What is trickle-down economics and does it work?

Multiple pound notes £5, £20 and £50 Pound Sterling
Rebecca Cattlin
By :  ,  Financial Writer

What is trickle-down economics?

Trickle-down economics is the theory that tax breaks and other beneficial policies for companies and the higher earners in society will put more money into the economy, which will eventually benefit everyone.

There’s no one type of trickle-down policy, but anything that disproportionately benefits the wealthy is often pointed to as one. These include:

  • Reductions in income tax
  • Capital gains breaks
  • Stamp duty cuts
  • Deregulation
  • Removing caps on remunerations (salaries and bonuses)

Trickle-down economic policies first came into the centre stage under Ronald Reagan’s presidency. The term ‘Reaganomics’ was used to describe the system of tax cuts, decreased social spending and market deregulation.

 

How trickle-down economics works

In theory, trickle-down economics works by boosting supply-side factors. In the short term, the benefits are given to the wealthy, but over the long-term, the more relaxed regulations and tax cuts create a boost in company investment.

As more capital is put into business – resulting in new operations, better technology and equipment – it should also lead to higher employment rates.

But it’s not just companies. Wealthy individuals also receive the benefits. The trickle-down theory goes that they’ll spend more money and create a greater demand for goods – which in turn will boost the labour market and create growth across industries like consumer goods, retail and even housing.

The additional revenue generated should then pay back the initial capital spent on tax cuts and other trickle-down policies.

 

Problems with trickle-down economics

Critics of trickle-down economics argue that the policies create larger income inequality within a country. By giving money to the wealthiest – instead of into the pockets of lower-income earners – it distorts the economic structure.

The actions of a government don’t take place in isolation. There are other factors that impact what companies and wealthy individuals will do with their capital, such as interest rates and the propensity to save.

In an environment where there are high interest rates, individuals might choose to keep their extra capital in a bank account to take advantage of the passive income. In lower rate environments, they might invest in assets which push up prices and might even provide dividend income. Or they could take that capital and put it into off-shore savings accounts to avoid paying further tax altogether.

So, the increased disposable income from trickle-down policies don’t necessarily filter into other sections of the economy. And even if it is spent, it’s usually on imports, which withdraw from – rather than contribute to – the domestic economy.

Does trickle-down economics work?

The success of trickle-down economic policies has come under fire from several studies. A 2020 study by David Hope and Julian Limberg of the London School of Economics showed that over five decades of tax cuts in 18 wealthy nations, the policies consistently benefited the wealthy but had no meaningful effect on unemployment or economic growth.

“The results also show that economic performance, as measured by real GDP per capita and the unemployment rate, is not significantly affected by major tax cuts for the rich. The estimated effects for these variables are statistically indistinguishable from zero.”

Another study by the Rand corporation showed that decades of trickle-down policies in the US redistributed about $50 trillion in wage growth from the bottom 90% of earners to the top 1%.

In fact, a report by the IMF in 2015 found that the opposite of trickle-down economics theory was true. It was increasing the income share of the poor that increased economic growth, while increasing the income share of the rich led to lower growth.

“We find that increasing the income share of the poor and the middle class actually increases growth while a rising income share of the top 20 percent results in lower growth.”

 

Trickle down-economics in the UK

All this brings us to the UK Government’s mini-budget that was announced on Friday 23 September – in which Chancellor Kwasi Kwarteng announced that:

  1. The cap on bankers’ bonuses would be abolished
  2. The rise in corporation tax and national insurance would be reversed
  3. Stamp duty would be cut
  4. The top income tax rate would be scrapped

The decisions were made to put millions into the pockets of the wealthiest to spur economic growth. PM Liz Truss has said ‘Lower taxes lead to economic growth, there’s no doubt in my mind.’

Clearly, markets didn’t agree with her.

Whenever a government does not make enough money through tax to cover its spending, the money has to come from national debt. The mini-budget is estimated to reduce revenue by £45 billion but has no intention to cut spending.

Typically, increases in government borrowing lead to greater returns on bonds because the dramatic increase in supply (without an increase in demand) causes the securities to fall in value. The bond yields have to increase to remain competitive and bring in investors.

After the mini-budget, 2-year UK government bonds hit the highest level since the 2008 crisis. This should in theory strengthen the pound as foreign investors rush to invest in domestic assets – but this didn’t happen.

Within a matter of days, £500 billion was wiped off UK markets. There was a run on sterling that caused it to fall to multi-decade lows against the dollar, and the FTSE tumbled as British assets were sold off.

In an unprecedented move toward a non-emerging market, the International Monetary Fund (IMF) made a statement criticising the decision. The supranational body urged the government to reconsider the tax cuts that it said would stoke inequality within the country.

Kwarteng is expected to make another statement on November 23, which the IMF said would represent an:

“Opportunity for the UK government to consider ways to provide support that is more targeted and re-evaluate the tax measures, especially those that benefit high income earners”.

The IMF criticism was immediately followed by words from the credit rating agency Moody’s stating that the unfunded tax cuts were credit negative and would permanently weaken the UK’s debt affordability.

With all the criticisms of the trickle-down economics theory as a whole, and the UK government more recently, it’s left onlookers asking what the alternative solution is.

 

What’s the opposite of trickle-down economics?

The most commonly cited opposing theory to trickle-down economics is ‘middle-out economics’. Research has shown that growth is generated primarily within the broadest section of society, what some call the middle class or mid-income brackets. It’s then distributed upward and downward.

This theory states that the priority of governments should be to support essential services that boost the middle of society – such as education, healthcare, childcare and public infrastructure. Doing this leads to the middle-income bracket thriving and being able to save, consume and take risks within an economy.

 

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