Tag Archives: Christina Romer

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

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.


Why Favor Manufacturing?

Pop Quiz: Did the Tea Act of 1773 raise or lower taxes on tea?

I suspect that many Americans believe that it must have raised taxes. We all know that it got the colonists quite upset. They must have been mad because they felt they were “taxed enough already,” right?

Wrong. The Tea Act actually lowered taxes. What got the colonists so upset was that it didn’t lower everyone’s taxes. It only lowered the taxes paid by one firm: the East India Tea Company. Historically, Americans don’t just oppose high taxation. They oppose inequitable taxation. That’s why I find it particularly puzzling that politicians in both parties are going out of their way to single out the manufacturing sector for favorable tax treatment.

"Boston Tea Party" by W.D. Cooper, Image in the Public Domain

The big government sponsored enterprise of the 18th Century was the British owned East India Tea Company. Like the GSEs of our time, the Company benefited from a number of government-granted perquisites, including a government charter and a monopoly on trade in the East. The Tea Act added one more privilege: inequitable taxation.

In 1767, in an effort to raise money, Parliament had passed the Townshend Acts which had imposed taxes on a number of colonial goods, including tea. But colonial resistance had led to partial repeal of these acts in 1770. After this, the only tax that remained was the tax on tea and it was paid by all companies that dealt in the trade. This wasn’t ideal for the Americans, but it was enough to make them stop protesting.

All of that changed in 1773 when Parliament passed the Tea Act. Unlike the Townshend Acts, the Tea Act was not designed to raise revenue. In fact, it didn’t raise a single tax. Yet it sparked the most concentrated and violent protests in the simmering dispute between the mother country and the colonies.

The Tea Act exempted the East India Tea Company from the tea tax, permitting the company to undercut its rivals and giving it a monopoly in the tea trade. To use an increasingly common phrase from today, the act “picked winners and losers.” Perceiving themselves the losers, Americans were outraged. In Charleston they left the tea to rot on the docks. In New York and Philadelphia they sent it back to Britain. And, of course, in Boston they threw it into the harbor.

All of this has been going through my mind as I have been reading President Obama’s corporate income tax proposal. I’d like to be reading that the president plans to lower the rate for all U.S. firms. After all, there is bipartisan consensus that our corporate tax rate is highly uncompetitive. Instead, I’m reading that the president’s plan calls for preferential treatment of manufacturers.

Why? Because it has become politically popular to favor the manufacturing sector. Just ask Rick Santorum. He would cut the corporate tax rate to 17.5 percent for all firms except manufacturers. They would pay zero.

Apparently politicians are convinced that because manufacturers “make things” that we can see and touch, they ought to be treated favorably. But does the consumer who buys a college education derive any less value than the consumer who buys a Ford? Are those who spend thousands of dollars a year on health care, hospitality, insurance, banking, travel, and hundreds of other activities just imagining that these services are worthwhile? Are the workers in these industries any less worthy than the workers on an assembly line?

We all want to know what will be the next big industry of tomorrow. But this is a question that must be left up to the American consumer. Whenever a politician awards special privileges to one industry or another, he attempts to substitute his judgment for that of the consumer. In the process, the politician artificially draws labor and capital into the favored industries. Think of housing during the 1990s and 2000s. Lured by favorable tax and regulatory treatment, millions of workers went into housing, finance, and related industries. When it turned out the public didn’t want as many houses as the politicians did, all of these workers were stranded with outdated skill sets.

How many factory workers will lose their jobs when it turns out that political interest in manufacturing doesn’t guarantee customer interest in manufacturing?

President Obama’s former economic advisor, Christina Romer, recently parted with her former boss and questioned the wisdom of favoring manufacturers. In doing so she joined a venerable American tradition in opposing inequitable taxation. It would be nice if more Americans joined her.


Update: Veronique de Rugy weighs in with a nice post here.