7/15/2012

What is Trickle-Down Economics?

“Trickle down” is of course a disingenuous misnomer invented by the left to stigmatize conservative supply-side economic policies. It implies favoring the rich—that doing so will “trickle down” to everyone else. Nonsense. Conservatives don’t care any more or less about the rich than do liberals. The point for conservatives is not to help the rich, but to limit the harm done to incentives by tax policy so individuals have greater opportunities to become rich. President Obama misrepresents supply-side economics and then goes on to misinform his audience that it’s never worked. People are entitled to their own opinions, but they’re not entitled to their own facts.    Every time supply-side economic policies have been tried, tax rate reductions were applied to every income group — lower-income, middle-income, and upper-income alike — giving everyone a better shot at success. This is true regarding supply-side policies of the 1920s, 1960s, 1980s and 2000s.

Economist Thomas Sowell has written that the actual path of money in a private enterprise economy is quite the opposite of that claimed by people who refer to the trickle-down theory. He noted that money invested in new business ventures is first paid out to employees, suppliers, and contractors. Only some time later, if the business is profitable, does money return to the business owners—but in the absence of a profit motive, which is reduced in the aggregate by a raise in marginal tax rates in the upper tiers, this activity does not occur. Sowell further has made the case that no economist has ever advocated a "trickle-down" theory of economics, which is rather a misnomer attributed to certain economic ideas by political critics.

Although the term "trickle down" is mainly political and does not denote a specific economic theory, some economic theories reflect the meaning of this pejorative. Some macro-economic models assume that a certain proportion of each dollar of income will be saved. This is called the marginal propensity to save. Many studies have found that the marginal propensity to save is considerably higher among wealthier people. Policies, including tax cuts, that seek to increase saving are often aimed at the wealthy for this reason. Saving usually means some form of investment, as even money placed in savings accounts is ultimately invested by the banks.

The first known use of trickle-down as an adjective meaning "relating to or working on the principle of trickle-down theory" was in 1944.   In an economic slump, some say the government should make efforts to increase the supply (output or production) of an economy. Say's Law states that the way to economic growth is to boost production, and demand naturally follows. This flew in the face of the belief of the time, which was that a lack of money -- and thus lack of demand -- caused bad economic times. Say asserted that there will always be a demand for the right kind of products.

You could think of it this way: If there are people willing to work during a recession, they obviously want money in order to consume something. They must already have a demand that is not being met -- what they demand is either too expensive for them to afford or is not being produced. Producing in-demand products and driving down costs will create profit for the seller, and thus the means for him to satisfy his or her demand. Hence, production greases the wheels of the economy. This logic made sense to major thinkers of the time, including Thomas Jefferson and James Madison.

A century later, the tide had turned in the United States. By the time the Great Depression hit in the 1930s, many legislators held the opposite view. The most notable opponent to Say's Law during this time was John Maynard Keynes, a British economist. Keynes argued that there are such things as overproduction and lack of demand, and the key is to increase demand rather than supply. Government should promote consumer demand rather than entrepreneurial production. When people consume more, they create more jobs and production.

Laffer's curve shows that when tax rates are at zero, revenues are zero as well -- the government makes no money when it taxes nothing. But it's the same result if the tax rate were 100 percent. The Laffer Curve postulates that once the rates get too high, the steep taxes discourage work to an extent that the revenues themselves suffer. Laffer showed examples in U.S. history where lowering high tax rates increased not only government revenue, but also increased gross domestic product (GDP) growth and lowered the unemployment rate.

Sowell, an ardent supporter of trickle-down theory, argues that the popular definition gets it backward. Instead of benefiting the wealthy first, the policy actually benefits the working class first. This may sound impossible -- after all, it's the wealthy who get the tax breaks, not the poor. However, Sowell maintains that because the wealthy make investments in order to make a profit, they spend the money first on expenses of the business venture. (In other words, spending money to make money.) These wealthy investors must pay workers, thus creating jobs, before they can expect to see any profits. Therefore, it's the workers who receive the most immediate relief.

There have been a number of well documented studies showing that it is a combination of spending cuts and reduction of tax rates that is the most effective way to stimulate economic growth. So before you start bashing "trickle down economics", study the facts.