Trickle down economics

trickle-down-effect

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.

How the trickle-down effect may work in theory

trickle-down-effect

If the richest gain an increase in wealth, then

  • They will spend a proportion of this extra wealth.
  • The extra wealth will cause an increased demand for goods and services, causing higher employment and a rise in wages.
  • The higher wages will also cause a multiplier effect, e.g. if more chauffeurs are employed by the rich, the chauffeur will gain increased income and, in turn, they will increase spending in local businesses.
  • A cut in taxes increases the incentive to work. Lower income tax encourages people to work longer. Lower corporation tax encourages business to invest, creating wealth.
  • Alternatively, the wealthy may invest their increased wealth. If the wealth is invested in new businesses, it will create new jobs and increase the incomes of those employed.
  • Higher spending and investment will stimulate economic activity leading to a rise in tax revenues (higher income tax, higher VAT).
  • Higher tax revenues can fund public programmes such as healthcare, education and welfare payments to the poor.

Trickle-down effect and tax cuts

An important element of the trickle-down effect is with regard to income tax cuts for the top-income earners. 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.
  4. The Laffer curve suggests cutting tax can even cause an increase in tax revenues as the lower tax rates are offset by higher growth.

A study by NBER June 1997 Engen and Skinner conclude that:

“cutting marginal tax rates across the board by 5 percentage points and cutting average tax rates by 2.5 percentage points would increase the growth rate of U.S. GDP by 0.3 percentage points per year.”

Video on Trickle-down economics

Criticisms of trickle-down economics

I have a joke about trickle-down economics. Only 99% of you will get it.

trickle-down-effect-criticism

Many economists are sceptical of the belief in ‘the trickle-down’ effect. One reason, the wealthy have a higher marginal propensity to save, and also n recent years, wealth has been saved in off-shore accounts to avoid paying tax. Therefore, when the wealthy gain extra income, only a small percentage may filter through to low-income workers.

Also, 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.

Tax cuts have no clear impact on growth. In The Economic Consequences of Major Tax Cuts for the Rich (2020), by David Hope and Julian Limberg, the authors found tax cuts for the rich, had no statistical effect on economic growth. They looked particularly at the 1980s in UK and US, where significant taxes were cut.

“The results also show that economic performance, as measured by real GDP per capita and the unemployment rate, is not significantly affected by major tax cuts for the rich. The estimated effects for these variables are statistically indistinguishable from zero.” (LSE)

A report by the IMF (2015) found increasing income share of the poor increased economic growth, but increasing income share of the rich, led to lower growth.

“We find that increasing the income share of the poor and the middle class actually increases growth while a rising income share of the top 20 percent results in lower growth.”

Real GDP and Median wages in the US

real-median-vs-real-gdp-web

In the US, real GDP has grown faster than median wages since the early 1980s. In the 1980s, taxes were cut for high earners and there was a significant increase in inequality. Proponents of the Reagan tax cuts and supply-side economics argue it was worth it because everyone benefitted from rising GDP. However, the median wage, (which is the wage the middle-income earners actually receive has increased slower than real GDP, suggested not all the gains of the top 1% have trickled down to average workers.

income-share-top-10%

Inequality and lower 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.

oecd-inequality Source: OECD Focus – Inequality and Growth 2014

Read more

Fall in Pound Sterling due to Brexit, Energy Crisis and Recession

pound-dollar-14-22-web-arrow

In recent months, the Pound Sterling has fallen against the dollar to levels not seen since 1985. This reflects long-term concerns about the UK economy, Brexit, the winter energy crisis and concerns about an imminent recession. The pound has fallen 16% this year, and the last month was the worst since 2016. The Pound is …

Read more

How the UK economy has changed in the past 70 years (1952-2022)

1952-2022-housing-UK

In 1952 when Queen Elizabeth II came to the throne, the UK was a major economic power, but still reeling from the costs of the Second World War, with rationing and austerity still visible. The post-war period saw a remarkable rising living standards, strong economic growth and radical changes in the economy, but also saw …

Read more

How did we end up with a broken housing market?

uk-house-price-to-earnings-ratios

For many people, especially those under 40, the UK housing market appears broken, with excessive prices making it difficult to buy and very expensive to rent. Housing costs are one the biggest factors in a long-term cost of living crisis. The UK isn’t alone, with many advanced economies also facing a broken housing market and …

Read more

The effect of tax cuts on economic growth and revenue

laffer-curve-2018

Politicians often promise tax cuts can lead to higher productivity, higher economic growth, and even pay for themselves through a boost to long-term incomes. These promises may chime with the electorate who tend to prefer promises of tax cuts. But, do tax cuts really increase economic growth?

There are two impacts of lower tax.

  1. Increasing demand in the short term
  2. The effect on supply and productivity in the long-term

Lower income tax rates increase the spending power of consumers and can increase aggregate demand, leading to higher economic growth (and possibly inflation).

On the supply side, income tax cuts may also increase incentives to work – leading to higher productivity.

However, the effect of tax cuts depends on how the tax cut is financed, the state of the economy and whether low tax rates actually increase productivity and the willingness to work.

The effects of reducing income tax rates

  1. Increased spending. Workers will see an increase in their discretionary income. With lower income tax rates, they would keep more of their gross income, so effectively they have more money to spend.
  2. Higher economic growth. With lower tax rates, we could expect to see a rise in consumer spending because workers are better off.  Because consumers spending is a component of aggregate demand (AD) (roughly 60%), then a rise in consumer spending should cause a rise in AD, leading to higher economic growth.
  3. Government borrowing. Tax cuts will, ceteris paribus, lead to lower tax revenue and this is likely to cause higher borrowing. Though some economists believe income tax cuts can increase productivity, which offset this fall in revenue.

