Trickle-down economic theory states that benefits for the wealthy trickle down to everyone else in the economy. These benefits for the wealthy include tax cuts for dividends, capital gains, high-income earners, and businesses.
Trickle-down economics assumes that company owners, savers, and investors drive growth. This theory promises that they will expand businesses using any extra cash from tax cuts. For example, owners will hire workers and invest in operations; banks will increase lending, and investors will buy more stocks and companies. Then, all of this expansion will trickle down to the working class, where they will drive demand and economic growth by spending their wages.
Supply-side economics, which is a theory that states that all tax cuts lead to economic growth, is similar to trickle-down economic theory. However, trickle-down economic theory is more specific, saying that targeted tax cuts are more effective than general tax cuts. Trickle-down economics recommends cuts to capital gains, corporations, and savings taxes, but it doesn’t promote tax cuts across the board. Instead, the wealthy receive all of the tax cuts, and the benefits trickle down to everyone else.
Proponents of supply-side economics and trickle-down economics prove their theories using the Laffer Curve. This is a curve created by Arthur Laffer, who showed the way that tax cuts create a powerful multiplication effect. These tax cuts create sufficient growth to replace the government revenue that was lost from them, resulting in an expanded, prosperous economy that provides a larger tax base.
Laffer did note that this effect is best when taxes are in the “Prohibitive Range,” which goes from a 100% tax rate to around 50%. When tax rates fall below this range, further cuts won’t be able to stimulate enough economic growth to offset lost revenue.
During Reagan’s administration, his policies (known as Reaganomics) made it seem that trickle-down economics worked since they helped to end the 1980 recession.
Not only did Reagan cut the top tax rate from 70% for people earning $108,000 or more down to 28% for those earning $18,500 or more. He also cut the corporate tax rate down from 46% to 40%.
However, trickle-down economics wasn’t the only reason for the recovery. In addition to the tax cuts, Reagan increased the government’s spending by 2.5% a year, and he also tripled the federal debt. It went from $997 billion in 1981 to $2.85 trillion eight years later in 1989. Most of this spending went to defence, supporting Reagan’s efforts to bring down the Soviet Union and end the Cold War.
Because of these other factors, Reagan never tested trickle-down economics in its pure form. It’s very likely that his huge amounts of spending played just as large a role as trickle-down economics in ending the recession.
According to trickle-down economics, Reagan’s and Bush’s tax cuts should have helped those at all income levels. But the opposite result took place: income inequality worsened. Between the years 1979 and 2005, the bottom fifth saw a 6% rise in after-tax household income. While this on its own seems great, it’s important to note what the top fifth experienced an 80% increase in after-tax household income. The income of the top 1% tripled, showing that prosperity was trickling up rather than down.
Trickle-down economics generally doesn’t work for the following reasons:
• Tax cuts for the wealthy don’t often translate to increased consumer spending, rates of employment, and government revenues in the long term.
• Instead, tax cuts for the middle- and lower-income earners drive the economy through the trickle-up phenomenon.
• The increased income for the wealthy that comes from the tax cuts only increases income inequality
So, Liz Truss and her tax cut plans may only result in a “trickle-up” phenomenon than a “trickle-down” expectation. That’s what happens when you don’t have a sense of economic history.
References:
Trickle-down economics: Why it only works in theory, Economics Online, 29 July 2021
Trickle-down economics, Tejvan Pettinger, Economics Help, 22 September 2022
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