Trickle-down economics is the theory that the economic benefits of tax cuts provided to businesses and individuals of upper income levels will indirectly benefit poorer members of society when the resources inevitably “trickle down” to them. This theory is very difficult to test, as there are many factors that affect an economy. A tax cut for the wealthy followed by economic growth doesn’t necessarily mean that the trickle down actually had a net positive effect. Similarly, a tax cut followed by an economic contraction doesn’t necessarily mean that the trickle down never happened. Rather than use empirical evidence, the majority of which seems to show that trickle-down economics does not work, this essay will discuss the theory on its face. It will not discuss the moral aspects of taxation, but simply the contribution to the economy from different tax policies.
The opposite of a trickle-down approach is a direct expenditure approach. Rather than providing tax cuts to the wealthy, revenues from taxes are used to spend money on infrastructure projects, military expenditures, social programs, welfare, etc. This money is directly injected into the economy, eventually going to someone who is likely to spend all of the money that he makes on goods and services (a construction worker, soldier, senior citizen or welfare recipient with little other income). Even a Government bureaucrat is likely to spend most of his income. Thus, for trickle down to really work, the tax savings afforded to a wealthy individual must have a greater economic impact than a direct expenditure does.
The major argument in favor of trickle-down is that this money will inevitably be invested by a wealthy individual in his or her company. In addition to this I would add other active investments such as real estate development, venture capital and startups. This sort of investment is good for the economy, as it adds jobs and creates new opportunities.
The argument against this theory is that business owners will make investments in their companies based on before tax earnings, not on after tax income. A business with a profit of $1,000,000 will hire a new worker for $50,000 a year if that worker is going to produce more than $50,000 in value to the company. Whether the owner makes $600,000 on her million in profits or $700,000 on her million in profits won’t factor in to whether she thinks that hiring an additional employee will be beneficial to her company.
There is a certain point in which a wealthy individual is taxed so heavily on additional income that she chooses to just stop investing it at all. This rate is very high though, as even if only $25,000 in additional income is gained from an additional $100,000 in profit, it is likely that most wealthy people will take the opportunity to earn that additional $25,000. In general though, a wealthy individual will likely to be more confident to make active investments if she will profit more from it. A tax cut would thus have to lead to a large amount of active investments in order to have economic growth that is greater than a direct expenditure approach.
The other hope from a major tax cut for the wealthy is that the wealthy individual will spend his/her new found money. Spending has the same effect as a direct Government expenditure does on the economy. Spending on homes, cars, restaurants, vacations, etc. stimulates the economy in a great way.
The problem is, wealthy people have the same basic needs as non-wealthy people. A billionaire still sleeps on one pillow on one bed in one room in one home. Less wealthy people are more likely to spend a greater portion of their income than wealthy people do. Savings rates among wealthy individuals have tripled since the great recession, with over a third of new income going into savings. That means that consumer spending will be greatly increased by taxing the wealthy compared to cutting taxes for the wealthy.
The worst thing that happens to money that would be otherwise taxed is that it is simply put into passive investments, especially cash. At one point in time, additional cash in a bank account was a good thing, as it meant that the bank could make more loans. However, today banks don’t lend out money based on their depositors’ cash holdings anymore, so it doesn’t really make a difference in the grand scheme of things. That money is out of circulation and isn’t contributing to economic growth.
Stocks theoretically provide capital to corporations. However, the stock market today is heavily rigged in favor of the wealthy. Wealthy individuals are able to invest in hedge funds and other sophisticated financial companies that are able to play the market in a more sophisticated way, whereas middle class individuals can only invest in mutual funds and 401k plans which hold pools of stocks. When the market goes south, wealthy individuals are able to capitalize off of the losses, whereas middle class individuals take a huge hit to their personal savings.
Passive real estate investments in existing apartment buildings drive up prices and lower capitalization rates on real estate investments for the middle class. This consolidates real estate ownership into the hands of the wealthy, which does not stimulate the economy.
The bond market provides funding for Government services. However, austerity has meant that the market for new debt and interest rates on bonds are shrinking. In a perfect world, the wealthy would invest their money in Government debt which stimulates the economy and leads to more Government revenue to pay off the debt. However, austerity has meant that this isn’t the case.
Trickle-down economic policies will only have a greater economic impact than direct expenditures if the money is invested in active investments. Rather than providing a tax cut, Governments should engineer the tax code to spurn active investment. A tax credit for hiring a new worker, for example, will ensure that the business owner uses his tax cut to hire someone rather than stashing those funds in a savings account. Simply cutting taxes will not lead to a trickle-down effect that is more advantageous than using the proceeds from those tax revenues on Government spending. All that it serves to do is pad bank accounts and increase inequality.