"Trickle down Effect"Does it work

Trickle down economics is a term used to describe the belief that if high income earners gain an increase in salary, then everyone in the economy will benefit as their increased income and wealth filter through to all sections in society.

However others criticise this belief that if the top earners in society gain an increase in income, everyone benefits as a result. Some studies suggest that increased income inequality can lead to this inequality being solidified through educational opportunities, wealth accumulation and the growth of monopoly / monopsony power. Furthermore, increased inequality may lead to lower rates of economic growth.

A recent report by the OECD found that since the start of the credit crisis in 2008, inequality has widened in many countries; however this inequality has led to lower rates of economic growth not higher.

This graph from an OECD report suggests that inequality is responsible for lower GDP. The OECD estimates that the UK economy would have been more than 20% bigger had the gap between rich and poor not widened since the 1980s.

Source: OECD Focus – Inequality and Growth 2014

Trickle down effect and tax cuts

An important element of the trickle down effect is with regard to income tax cuts for the rich. It is argued that cutting income tax for the rich will not just benefit high-earners, but also everyone. The argument is as follows:

1. If high income earners see an increase in disposable income, they will increase their spending and this creates additional demand in the economy. This higher level of aggregate demand creates jobs and higher wages for all workers.
2. Alternatively, increased profits for firms may be reinvested into expanding output. This again leads to higher growth, wages and incomes for all.
3. Lower income taxes increase the incentive to for people to work leading to higher productivity and economic growth.

Criticisms of the trickle down effect

• High income earners have a high marginal propensity to save. Therefore, the increased disposable income from a tax cut does not filter into other sections of the economy because it is saved not spent.
• Instead higher incomes may be used to accumulate wealth; this wealth accumulation leads to further capital gains and income from assets – leading to even higher levels of income and wealth inequality.
• Higher GDP doesn’t address the fundamental inequality of capitalist society. Even if tax cuts did lead to higher economic growth, higher output necessarily lead to higher real incomes for all. Low income workers may be left behind in certain types of economic growth. The UK recovery 2011-14 has been notable for low real income growth.
• Budget deficit. Cutting taxes in the US, led to an increase in the budget deficit. (from 2.7% of GDP in 1980 to 6% of GDP in 1983) Although, this provides a temporary fiscal boost, a budget deficit creates problems for the future economy (possibility of higher interest rates, higher taxes in the future)
• Wrong target. If you want to reduce relative poverty, it makes sense to target income tax cuts and benefits at those who need it. Cutting taxes for the rich, in the hope some may trickle down to the poorest is a very inefficient way of working.
• Cutting taxes does not necessarily increase incentives to work (both the substitution and income effect are at work and may cancel each other out).
• It was hoped cutting income tax would encourage people to work overtime and work more hours. But in practise, this didn’t occur.

Ronald Reagan and the trickle-down effect

Ronald Reagan was closely associated with the trickle-down effect in the 1980s. This is because during his presidential term, he cut income tax for the high earners. He did not sell this policy on the grounds that ‘there will be a trickle down effect.’ However, opponents often claimed that this miserable ‘trickle down effect’ summarised Reagan’s economic policy and disdain for reducing poverty.

G.W. Bush and trickle-down effect

The economic policy of George W. Bush closely mirrored that of Ronald Reagan. Faced with an economic downturn in 2001, he cut income taxes; most of which were targeted at higher earners.

Inequality in US

Top 1% gained increased share of income, bottom 80% saw drop in income share