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Trickle-Down Economics: Does Anyone Actually Believe In It?

by Matt Mitchell on June 1, 2012

in Crony Capitalism, Economic Growth, Tax and Budget

I have heard a lot about “trickle-down economics” lately. The President has taken to using it in speeches. And pundits have increasingly invoked the idea. Back in February, I was asked about the term when I testified before a House committee and had to confess that I have never met an economist who has advocated anything close to “trickle down” economics.

The words “trickle down” imply that if you redistribute money to the wealthy, they will spend it (say, by hiring workers or by buying products) and it will somehow find its way into the hands of the poor. To the extent that any economists endorse such a notion, they are emphatically not free market economists.

This is not to say that there is no case for low taxation. There is a strong theoretical case for low taxation (so long as it is accompanied by low spending!). And it is backed by good empirical evidence.

But the case for low taxation is not—as the phrase “trickle down” implies—based on the idea that we should give money to a wealthy person so she can spend it. Instead, it is based on the idea that if we take money away from either a rich or a poor person when they engage in some activity, they will tend to engage in less of that activity.

If we tax work, people will tend to work less. If we tax consumption, people will tend to consume less. If we tax saving, people will tend to save less. The idea is rooted in basic microeconomics. Taxing labor, for example, makes leisure less expensive. So people choose more leisure. This is called the substitution effect.*

All this theory is well and good, but is there any evidence to back it up? Yes. Michael Keane offers a nice survey of labor supply and taxation studies in the December issue of the Journal of Economic Literature. He identifies at least two major patterns in the evidence:

  1. Women are more responsive to taxes than men (most economists think men are relatively unresponsive to labor taxes, especially in the short run).
  2. People—particularly women—are more responsive to taxes when they consider whether to work than they are when they consider how much to work. In the average study, the long-run elasticity for female labor is 3.6. This means that if a tax hike reduces after tax wages by 10 percent, female labor force participation tends to fall by about 36 percent. As Keane puts it, this is a “very large” effect.

In my view, both of these patterns make sense. Historically, women have been more likely than men to work at home and so higher taxes seem more relevant for them than for men (as more women work outside the home and as more men stay home, I’d expect this gender difference to narrow). It also makes sense that taxes have a larger effect on the decision to work at all than on the decision to work a certain number of hours. Most of us can’t tell our employers that we want to work 30 hours a week rather than 40. But we can tell our employer that we don’t want to work at all. And evidently a lot of people—particularly women—do tell their employers this when taxes are high.

So far, I’ve only discussed how taxes affect labor supply. But they may also depress consumption and investment. What is the overall effect on the economy?

One of the best recent studies is that by President Obama’s former economic advisor, Christina Romer and her husband, macroeconomist David Romer. The Romers set out to understand the effect of taxation on an economy. But they knew that there was a major problem: taxes are not randomly increased or decreased. Instead, politicians tend to keep taxes low when the economy is in recession and raise them when the economy is booming. This makes it very difficult to disentangle cause and effect. So the Romers painstakingly analyzed decades of presidential speeches and government documents to identify exogenous tax changes (i.e., changes that were undertaken for reasons other than the condition of the economy). They then compared the performance of the economy following such exogenous changes. They concluded that exogenous tax increases are “highly contractionary.” As they put it in the conclusion:

Our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent.

Now here is the irony: As I note above, few if any economists advocate redistributing resources to the wealthy in the hopes that they will trickle down to the rest of us. But over the objection of economists—particularly free market economists—policy makers do this all the time. Think of President Bush’s TARP. Or President Obama’s decision to extend TARP to the auto companies. Or his excursions into venture capital. In each case, money was actually transferred from taxpayers to the (mostly) wealthy managers and shareholders of private firms.

If words mean anything, each of these policies—and not, say, an across the board reduction in marginal income tax rates—should be labeled “trickle-down economics.” But in politics, words often mean nothing.

————————————–

*  You might be thinking that the income effect offsets this: By taxing income, you not only make leisure less expensive, you also make people feel poorer. In response to feeling poorer, they may feel that they need to work harder to make up for the loss income. This works for an individual, but as economists James Gwartney and Richard Stroup long ago explained in the American Economic Review, it does not work for society as a whole. This is because governments do something with the money they collect in taxes. And the income effect of spending government revenue makes people work less. So at the economy-wide level, the income effect from spending offsets the income effect from taxing. All you have left is the substitution effect and that unambiguously reduces labor supply.

