Economic Watch

Explainer: trickle-down economics

Trickle-down economics

Careful listeners might sometimes hear a gentle trickle in our economy, but many parts of the waterwheel would need to be positioned just right in order to generate a steady flow.

To anyone who lived through the years of Ronald Reagan’s US presidency, the term “trickle-down economics” should already be familiar.

While Reagan wasn’t the first politician to say “trickle down” with a straight face, the economic story signalled by the term was frequently invoked during the Reagan years, most famously to justify massive tax breaks that disproportionately favoured the rich.

The terms origins can be traced back to William Jennings Bryan, but his phrasing - “leak through” - didn’t really catch on. Through the years the same basic idea has also been known variously as “supply-side economics” and “Reaganomics”.

Critics of trickle-down policies haven’t overlooked the fact that giving the rich a helping hand may yield political benefits for the politicians offering that help.

Since Reagan’s time, trickle-down economics has been derided by other politicians as “voodoo economics” and as “the rich pissing on the poor.

The broad idea of trickle-down economics is that giving economic help to companies or people at the top of society should, through one of various possible mechanisms, generate benefits for those in layers further down. Let’s look at the various mechanisms through which this is theorised to work.

Mechanism 1: Corporations who get tax cuts increase investments in the country that gives them

In theory, some companies might be drawn to expand operations in Australia because of lower company tax rates. If those expansions created jobs for previously unemployed people, or equal or better jobs for Australian workers compared to what those workers previously could get, then the benefits would be spread to workers. Plus, these companies could add to the demand for Australian-made intermediate goods.

If the expanding companies were more productive than other companies, due to using more efficient production processes, then this could also raise overall Australian productivity. In theory, this would allow all of us to get more out from putting less in.

Yet many companies are more likely to look to other margins when making the decision about whether to enter or expand in Australia, including the cost of labour, the degree of red tape, qualities of relevant markets, and Australia’s geographical location.

This is partly because the tax breaks usually floated by politicians are modest ànd  the corporate tax rate differences between Australia and many of its peers are comparatively small anyway.

There is also a lemmings-over-a-cliff concern here: if our peer nations start taxing companies at rates below what is required to finance effective government, should we follow them?

More subtly, the incentive effects we’d predict from a company tax break are complicated by the fact that no company operates like a person. Though we routinely attribute human traits to companies, in reality decisions taken by companies are myriad and in many different areas – each taken by  individual person in a particular department with particular constrained information and decision-making authority.

It’s not guaranteed that each decision maker in a company will know about a bit of extra cash due to a tax break and be spurred by it to take a particular decision that dovetails with decisions taken in other departments.

To the extent that the company does not act as a unit, hoped-for labour demand and productivity effects may not materialise.

The same is true if tax-break money is used for other purposes, like dividends to shareholders or lining the pockets of the top brass.

Mechanism 2: Rich people who get tax cuts will use the extra money in a way that helps the country as a whole

The main idea here, as with Mechanism 1, is that more investment will create more jobs and potentially increase productivity (which results from those jobs). Some rich people might indeed invest the extra dollar directly into the stock of an Australian business.

In fact, since rich people have a lower marginal propensity to consume than poorer people, they’re more likely to spend an extra dollar on investment than on stuff.

Nonetheless, a rich person might choose to buy Australian-made products with that money, which should act as a stimulus to Australian businesses. Of course, that person could also instead online shop for overseas products or travel abroad, in which case that extra dollar would flee the country.

A rich person might instead also lend the bank that extra dollar via a deposit into a bank account. If the bank then promptly loaned it money out to domestic borrowers, we might see a positive economic effect – if the main borrowers were businesses that went on to use the money for a productive purpose.

If the extra dollar ended up with less productive businesses, we might see a temporary uptick in employment and intermediate goods sales, melted away when the business was out-competed.

If home buyers got the money instead, it might mainly fuel increased house prices.

Mechanism 3: Aggregate tax revenue will rise when taxes are cut

Perhaps the most radical notion in supply-side economics is that cutting taxes might, counter-intuitively, raise tax revenue.

Suppose a company making $100 in profits, faced by a company tax rate of 30% (creating $30 a tax liability), experience the tax rate dropped to 28%.

The extra $2 of “found money,” might be invested in the business and generate a rise in profits, say to $110. This would create a tax liability of $30.80, $0.80 more than collected under the higher rate.

Notice how large the return on the investment of the “found money” had to be, to create even a tiny increase in corporate tax revenue, from this 2-percentage-point tax break.

More taxes could also be raised if the employees of that company, as it expanded, shared in its increased productivity in terms of their taxable take-home pay.

An increase in government tax revenue could then in theory be allocated to welfare, infrastructure, and other progressive budget line items, benefiting more people indirectly.

Naturally, this is not necessarily how things will play out. The “found money” from the tax break might be used in ways that do not yield an increase in productivity and profits of the required amount to create a tax revenue hike, and any revenue hike may not be directed to progressive expenditures.

In sum, careful listeners might sometimes hear a gentle trickle in our economy, but many parts of the waterwheel would need to be positioned just right in order to generate a steady flow.

Also Read: The future is not what it used to be

                    S. A. economy not working for anyone

                    Brexit: Will the Empire strike back?

(This article was first published on The Conversation website. Gigi Foster, is Associate Professor at the, School of Economics, University of New South Wales, Australia) UNSW

by Gigi Foster

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