Trickle Down Economics-Does It Really Work?

There are plenty of ideologies and laws that have been challenged, overturned, or simply no longer enforced due to changes in society. An ideology that affects our everyday lives-therefore making it worthy of a second-look (or at least some fine tuning) is the Trickle Down Theory.

What is the Trickle Down Theory?

Accredited to former President Ronald Reagan, the trickle down theory is an economic strategy stating that “decreasing marginal and capital gains tax rates-especially for corporations, investors, and entrepreneurs can stimulate production in the overall economy” (Investopedia). In other words, the government should give tax breaks to businesses in the hopes that it would lead to more job growth. In theory, no pun intended, this sounds perfect! Think about it-if we give tax breaks to the people who are creating jobs-they will have more money to reinvest into their own companies. This should lead to the formation of more stable companies which would provide long-term employment opportunities and potentially higher wages overall (ie through business-to-business competition for workers).

So what’s the problem?

According to a recent article published by Alanna Petroff, “the International Monetary Fund (IMF) did research on the effectiveness of this economic strategy by analyzing over 150 countries and has concluded that wealth does not trickle down from the rich to the poor. In fact, researchers found that when the top earners in society make more money, it slows down economic growth overall.” This is startling information coming from an agency whose job is to secure financial stability (IMF.org). [Unfortunately, there is no simple answer to justify why this trend occurs. One reason could be the inert limitation involving the reality of the trickle-down theory as it relies on the morality of those receiving the tax breaks. For example, if someone was generous and wanted to invest that extra money into the overall growth of the economy through increasing productivity and wages-then it works fine. But what happens if someone wanted to keep that extra money for themselves or their heirs as opposed to reinvesting? Productivity could still increase but the distribution of wealth could become grossly skewed. Sadly, that is exactly what has happened as illustrated by the graph on the left.] The IMF went on to suggest “that when the richest 20% of the population increase their income by as little as 1% the overall growth of the economy shrinks by 0.1% within five years; as opposed to when the poorest 20% of the population increase their income by 1% the overall growth of the economy actually increases by 0.4% within the same time period.” Even though those numbers do not seem too impactful, it does show that a simple increase in income from the bottom up actually betters the economy overall compared to relying on wealth to trickle down.

Why use this theory then?

According to billionaire Noah Smith, “economics is often less science and more scam…The real magic of trickle-down economics, by the way, isn’t to convince people that if the rich get richer, that’s good for the economy and therefore good for you. The real power comes from convincing people that if the poor get richer, that will be bad for the economy and bad for you.” What an interesting thought. Despite historical evidence showing that previous increases in wages (for those receiving federal minimum wage) has actually boosted the economy we still embrace the notion that giving tax breaks to the rich will somehow create a better world for those under them. Economist Jay L. Zagorsky presents a historic example of how a simple wage increase quickly lowered the unemployment rate. “In 1949, the federal minimum wage was 40 cents per hour. It was increased to 75 cents in 1950, an 88% jump…This hefty pay hike – the biggest in a single year – did not appear to crush economic activity. On the contrary, the national unemployment rate fell in subsequent years, to 2.9% [1953] from 5.9% [1949].” In as little as 4 years the unemployment rate dropped 3.0%. Unfortunately, increasing wages is not a solution directly endorsed by many politicians-instead you may hear about more governmental assistance plans.

What’s wrong with government spending?

Whenever the population complains about jobs the government answers with increased spending programs to promote economic growth. However, an important consideration of the trickle down theory, is that the economy is stimulated and grows with little to no direct government intervention; if you noticed it was the businesses, investors, and entrepreneurs (private sector) that drove the economy. Some of the more recent tactics used by the government to improve the economy was the tax rebates in 2001 and 2008 by former President Bush, as well as President Obama’s $787 billion stimulus bill in 2009 (heritage.org). In his article, Brian M. Riedl, wrote that government spending “could increase long-term productivity rates–but only if [the] government invests more competently than businesses, nonprofit organizations, and private citizens would have if those investment dollars had stayed in the private sector. Historically, governments have rarely outperformed the private sector in generating productivity growth. Thus…government spending typically reduces long-term economic growth.” Politically speaking, it looks great when a candidate wants to spend more money to help the economy; but in reality (whether Republican or Democrat) taking more from the private sector does more harm than good. Why? Think about it, who knows about the needs of a neighborhood, community, county, state, etc. better than the residents of those places? The money the private sector uses generally goes to meet the needs of local residents as opposed to when the government chooses to spend it. The chart below illustrates the billions our government dumps on military spending compared to that of other ventures.

Conclusion

Even though the trickle-down theory is not a law it does play a major role in our day-to-day operations. Unfortunately, the true success of the trickle down theory relies primarily on moral obligation as opposed to factual historical data. Granted the economy has improved from a productivity standpoint but, the lack of wage increases has created an even greater disparity in income. So far our government has only provided temporary band-aid fixes without addressing the root of the epidemic. A true plan of action needs to be implemented to not only decrease the income gap but to also make private sector investing (without having to get bank loans) a higher priority.

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