classes. Or to put it differently, not everything below will apply to the ideology of moderate supply-side economics as an ideology.

Trickle-Down and Tax Revenue

The main problem with tax cuts is that they bring less revenue to the government. And as we saw recently with Congress’ new budget, it is much easier to cut taxes than to cut spending. This is because tax cuts generally have public approval (this latest tax cut being an exception), because (at least in theory) normal citizens have more money. On the other hand, most major government spending programs are also very popular and would be difficult to cut without public backlash. This gives us the situation America is currently in: spending much more than they are now capable of bringing in and, as a result, borrowing more money in the form of government-issued bonds.

Supporters of trickle-down economics generally explain this away through a little device called the Laffer curve. The Laffer curve was initially conceived by political economist Arthur Laffer. The curve is based on the idea that taxation is an incentive against bringing in income. For example, if you make ten dollars from mowing a lawn, you will want to mow the lawn more than if you make ten dollars but lose five
dollars to your parents. Not only do you now have less incentive to work, but you also have five fewer dollars to plug into the economy.

At the low end, for example, 20% taxation, you still have a lot of incentive to work and a lot of money to spend, but when 80% percent of your money goes to the government, you are less interested in working and have almost no money to spend. The result of this is economic decline rather than economic growth, which leads to smaller amounts of revenue which the government can bring in taxes. The argument then made by the major supporters of trickle-down economics is that we are on the far right part of the Laffer curve, where taxes are so high that we are actually bringing in less revenue than we could.

The optimism of this concept, that tax cuts could pay for themselves by bringing in the same (or even more) revenue, is pretty radical and is held by very few today. There is no denying that tax cuts do help to pay for themselves by stimulating the economy and, in turn, bringing in more revenue. Harvard University’s Greg
Mankiw gave the estimate that a typical tax cut will pay for 1/3 of the decrease in revenue. Later modeling by the Congressional Budget Office suggests that the revenue increases from tax cuts would be “relatively small.”

Where are we on the Laffer Curve?

The question we have yet to answer is: what taxation level brings in the most total revenue? The answer is: nobody really knows. Most economists think that revenue maximizing rates are in excess of 50%; when asked about the optimal rate, 70% as a tax maximizing rate is a standard answer, and is based off an aggregate of economic research on the subject. Radical economists on the right suggest a 15-25% tax rate maximizes revenue, while radicals on the left claim an >80% tax rate would maximize total revenue. Recent research by University of Chicago’s Harald Uhlig suggests an asymmetric Laffer curve based around 70%.

The Laffer Curve. Notice the red and blue curves, reflecting the ideological influences on each approach to the government revenue and tax rate correlation.

Uhlig’s research further suggests that the United States can increase tax revenue by 30% by increasing taxes and that the European Union could increase revenue by 8% with tax increases (suggesting in other words that a tax increase would work better in the United States than in the EU). In other words, we don’t really know where we are on the Laffer curve right now but we can be relatively sure that we are on the left and that a tax increase in America would increase total tax revenue. Or in other words, there is no conceivable scenario where the Republican tax cut pays for itself.

Final Arguments and Conclusion

The main problem with the Laffer curve as economic paradigm is that because of how ambiguous it is, it manages to give a kind answer to any ideology which you hold. If you’re a supply-side economist, it’s very easy to say that we are on the left side of the maximum revenue. Similarly, if you’re a proponent of increased taxation, you can just as easily point to the revenue gains the government could have if
only taxes were raised.

Furthermore evidence supporting tax decreases – especially tax decreases on the rich – is essentially nonexistent. To the contrary, a 2015 study by the International Monetary Fund, which studied the effects of lower taxes on the wealthy, came to the conclusion that decreased taxes on the wealthy leads to greater economic inequality and lower economic growth, whereas increases in the wealth of the bottom 20% is correlated with high economic growth. In other words, most evidence agrees that the money never actually trickles down, but actually trickles up.

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