Trickle-Down Theory

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What is the 'Trickle-Down Theory'

Trickle-down economics, or “trickle-down theory,” argues for income and capital gains tax breaks or other financial benefits to large businesses, investors and entrepreneurs in order to stimulate economic growth. The argument hinges on two assumptions: all members of society benefit from growth; and growth is most likely to come from those with the resources and skills to increase productive output.

BREAKING DOWN 'Trickle-Down Theory'

Tricke-down economics is political in nature, not scientific. Although it is commonly associated with supply-side economics, there is no single comprehensive economic policy identified as trickle-down economics. Any policy can be considered “trickle-down” if the following are true: first, a principle mechanism of the policy disproportionately benefits wealthy businesses and/or individuals in the short run. Second, the policy is designed to boost standards of living for all individuals in the long run.

Examples include the U.S. bank bailouts of 2008 and the Common Agricultural Policy (CAP) of the European Union.

Origins

The first reference to trickle-down economics came from American comedian and commentator Will Rogers, who used it to derisively describe President Herbert Hoover’s stimulus efforts during the Great Depression. More recently, opponents of President Ronald Reagan used the term to attack his income tax cuts.

Trickle-down and the Laffer Curve

American economist Arthur Laffer, an advisor to the Reagan administration, developed a bell-curve style analysis that plotted the relationship between changes in the official government tax rate and actual tax receipts. This became known as the Laffer Curve.

The non-linear shape of the Laffer Curve suggested taxes could be too light or too onerous to produce maximum revenue; in other words, a 0% income tax rate and a 100% income tax rate each produce $0 in receipts to the government. At 0%, no tax can be collected; at 100%, there is no incentive to generate income. This should mean that certain cuts in tax rates would actually boost total receipts by encouraging more taxable income.

Laffer’s idea that tax cuts could boost growth and tax revenue was quickly labelled “trickle-down.” Between 1980 and 1988, the top marginal tax rate in the United States fell from 70 to 28%. Between 1981 and 1989, total federal receipts increased from $599 to $991 billion. This empirically supported one of the assumptions of the Laffer Curve. However, it neither shows nor proves correlation between a reduction in top tax rates and economic benefits to low- and medium-income earners.

Forms and Problems

Trickle-down economics comes in many forms. Supply-side arguments, normally associated with tax cuts for high earners, suggest the wealthy would be more incentivized to raise output and create better jobs. Demand-side arguments, associated with subsidies and tariffs, argue the wealthy need protections in order to keep paying their employees or to raise spending.

All trickle-down policies, however, transfer wealth and advantages from all taxpayers towards an already wealthy few. This interventionism necessarily distorts the economic structure. In normal free markets, those at the top can only increase their wealth after providing more valuable goods and services, not before.