Written By: Freedom Economics
What Is "Trickle-Down" Economics?
The trickle-down "theory" states that tax cuts for businesses and the wealthy will generate prosperity at the top that will eventually "trickle-down" to everyone else. This theory has been heavily criticized, by some, in the political arena.
This "theory" does not exist. According to famed economics Thomas Sowell:
"No such theory has been found in even the most voluminous and learned histories of economic theories"
It is, in fact a defamatory characterization used by opponents of the free market.
A False Theory
"The very idea that profits 'trickle-down' to workers depicts the economic sequence of events in the opposite order from that in the real world. Workers must first be hired, and commitments made to pay them, before there is any output produced to sell for a profit, and independently of whether that output subsequently sells for a profit or loss. With many investments, whether they lead to profit or a loss can often be determined only years later, and workers have to be paid in the meantime, rather than waiting for profits to 'trickle down' to them."
Sources: "Trickle Down" Theory & "Tax Cuts for the Rich", Thomas Sowell (P. 10-11)
The Key Difference
"Proponents of tax rate cuts base their arguments on anticipated changes in behavior by investors in response to reduced income tax rates. Opponents of tax cuts attribute to the proponents a desire to see higher-income taxpayers have more after-tax income so that their property will somehow 'trickle-down' to others, which opponents of tax cuts deny will happen"
Sources: "Trickle Down" Theory & "Tax Cuts for the Rich", Thomas Sowell (P. 6)
Zero Sum View
The central false premise of the critics is that "cutting the tax of the rich" and allowing them to keep more money, will only benefit them [the rich]. However, this is a mistaken zero-sum view, where the gain of someone is the loss of someone else.
"The real effect of tax-rate reductions is to make the future prospects of profit look more favorable, leading to more current investments that generate more current economic activity and more jobs"
Sources: "Trickle Down" Theory & "Tax Cuts for the Rich", Thomas Sowell (P. 11)
Government Revenue (Laffer Curve)
The primary purpose of lowering tax rates is for the government to collect more taxes. The Laffer Curve shows the relationship between tax rates and the amount of tax revenue collected by governments. Beyond a certain rate, an increase in the tax rate will decrease tax revenue. The rationale for that is that, a 0% tax rate, revenue would be 0, and at 100% tax rate, people would choose not to work.
Arguments for cuts in the tax rates have been made not only by free-economists or conservatives, but classic liberals as well:
"Taxation may be so high as to defeat its object," that "given sufficient time to gather the fruits, a reduction of taxation will run a better chance, than an increase, of balancing the budget" - John Maynard Keynes
"There is a point at which in peace times high rates of income and profits taxes discourage energy, remove the incentive to new enterprise, encourage extravagant expenditures, and produce industrial stagnation with consequent unemployment and other attendant evils..." - Democratic President Woodrow Wilson
"It is a paradoxical truth that tax rates are too high today and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now..." - Democratic President John F. Kennedy
Effects of Tax Rates
Beyond a certain rate, people with large sums of money are better off putting their money into tax-exempt securities. They hide their money not to pay the high taxes, instead of investing it in the private economy, where the money would create more output, income, and jobs.
"I agree perfectly with those who wish to relieve small taxpayer(s) by getting the largest possible contribution from the people with large incomes. But if the rates on large incomes are so high that they disappear, the small taxpayer will be left to bear the entire burden" - President Calvin Coolidge
- The Tax Cuts of the 1920s: Tax rates dropped from over 70% to less than 25%. Tax revenues rose from $719 million in 1921 to $1,164 million in 1928. The share of the tax burden borne by the rich climbed from 44.2% in 1921 to 78.4% in 1928.
- The Kennedy Tax Cuts: Top tax rate reduced from more than 90% down to 70%. Tax revenues rose from $94 billion in 1961 to $153 billion in 1968. Tax collections from those making over $50,000 per year climbed by 57% between 1963 and 1966.
- The Reagan Tax Cuts: Top tax rate reduced from 70% to 50%. Total tax revenues climbed by 99.4% during the 1980s. The share of income taxes paid by the top 10% rose from 48% in 1981 to 57.2% in 1988. The share paid by the top 1% rose from 17.6% in 1981 to 27.5% in 1988.