Effect of tax cut when the economy is below full capacity

increase-AD-Keyneisan-LRAS-middle

Impact of tax cuts on AD/AS diagram, when there is spare capacity in the economy.

How are tax cuts financed?

Will a cut in tax really increase aggregate demand? Firstly, it depends on how the tax cut is financed.

  • Tax cuts financed by spending cuts. Suppose the government offered £4 billion of income tax cuts, but at the same time cut £4 billion from welfare spending. In other words, the tax cut is financed by cuts in government spending. In this case, we will not see an increase in AD because some people are better off from the tax cut, but others will cut their spending due to lower welfare payments. There is no overall increase in injections into the circular flow of income. [In fact, those on welfare benefits are likely to have a higher marginal propensity to consume (mpc) than those on higher income levels so this could actually cause lower AD].
  • Government borrowing. Alternatively, the government could finance the tax cut by increasing government borrowing. Would this increase AD?
    • In a recession, we probably would see higher AD. This is because the government borrowing will be financed by people wanting to save anyway. In this case, the government is injecting unused resources into the circular flow. In a recession, the tax cut makes a big difference to people’s spending power
    • If the government increases borrowing in a boom to finance a tax cut, we are more likely to get crowding out. This essentially means the government borrow more by selling bonds to the private sector. If the private sector buys government bonds, they have less money to invest elsewhere. Also, during high growth, higher borrowing may lead to higher bond yields, and these higher interest rates cause financial crowding out.
  • Cutting taxes in a boom

Cutting taxes when the economy is already growing quickly is likely to cause inflationary pressures.

keynesian-increase-ad-lras
Effect of cutting taxes when the economy is close to full capacity

In 1988, chancellor Nigel Lawson cut income tax. The top rate of tax was cut from 60p to 40p and the basic rate from 27p to 25p. These tax cuts occurred during a period of strong economic growth; these tax cuts (combined with loose monetary policy) led to even higher economic growth, but inflation also increased to 8% in 1989 and caused a subsequent boom and bust. The tax cuts also caused a rise in import spending and an increase in the UK current account deficit.

  • Tax cuts financed by improved productivity. If the economy sees rising productivity, then this can enable tax cuts. For example, if an economy saw productivity growth of 4% a year (e.g. due to new technology) then this high rate of economic growth would automatically lead to higher tax revenues (higher VAT, corporation tax). With this kind of economic growth, it may be possible to cut tax rates – but maintain tax revenue.

Impact of tax cuts on productivity

If we take a cut in income tax, it could also affect the supply side of the economy.

  • Lower income tax rates may encourage people to work longer. Overtime is more worthwhile if you get to keep more of your income. Lower income tax rates may encourage people to move to that particular country. This is the substitution effect – work is more attractive with lower tax rates.
  • However, there is also the income effect. With lower tax rates (and effectively higher wages), it is easier to get your target income by working fewer hours. Therefore, tax cuts may not increase labour supply because people don’t need to work more if work is more highly paid.

laffer-curve-2018

A controversial economic argument is the “Laffer Curve“. This argues that if you cut income tax rates, then the tax cut increases the incentive to work so much, that the government can actually gain more tax revenue. It seems to offer the best of both worlds – lower tax rates and higher tax revenues.

There is a debate about the extent to which tax cuts increase productivity and economic growth. If marginal income tax rates are very high, e.g. 80%, then cutting tax rates is likely to increase labour supply and productivity. But, with tax rates of 20 or 30%, cutting income tax rates is no guarantee of increasing productivity and growth.

Cut in indirect tax

If the government cut an indirect tax like VAT, the effect is similar. If goods are cheaper because of lower tax, consumers will effectively have more purchasing power. After buying the same number of goods, they will have more money left over. Therefore consumer spending may rise. There will be little impact on productivity.

Do tax cuts increase economic growth?

Short-term. If the economy is close to full employment with a low saving ratio, then tax cuts financed by borrowing from the private sector could well ‘crowd out‘ the extra disposable income consumers have. Therefore, the impact on growth is limited, but it will cause higher inflation.

However, in a recession, when saving rates are very high, then government borrowing doesn’t remove money from the economy because it was just been saved.

Ricardian Equivalence

Another issue is the idea that consumers may respond to tax cuts by deciding to save more. The reason is that rational consumers may see a tax cut financed by borrowing will lead to future tax rises. Therefore, consumers don’t spend the tax cut but save it for future tax rises. More on: Ricardian equivalence 

Read more

What causes a government to default on its debt

governments-at-risk-of-default-web

Earlier this year, the World Bank warned up to 40 nations are at risk of defaulting on their sovereign debt. Already Sri Lanka, once hailed as an economic jewel, has badly defaulted as the country slides into economic turmoil. But, the bank warns many others, such as El Salvador, Ghana, Tunisia, Egypt, Kenya and Argentina …

Read more

End of Russian Fossil Fuel industry

russian-gdp-web

The Russian fossil fuel industry is facing a real crisis. Western sanctions and Russia’s own embargo on exports to the West mean that the industry is facing long-term decline. Already there have been reports of ‘capping’ of natural gas facilities. This means that natural gas is burnt at its source because the industry cannot sell …

Read more

Item added to cart.
0 items - £0.00