Trickle Down Theory

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Before we start this article let us for a minute imagine that you have been chosen to become the financial head of a country. You decide that as your first act you will lower taxes for everyone. Afterall who likes to pay their taxes? Your reasoning behind this also had a little bit of thought behind it though. You think that lowering taxes will help corporations and the rich save more who will in turn put that money into the economy. This saved money in the economy can help the people of your country lead a better life.

What you have used is known as the trickle down theory in modern economics. Let’s understand it a bit better.

Trickle down effect in theory

To really understand Trickle down theory, one must be familiar with the basics of Economics. Firstly, every economy will always go through its ups and downs. These periods of ups and downs are known as expansion (ups) and recession (downs).

When the economy is expanding the government has to only worry about it overheating. But when the economy falls into a recession the government is up in its arms trying to find a solution. The most common approach to dealing with a recession we have seen is to reduce taxes.Trickle Down theory is one idea that can help supposedly spur up economic activity.

In a nutshell, Trickle Down theory is based on the premise that if you give the top dogs in your economy a tax break, they would earn extra money which they could re-invest into the economy. This re-invested money would help spur up productive activities, which would be taxable thus helping turn the economy up, while helping the government earn the money it lost by giving the top earners a tax cut. While today the term is mostly attributed to Reaganomics and the 80’s, it actually dates as far back as the 1920’s and 30’s when Humorist Will Rogers said in a newspaper column, regarding the republican loss in the 1932 American General Election “This election was lost four and six years ago, not this year. They [Republicans] didn’t start thinking of the old common fellow till just as they started out on the election tour. The money was all appropriated for the top in the hopes that it would trickle down to the needy. Mr. Hoover was an engineer. He knew that water trickles down. Put it uphill and let it go and it will reach the driest little spot. But he didn’t know that money trickled up. Give it to the people at the bottom and the people at the top will have it before night, anyhow. But it will at least have passed through the poor fellow’s hands. They saved the big banks, but the little ones went up the flue.

The Basics: Supply and Demand

The study of economics relies mainly on 2 parts, Supply and Demand. Consider them as 2 wheels of the cycle of a country’s economy. The main question that eluded most economist’s minds and still does till this day is should the chain and pedal be connected to the supply wheel or the demand wheel. In other words, should the government try to control the supply side of the economy or the demand side of the economy.

In the early 19th century Jean Baptiste Say argued that during an economic recession, the government should try to control the supply side of the economy,i.e. connect the chain and pedal to the supply wheel. Say’s Law states that the ability to purchase something depends on the ability to produce and thereby generate income. It implies that production is the key to economic growth. If the people are working in a recession they have demands that are unfulfilled, either due to price or supply, he argued.

Over a century later, when the developed world faced the great depression of the 1920s, his theories could not solve the problem of demand contraction and unemployment attributable to excess supply. This gave way as a new theory from economist John Maynard Keynes began to get popular.

The basic theory of Keynesian economics states that demand — not supply — is the driving force of an economy and the best way to pull an economy out of a recession is for the government to increase demand by infusing the economy with capital. In short, consumption (spending) is the key to economic recovery. According to Keynes, it is better if the chain and pedal of the economy is connected to the demand wheel and not the supply wheel. This is essential in an economy that is stuck in recession. Keynes said that in such situations it is better for the government to step into the market than leaving it to the forces. The government could enter the market to spend on infrastructure and help to move the demand wheel, which is stuck.

On the other hand, trickle down theory sides with supply-side economics. It essentially believes that the government should have zero involvement in the market and should help incentivize businesses by providing tax cuts for corporations and high earners and while also leaving less regulations in the market. This is why trickle down theory is usually considered to be any policy that disproportionately benefits the rich.

Laffer curve

The laffer curve is a tool used by supporters of Reaganomics and Trickle down theory. Developed by Alfred Laffer, it uses the relationship between Tax Rates and Tax Revenue to make a bell shaped curve. When the tax rate is 0% the revenue that the government earns from it is 0. But, if the tax rate is bumped up to a 100% the tax revenue will still be 0 because people will not have any incentive to either earn money or to disclose their earnings to the government,because if the government will take all of it, why bother?

The graph’s non-linear curve advocates that taxes shouldn’t be either too light nor too heavy and that the government should cut down on specific tax rates to boost tax revenue. Laffer’s idea that tax cuts could boost growth and tax revenues was quickly labeled as “trickle-down”.

Alfred Laffer was an economist, part of the Reagan administration. The development of the Laffer curve helped President Reagan justify cutting taxes on the rich corporations and individuals.

Criticism

The idea of cutting taxes for the rich sounds absurd, but when you follow it up with the statement that it will help the lower and middle class it makes no sense. That is why critics of the idea argue that without an equal tax break for low income earners, trickle down theory only helps to widen the gap between the rich and the poor.

A study conducted by David Hope and Julian Limberg from the London school of Economics titled “The Economic consequences of Major Tax cuts for the Rich” concluded that, “We find that major tax cuts for the rich push up income inequality, as measured by the top 1% share of pre-tax national income. The size of the effect is substantial: on average, each major tax cut results in a rise of 0.8 percentage points in top 1% share of pre-tax national income. The effect holds in both the short and medium term. Turning our attention to economic performance, we find no significant effects of major tax cuts for the rich. More specifically, the trajectories of real GDP per capita and the unemployment rate are unaffected by significant reductions in taxes on the rich in both the short and medium term.

Trickle down theory in practice

Conclusion

Many methods and policies can be helped to boost the economy of a country during a recession, such as, Newer monetary policies, trade and exports, Foreign Direct Investment from investors overseas or even providing tax relief to the middle and lower classes to close the gap between the 1% and the rest of the population, but providing tax relief to the rich in the hope that they will eventually put it back into the economy, is but a tried and failed method.

Sources

Will Roger’s quote

Reaganomics

Say’s Law of Market

Keynesian Economics

Laffer Curve

The Economic consequences of Major Tax cuts for the Rich