Trickle down effect

Template:Mergefrom In economics the trickle-down effect is believed to be central to conservative economic theory, despite the fact that, according to laissez-faire economist Thomas Sowell, no conservative economist has ever advocated such a theory [1] (http://www.townhall.com/columnists/thomassowell/ts20050329.shtml). Of course, the validity of this belief depends on one's definition of both "trickle-down" and "conservatism".

Trickle-down theory is promulgated by right-leaning newspapers such as The Wall Street Journal editorial page and libertarian and conservative think-tanks such as the American Enterprise Institute and the Cato Institute. This theory does not say that benefits given to the upper classes will "trickle down" to those below them on the social hierarchy due to the benevolence or generosity of the rich; rather, its proponents maintain this will occur mostly as a result of the normal workings of unfettered markets.

The concept is hard to define, while the validity of the concept depends on the definition. For example, one online magazine defines trickle-down theory as an "economic theory which advocates letting businesses flourish, since their profits will ultimately trickle down to lower-income individuals and the rest of the economy" [2] (http://www.investorwords.com/5075/trickle_down_theory.html). Another defines it as being the same "as Supply Side Economics. ... An economic theory that the support of businesses that allows them to flourish will eventually benefit middle- and lower-income people, in the form of increased economic activity and reduced unemployment" [3] (http://www.moneyglossary.com/?w=Trickle+Down). One economist defines it as "A theory of economic development that claims higher standards of living for the poor will develop gradually [with economic growth] and not at the overt expense of the more affluent." [4] (http://www.economyprofessor.com/economictheories/trickle-down-theory.html) Other economists define it as simply the economics of President Ronald Reagan, known as "Reaganomics."

However, following the two definitions above, it seems to be a more general theory applied by President George W. Bush in economic policy-making, and perhaps by most of recent U.S Republican Party policy proposals, hearkening back to those of Calvin Coolidge and Warren G. Harding, if not William McKinley. There are at least three different ways of looking at the trickle-down effect.

Contents

1 Upper income and corporate tax rate reductions

2 Laissez-faire

3 The Growth of the GDP Benefits All

4 See Also

4.1 Wikipedia
4.2 External links

Upper income and corporate tax rate reductions

In this view, it is a central tenet that government policies which benefit upper-income taxpayers and corporations (through tax cuts, subsidies, deregulation, etc.), will indirectly benefit the middle classes and even the poor. These benefits will trickle down. This tenet is central to Supply-Side economics, a version of laissez-faire economics, and it was a highly charged issue during the Reagan Administration. In fact, at some times, pro-Reagan economists, such as Arthur Laffer, were arguing that the benefits of supply-side rate reductions were so large that total tax revenues would actually rise, helping to pay for the Reagan administration's increased spending on the military and the like, so that the government deficit would not rise.

Note that it is also part of Keynesian economics to see the possibility that reductions in the tax rate will stimulate increases in tax revenue, though usually not enough that the tax cut "pays for itself". Of course, the mechanism by which Keynesian economics sees revenues increasing differs too: while Supply-Siders see changes in marginal tax rates as stimulating the incentive to supply, the Keynesians see increases in aggregate demand as allowing increased revenues to be realized.

Instead in standard theory, rate reductions can bring about increases in revenue when the distance between "marginal" and "actual" tax rates is quite large, and the reason for the difference is the amount of income being "sheltered" from taxation. According to this argument, rate reductions, because they make inefficient tax shelters less compelling, free capital for more productive uses, or even for consumption. More generally, the argument is that decreased marginal tax rates increase the incentive for individuals to work and save their income.

Rate reductions, when they raise personal disposable income, increases aggregate demand until it reaches potential output, while Supply-Side economics sees their policies as increasing potential output. There is no evidence that potential output increased at faster than trendline during the 1980s after "Supply-side" tax cuts were instituted. Further, Supply-Side economists often see the positive effects on potential as happening very quickly, almost immediately, which, given the severity of the 1981-1982 recession does not seem to be the case. Keynesian policies that affect the supply side, such as government investment in infrastructure, education, public health, and the like are seen as taking years to pay off. Compared to these Keynesian "supply-side" policies, those of the Supply-Side economists are criticized for promising a "free lunch" that cannot be delivered.

Trickle-down theory is often seen a major rhetorical variant of "what's good for business and the rich is good for the country." In this form it was ridiculed by Franklin Delano Roosevelt as "toryism". While many believe this is generally true, others argue that trickle-down economics simply helps the special interests of business and its owners. David Stockman said Supply-Side rhetoric was used during the Reagan Administration as a "trojan horse (http://www.theatlantic.com/politics/budget/stockman.htm)" for lowering taxes on the wealthiest individuals. One economist critical of this theory, John Kenneth Galbraith, has summarized trickle-down theory as "horse and sparrow" (http://www.kat.gr/kat/history/Txt/nv/GoodSociety.htm) economics: "if you feed enough oats to the horse, some will pass through to feed the sparrows." Before he became Vice-President under Reagan, George H.W. Bush had referred to this theory as "voodoo economics."

In Robert J. Gordon's Macroeconomics (9th ed, 2003, p. 393) he points to three elements behind the idea of supply-side tax reductions:

1. Taxes on income reduce the after-tax rewards for working and saving. This is called providing incentives.

2. An increase in this reward would cause a big and significant increase in both working and saving. These are seen as raising potential output. This is called improving the supply side.