 

  • Woj

    It’s amazing how some political dogmas remain without any economic support. Part of the problem likely stems from the lack of clarity in economic terminology, even within the field. A post at Advisor Perspectives, by Michael Edesess, a few weeks back discussed a similar issue from a mathematical perspective (title is An attack on Paul Krugman).

  • Why does Matt choose to use a label “trickle-down” economics that isn’t used in any way, shape, or form by economists? Why doesn’t Matt take the time to learn about “supply-side” economics that has been around since the 1920’s? It’s earliest practitioner was Secretary of Treasury Andrew Mellow who was responsible for the roaring 20’s using supply-side economics. President John F. Kennedy followed the policy prescription of Nobel Prize winning economist Robert Mundell to spark an economic boom from 1964-1969 (before LBJ destroyed the boom with policies duplicated by Barack Obama). 

    Basically supply-side economics doesn’t cut the taxes of the rich, it cuts ALL taxes across the board and also calls for sound money so that the economic boom caused by the tax cuts isn’t inflationary. 

    Educate yourself Matt so you can write a more informative piece. 

    • Matt Mitchell

      Hi Dave,
      Thanks for your comment. Would you please re-read (read) my post? When you do, I think you will discover that my point is exactly the opposite of what you assume it to be. I cite both theory and evidence that supports tax cuts (so long as they are accompanied by spending cuts). I’m attacking the label “trickle-down” because it is the straw-man argument which opponents of modest spending and modest taxation use.
      Thanks.

      • Your article attempts to attack a straw man (trickle-down) with another straw man (tax cuts coupled with spending cuts which is no recognizable economic theory I know of). You seem to think you are advocating supply-side economics, but you certainly aren’t. 

        If you have never read a 1962, 7-page policy paper entitled “The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability” by Nobel Laureate Robert Mundell then you do not understand supply-side economics at all. Spending doesn’t have a thing to do with supply-side economics. Taxation (fiscal policy) and sound currency (monetary policy) make up the economic ingredients of supply-side economic theory which targets economic growth across the entire spectrum of tax brackets and not in any way, shape, or form involves trickling down from above. 

        So if you want to refute endless straw man arguments do so by simply describing in a factual manner the economic theory whose bush you are beating around. 

        Macroeconomic theory that deals with demand (which is exactly what government spending is meant to increase, aggregate demand) has nothing to do with supply-side economics. 

        Supply-side economics deals with the opposite side of the economic equation from demand-side economics (Keynesian spending if that labels makes it easier to deal with.) So your discussing spending is totally off base which is why I said you needed to educate yourself. 

        So go blow $5 at Robert Mundell’s personal website, spend an hour readomg the 7 pages published 50 years ago that inspired Kennedy and Reagan and educate yourself. 

        • Matt Mitchell

          Hmm.  Are you under the impression that the free market position is to cut taxes and not cut spending? And are you under the impression that there is no theoretical or emperical case for limited government?

          • Matt, you are a professor of economics correct? The “free market” now has a position? I always thought the free market was an entity where property owning individuals voluntarily exchanged goods, and was not a “position.” 
            I’ll state it clearly for you since you seem too lazy to at any time in your journey towards a PhD in economics to familiarize yourself with what supply-side economics really is. 

            Supply-side economics is the idea that lowering marginal taxes and providing a sound currency that retains value will promote economic growth. Period. End of story. 

            Now you have your own created labels of “trickle down” or “free market position” or whatever other personal name you give to some jumble of economic ideas only you are familiar with, but supply-side economics is something that has been clearly defined for a half a century in the pamphlet that contains Robert Mundell’s policy mix that I gave you a link too. 

            Supply-side policy specifically addresses fiscal (taxation) and monetary policy and not government budgets and spending programs.

