posted on 26 June 2015
Written by Daniel Lara-Agudelo, GEI Associate
The theory of trickle-down economics holds that “decreasing marginal and capital gains tax rates - especially for corporations, investors and entrepreneurs - can stimulate production in the overall economy” (Investopedia). This idea formed the backbone of “Reaganomics” and supply-side economics, policies that were made famous during the presidency of Ronald Reagan and later endorsed, mostly, by members of the Republican Party.
Over the years, many economists have condemned such policies, especially Keynesians who prefer that an emphasis be placed on consumers rather than on businesses. Recently, the IMF (International Monetary Fund) released an “IMF Staff Discussion Note” that addressed the many grievances against the trickle-down theory entitled “Causes and Consequences of Income Inequality: A Global Perspective”. Essentially, they concluded that trickle-down economics does not work because it is contributing to the ever-escalating problem of income inequality.
Income inequality is one of the most pressing issues facing the United States and many other nations today. It is known to be linked to stunted economic growth, societal unrest, prolonged recessions, and more frequent financial crises (Aimee). The first of these, stunted economic growth, is perhaps the most worrisome. In their report, the researchers at the IMF stated that there is an “inverse relationship between the income share accruing to the rich and economic growth”. In addition to decreased growth, income inequality is also believed to cause great social harms. Less-wealthy individuals in countries where there is extreme inequality tend to “play the system” in order to get what they want. This usually results in “resource misallocation, corruption, and nepotism” all of which can do significant damage to the economy (Aimee). Lastly, there are also problems when it comes to the severity and duration of future recessions. According to CBS News, the greater the income disparity in the country, then the more volatile the business cycle will become. All of this serves to show the risk of implementing policy that is based too heavily on the trickle-down theory.
In light of what the IMF has stated in its report, many economists have taken the opportunity to push a rival theory known as trickle-up economics. This theory suggests that policy should be aimed at stimulating the aggregate demand of working and middle class citizens. In order to do this, proponents of trickle-up economics are calling for a more progressive tax system, as well as a higher minimum wage.
The idea of increasing the minimum wage is an extremely controversial topic in modern day economics. After all, basic theory tells us that if such a change is made then low-skilled and young workers will likely lose their jobs. However, in recent years, many economists have rejected this claim. The Department of Labor has posted the following on its website concerning the topic (without citing specific references):
Unfortunately, there is not a clear answer to this issue; if you take the number of economists supporting an increase there are just as many who are opposed. The problem is that it is impossible to know how a higher minimum wage will affect American jobs without it happening in the first place. For now we can only rely on estimates, estimates which can oftentimes be inaccurate.
Aside from the potential, yet largely unknown, problems of raising the minimum wage, the other issue facing the trickle-up theory has to do with the government overreaching when it comes to taxes. Currently, the U.S. tax system is quite progressive; those at the top of the brackets pay about 40% of their income in taxes and the rate for corporations is at 35% (Montgomery). The problem with this is that too high of a corporate income tax would incentivize corporations to move their businesses elsewhere. Already, companies like Liberty Global PLC, Chiquita Brands, Medtronic, and many others have relocated to other countries, mostly in Europe (Douglas-Gabriel). This demonstrates the risk of going overboard when implementing trickle-up economics. If the corporate tax increases from where it is now there is no telling how many more companies will leave, and the effect that this exodus would have on the economy.
On the whole, economics is all about trade-offs, and both the trickle-down and the trickle-up theories have trade-offs associated with them. Therefore, before anything can be done with regards to policy it is necessary to first consider the risks involved, not just the potential benefit.
Dabla-Norris, Era, Kalpana Kochhar, Nujin Suphaphiphat, Frantisek Ricka, and Evridiki Tsounta. "Causes and Consequences of Income Inequality: A Global Perspective." IMF Staff Discussion Note (2015): n. pag. Web. 21 June 2015.
Douglas-Gabriel, Danielle. "These Are the Companies Abandoning the U.S. to Dodge Taxes." The Washington Post, 6 Aug. 2014. Web. 23 June 2015.
"Minimum Wage Mythbusters." U.S. Department of Labor. N.p., n.d. Web. 24 June 2015.
Montgomery, Lori. "Obama Hits at Companies Moving Overseas to Avoid Taxes." The Washington Post, 22 Sept. 2014. Web. 23 June 2015.
Picchi, Aimee. "Is Trickle-down Economics to Blame for Inequality?" CBS Interactive, 15 June 2015. Web. 21 June 2015.
"Trickle Down Theory Definition | Investopedia." Investopedia. N.p., 25 Nov. 2003. Web. 21 June 2015.
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