3. In the Laffer variant, the increase in work and saving would allow the government to collect more extra revenues than was lost due to the tax reductions. That is, there is a "free lunch" for reducing marginal tax rates.

While Gordon sees the first as valid, the second and third do not pass the test of empirical data, in his survey. One problem is that a rise in after-tax income does not always mean a rise in work or saving as predicted in (2). In economics jargon, the supply-side argument incorporates the incentive or substitution effect but ignores the income or wealth effect. To put this in more concrete terms, an individual who enjoys the benefit of a tax reduction could decide to work more, because the marginal value of his or her labor is higher, or decide to work less, because the value of time off is greater, to him, than more money would be. Getting greater after-tax income due to the tax cuts, this can actually work fewer hours and get more income.

In its defense, the economy did improve in the later Reagan years, after supply-side economics was implemented. But almost all economists would reject this history as a justification of supply-side economics; instead, they apply an eclectic version of Keynesian economics. Paul Volcker, the Fed chief appointed by Jimmy Carter, had already begun implementing contractionary monetary policies to solve the problem of severe inflation by raising unemployment (see Phillips Curve). Once inflationary expectations were squeezed out of the system, by the recession of 1980 and the much more severe 1981-1982 recession, the Reagan policy of deficit spending by "across the board" rate reductions and military spending increases, can be seen as sparking the prosperity of the late 1980s through demand-side fiscal stimulus. This expansionary effect was helped by the rapid fall in oil prices, especially around 1986. Contrary to Supply-Side promises, the government deficit rose from 1.6 percent to 2.8 percent of GDP from 1979 to 1989. The government debt rose from 25.6 percent of GDP in 1979 to 40.6 percent in 1989.

Laissez-faire

Second, there is the related view that unfettered markets benefit all in society. As the fictional Gordon Gekko said in the 1987 movie "Wall Street", "greed is good." In the trickle-down theory, competitive markets make it good not just for the rich and powerful but for the poor and powerless.

To many conservatives the unfettered and competitive market is synonymous with the "free market". This is linked to the first version of trickle-down economics because free-market rhetoric was often used to justify tax reductions for upper income brackets and corporations. Further, to many, much of the laissez-faire theory turned out in practice to be nothing but government favoritism for corporations over labor and consumers.

David Stockman, one of Ronald Reagan's economic advisors, placed supply-side economics in a long tradition in economics, and maintained that laissez-faire will benefit not just those well-placed in the market but also the poorest. The general principle is argued in Bernard de Mandeville, The Grumbling Hive (1733): "private vices are public virtues". Because the wealthy spend lavishly and employ others, they help the poor. In the context of trickle-down theory, the rich are called the "creative sector" of the economy, and their demand for capital goods is seen as being the driving force of the economy.

Some interpret the following quote from Adam Smith in this light.

"It is the great multiplication of the productions of all the different arts, in consequence of the division of labour, which occasions, in a well-governed society, that universal opulence which extends itself to the lowest ranks of the people." (An Inquiry into the Nature and Causes of the Wealth of Nations, ch. 1 (http://geolib.com/smith.adam/won1-01.html). Emphasis added.)

In this interpretation, the "well-governed society" replaces the state's guidance with markets as the method of resource allocation. Smith strongly criticized the King and other state officials for being economic actors who used their power to advance their own special interests, as part of what he called the "Mercantile System".

Many doubt, however, that Adam Smith can be invoked in favor of trickle-down theory. The Wealth of Nations is a comprehensive criticism of special interests, and in practice, supply-side economics often bears a striking resemblance to the sort of special-interest arrangements that Smith criticized.

The Growth of the GDP Benefits All

A third variant centers on Kuznets' "Law", which says that increases in income inequality that occur in the early stages of industrialization are followed by increases in income equality. A more general version argues that increases in real gross domestic product are almost always good for the poor. This is linked to the previous version of trickle-down because GDP is best seen as a measure of market activity, the buying of goods and services produced for sale. As many critics have noted, it does not measure well-being very successfully. (One effort to replace GDP as a measure of well-being is the Genuine Progress Indicator (http://www.rprogress.org/projects/gpi/).)

One difference between Kuznets' "Law" and the other two trickle-down arguments is that the narrowing of the income distribution could reflect government action: after a period of increasing inequality leads to greater total wealth per person, people may decide that they can "afford" greater equality of distribution and then push the government for this result. However, this is not the standard interpretation.

Though Kuznets' "law" seems to describe the process of industrialization in the U.S., at this point it has expired: since the 1970s, the U.S. has seen steady increases in inequality in wealth and income. Rises in gross domestic product have usually coincided with increases in inequality.

The opposite of this version of the trickle-down effect can be seen in Karl Marx's "absolute general law of capitalist accumulation," in which he posits the normal tendency of economic growth under capitalism as being that wages fall behind the growth of labor productivity. This "immiseration" tendency implies that the workers' share of the total product will fall in percentage terms. In recent decades, when this theory fits better with the empirical data in the United States than it did during the 1950s or 1960s, more people have begun to think in these terms (though probably without citing Marx). For example, people posit a "race to the bottom," in which wages around the world are being dragged down to the standards of manufacturing in poor countries (adjusted for differences in labor productivity). (See Globalization.) Others point to the "Wal-Martization" of the U.S. economy, as the package of low wages, low benefits, and low job security that characterize the Wal-Mart corporation have become more general.

Trickle down effect

Upper income and corporate tax rate reductions

Laissez-faire

The Growth of the GDP Benefits All

See Also

Wikipedia

External links

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