          • Matt Mitchell

            This
            conversation has taken an unconstructively ad-hominem tone. There are various
            free-market schools of thought on macro: Monetarist, Real Business Cycle / New
            Classical, Austrian, Supply Side, Public Choice-influenced (I’m thinking here
            of Buchanan and Wagner). These are not mutually exclusive categories of course.
            The supply side insight that taxes matter is important (see my post!). But
            spending matters too and I don’t think it is a fair characterization of any of
            these models to claim that they think spending doesn’t matter at all (even if
            some models focus on taxes). If that were so, we could cut taxes to 0, continue
            to spend $3.7T a year and wait for prosperity to arrive. I seriously doubt
            that’s what Mundell was advocating. Have a great day!

          • Matt, could you please provide a definition of supply-side economics and what literature you base it on? 
            I gave you a specific definition and source. 
            Robert Mundell presented the ideas for supply-side economics in his 1962 publication  “The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability”.  He called for marginal tax cuts on the fiscal side to encourage productivity and sound money policy on the monetary side that targeted stable price levels. 

            Now I’ve read your entire article and numerous posts by you and I see labels being thrown around like they are self-defining. I would suggest that your reasoning is obtuse because of this. I would also suggest reading Bastiat if you want some guidance on how to clearly refute arguments for centralized economic control by bureaucrats. 

  • Don M

    Well, you could have just written a headline “taxes contract economic the economic activity that is the subject of the tax.”  No one disputes that, as you note – not even the Obama people.  That doesn’t validate “trickle down” or “supply side” economics.  The fact that the taxes studied in the second instance were independent of a contraction means that no evidence for Keynesian views is presented here, one way or another.

    Right now, we have an unusual situation: profits are high, but production and demand is low.  The question is whether, if the government can affect the situation, where the solution lies: on the demand side or supply side? 

    The mere fact that taxes contract economic activity doesn’t mean that taxes should always be cut.  Cutting payroll taxes to 1% would encourage labor, but it wouldn’t pay for social security.  These are independent questions: what level of government services we desire, and the tax rates to support that level, and whether the imposition of those taxes has ancillary effects.

    But “trickle down?”  I can’t find it here.

    • Matt Mitchell

      Hi
      Don M. I guess I have the same advice for you as I had for supply-side-Dave.
      Please re-read the post. I don’t claim to be saying anything about Keynesian
      economics (in this post). I don’t even use the term. I’m simply noting two
      points. First, the term “trickle down” implies that free-market economists who
      desire low taxation want to transfer money to the wealthy. This is simply not
      true. Second, many people seem to think there is no evidence that high taxation
      (and spending) harm an economy. This is not true either. It sounds like you might agree with me.

  • The statement is made in the article that there is a case for cutting taxes so long as it is accompanied by low spending. I will assume that lower spending means a reduction in spending because it is not a well chose statement. 
    Let’s examine a scenario. Income taxes get reduced from 71% to 50% uniformly across all brackets, and income tax revenues increase by 10% because the tax base broadened and economic growth increased  substantially. 
    Let’s say at the time of these tax cuts that a surplus existed. In order to keep the growing surplus from being a drag on the economy, spending is increased. 
    This is a case where taxes can be cut and spending increased. 

    A second scenario is that tax rates are reduced by 30% across all brackets at a time when government was running a deficit. The increased revenue from the broadening of the tax base and increased productivity would actually reduce the deficit without cutting spending. 

    Economic growth is the key, not spending. All spending is not equal, but all marginal tax cuts that increase revenue are. 

    Historical examples of marginal tax cuts increasing revenue occurred in the 1920’s, 1964-69, and 1983-89. 

  • The idea that actual taxes or funds from taxpayers actually funded TARP or the other bailouts is erroneous. We are already in a deficit so the TARP and bailout money could not have come from taxes. It also wasn’t borrowed because the social security trust fund and the FED are the two biggest buyers of US government securities since the meltdown in 2008. 
    The funds came from a massive expansion of the money supply in the government’s accounting ledgers. The movement of this book supply of money to the real economy is much slower and has caused considerable inflation that was offset by the deflation caused by the massive economic losses of the financial meltdown experienced by bondholders in the effected entities. 
    This of course massively devalued the value of the dollar which effected anyone holding dollars all over the globe. 

    The bailouts devalued the dollar all over the globe and penalized savings accounts denominated in dollars. 

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