Several times when I discuss conservative vs liberal/keynesian economics, the topic of trickle-down economics comes up. I’m typically not the one to bring it up; very often, trickle-down economics is brought up even though we weren’t discussing anything even remotely related to it. Trickle-down economics is something liberals bring up when they’re out of arguments; they think of it as the greatest failure of conservative economic policy and imagine mentioning it will get conservatives on the defensive, and very often they’re right.
The purpose of this post is to set the record straight: Does trickle-down economics work?
First, since Reagan’s economic policies are said to be the best example of trickle-down economics in action, let’s look at what he accomplished: Liberals like to point out that the wealth distribution under Reagan was very unequal; wealth didn’t seem to trickle down as predicted.
Now, that certainly seems horrible. But let’s put things in their right context. The first step is always to produce wealth, before you can redistribute wealth. And in the 1970’s, both during the Nixon, Ford and Carter administrations, America’s problem had not been the redistribution of wealth: It had been the creation of wealth, or lack thereof. The 1970’s was characterized by high inflation and stagnated growth (stagflation). Reagan’s economic policies undoubtedly fixed this: The 1980’s was characterized by high growth and low inflation, the exact opposite of the decade before. Not only that, but tax revenue grew as well (unfortunately, spending grew more).
But what about the trickle-down part? OK, let’s sort this out once and for all: Wealth does trickle down – just not in the way and shape conservatives in the 1980’s may have given the impression that it did.
Think of every product that we take for granted today: The refrigerator, the computer, air conditioning, the radio, the TV… most of these started of as luxury goods. Even running water used to be a luxury, a luxury which then slowly but surely became available to the masses (ie, the wealth of running water trickled down). Now if there had been no rich people, there would have been no-one who could have invested in the R&D (a high-risk investment the state was unlikely to make) which created all these inventions, and also since the production costs were so high initially, no-one would have been able to afford them.
However, this does not mean that cutting taxes for the rich is automatically going to make everyone richer. The key is that you need to have a good business environment, not just low marginal tax rates. If you lower taxes for the rich, but your country lacks investment opportunities, then that money will be invested abroad. Such money, then, will certainly not trickle down. The US historically had a lot of investment opportunities, but the 1970’s (and in particular Carter’s government) sort of dragged the US brand in the mud. Of course it took time to rebuild that and convince investors that the US was a good investment again – simply cutting tax rates won’t fix that overnight. Otherwise, one of the ways that wealth trickles down is through hiring – when the rich get more money, they invest more, and that leads to hiring of non-rich people. But like I said, this can take some time.
The main effect when you cut taxes for the wealthy is that you make education more profitable. If more middle- and working class kids decide to go to college instead of taking a job as a waiter, this means said kids will have a higher lifetime income (because jobs which require a college degree generally pay more than those who don’t). In other words: Cutting taxes for the rich will lead to more wealth for those who are not fortunate enough to come from a rich family. Wealth will have trickled down.
This leads to my next point: Wealth does not trickle down by itself. Cutting taxes for the rich does not lead automatically lead to a trickle down effect. If the working class people decide to sit on their behinds and whine about the tax cuts, instead of going to college and taking advantage of it, of course they won’t benefit very much from it. It’s all up to them.
Also, just a quick thing about tax cuts you should know: When you cut taxes, there is an income effect and a substitution effect. These may seem like complicated economic terms, but it’s really quite simple: Basically, when you cut taxes, you make work more profitable, which increases the amount of work that gets done (and, indirectly, the wealth of the country). But, and this is something conservatives tend to forget, you also decrease the amount of hours a person has to work to earn a certain amount. Let’s take a person who used earn 1000 dollars per week by working 40 hours at the hourly after-tax salary 0f 25 dollars. Now imagine taxes are cut, and his new hourly after-tax salary is 30 dollars. This means he now only has to work 33.3 hours to earn 1000 dollars. So he may very well decide to work less, even though we would think that since work is more profitable he should be working more.
However, most people don’t have the kind of flexible working hours that are necessary to do this, so in practice it’s unlikely that a tax cut will decrease productivity – the point is that the effect is mixed and a tax cut is far from guaranteed to increase the number of hours worked.
The best thing about tax cuts is not that they make people work more. The best thing about tax cuts is that they give you more freedom, and that it changes the mentality in society. In the 1970’s, America was a society in which government was expected to solve every problem, and protect the citizens from themselves (for example with seatbelt laws, to mention one of the more ridiculous examples). Under Reagan, this began to change. The poisonous attitude that everything belongs to the government and that you should be happy you get to keep anything of your paycheck began to change. The idea that all success is due to government and so all successful people should be taxed harder than everyone else lost popularity under Reagan. America became more like the America we all know and love. Since Reagan left this as we know has began to change back, and Obama’s presidency can definitely be seen as the return of the Carter era. Now all we need is another Reagan…
A society of self-reliance and individual independence from government is a society that is good for everyone – especially the poor. The minute the poor realize that government is the problem rather than the solution (as Reagan realized) is the minute the poor can free themselves from poverty.
A big criticism of trickle-down economics comes from economists and leftists in general who claim that surely it’s better to just cut taxes/raise welfare payments for the working- and middle class; that’s has to be a lot more efficient than cutting the highest marginal tax rate and waiting for wealth to trickle down. But to me, it’s not just about wealth, it’s about the incentives you create: If you, like the left often suggests, cut taxes for everyone except the wealthy, you are creating horrible incentives against education, entrepreneurship and hard work in general. While it’s true that lower-paid individuals tend to spend more of their income, and so can be expected to spend a higher percentage of a tax cut if they got one, it’s not spending that drives the economy but saving (see any economic textbook ever written on the topic of long-term economic growth). While it is theoretically possible to save too much, the US has never (at least not in modern times) been even close to having an unhealthily high savings rate.
And here is my final point: As we all know, there are certain people in society, whom can only be classified as deadbeats. People who don’t want to work nor educate themselves, but who still think the rest of us should provide for them. When people (even economic scientists) talk about the difference between the top 10 % and the bottom 10 % in wealth and income, they often forget that a significant part of the bottom 10 % are deadbeats. Yes, it’s harsch, but it has to be said: I don’t think it’s a bad thing if the difference in wealth and income between hard-working entrepreneurs and deadbeats increases.
1) Trickle-down economics can work, if combined with other measures that create a good business environment.
2) Even when it works, it takes a long time for wealth to trickle down. This is because it takes some time for employers to hire, and for people to discover how much more profitable a college education has become. Consumption and investment patterns can be quite sticky.
3) One of the great benefits lies in the culture it promotes, a culture where success isn’t punished and the government doesn’t try to take credit for the success of entrepreneurs (like Barack “You didn’t build that” Obama does).
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