What is the economic theory that suggests the use of tax cuts to the wealthy to stimulate the economy?

President Trump sold his 2017 tax cuts as “rocket fuel” for the economy, arguing that freeing up money for the wealthy would allow them to hire more workers, pay better wages and invest more. The tax savings, in other words, would trickle down from the rich to everyone else.

According to one of the most comprehensive studies to date on tax cuts for the rich, this should come as no surprise. A London School of Economics report by David Hope and Julian Limberg examined five decades of tax cuts in 18 wealthy nations and found they consistently benefited the wealthy but had no meaningful effect on unemployment or economic growth.

The researchers started by constructing a composite measure of “tax cuts on the rich” encompassing a variety of taxes, including the top tax rate on personal income, the estate tax and the tax on capital gains. Because these taxes are levied predominantly on the wealthiest members of society, the wealthy stand to gain the most when they are cut.

While previous studies on the effects of taxing the rich have tended to focus on just one type of tax, “our measure combines all of these important taxes on the rich into one indicator,” Hope and Limberg said in an email. “This provides a more complete picture of taxes on the rich, but it also allows for comparisons across countries and over time.”

Using this measure, they set out to identify “major” tax cuts on the rich in 18 wealthy nations from 1965 to 2015. In the United States, that included the Reagan-era tax cuts of 1981 and 1986, which dramatically reduced the top income tax rate from 70 percent to 28 percent after fully taking effect.

They then traced what happened to those nations’ economies in the five years after the cuts were implemented. They focused particularly on income inequality, economic growth as measured by gross domestic product, and the unemployment rate. They aggregated those trends across countries to capture the broadest possible picture of the tax cuts’ effects.

Their results appear in visual form below.

First, the tax cuts succeeded at putting more money in the pockets of the rich. The share of national income flowing to the top 1 percent increased by about 0.8 percentage points. (For comparison, in the United States the bottom 10 percent of earners capture only 1.8 percent of the country’s income).

But they had no effect on economic growth or employment. Though those quantities fluctuated slightly after the major tax cuts that were studied, the effect was statistically indistinguishable from zero. The “rocket fuel” so often promised by supporters of these tax cuts? It fizzles out time and time again.

“In the last decade, especially with the pioneering work of Thomas Piketty and his co-authors, there has been a growing consensus that tax cuts for the rich lead to higher income inequality,” Hope and Limberg said. Piketty, a French economist, wrote “Capital in the Twenty-First Century,” a book on the growth of inequality in rich nations.

Given the evidence, why are such targeted tax cuts perennially popular among policymakers, especially Republicans? The authors point to one major reason — the power of wealthy individuals and corporations to set policy agendas through lobbying and campaign contributions.

“There is a large political science literature on the power of rich voters and organised business interests to shape public policies in their favour,” the authors write in their report.

Hope and Limberg say their findings offer one clear pathway for policymakers looking to dig their way out of the financial hole created by the coronavirus crisis: Make the rich pay for it.

Though the pandemic cost tens of millions of Americans their jobs and sent the U.S. economy into a tailspin, many at the top of the income distribution have seen their wealth skyrocket. The nation’s 651 billionaires saw their net worth spike by more than $1 trillion during the first nine months of the pandemic, according to Americans for Tax Fairness, a liberal group advocating for higher taxes on the wealthy.

“We would argue that governments should not be unduly concerned that taxing the rich will harm their economies when deciding how to pay for the costs of COVID-19,” the study authors said via email.

Given the historically low tax burdens on the wealthy in the United States, their ability to pay for higher taxes has probably never been better.

We’ve been living with the pandemic a while now, and in that time we’ve seen the major effects it has had on economies. Not only on an international level, but on an individual one too. We’ve seen, time and time again, how the marginalised have been hit hardest and the lowest earners have struggled.

But why is this the case? While every country’s security nets may look different, since the 80s many Global North countries have prescribed to the idea of trickle-down economics, believing that giving benefits to the richest will trickle down to the working class through stronger economic growth.

In 2020, new research was released that proved just how wrong this theory is. Wealth inequality is at an all-time high, but there are other options out there. So let’s talk about what this theory is, why it doesn’t work, and what we could do instead.

The idea behind trickle-down economics is simple: cut taxes for the richest and the benefits will trickle down. These policies should enable wealthy owners to create more jobs for middle and lower class citizens, meaning the benefits are felt by everyone. Any lost tax revenue is, theoretically, regained by the economic boost created by these jobs, as well as taxes paid by workers now they have more money. 

This theory is linked to the Laffer Curve, a concept from Arthur Laffer that suggested tax cuts create growth over time which can replace lost revenue, as the more prosperous overall economy provides a larger tax base. However, Laffer also specified that most revenue is gained when taxes are in the “prohibitive range”, which is between 100% – around 50%. If the tax rate falls below 50% (as it has since the 80s in many countries), then further cuts won’t stimulate economic growth enough to offset the lost revenue.

Trickle-down economics assumes investors, savers, and company owners are the real drivers of growth. It promises they’ll use any extra cash from tax cuts to expand businesses. Investors will buy more companies or stocks. Banks will increase lending. Owners will invest in their operations and hire workers. All of this expansion will trickle down to workers. They will spend their wages to drive demand and economic growth.

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Unfortunately, wealthy business owners need to use these tax cuts to actually grow their businesses, including paying proper wages people can live on, but this often doesn’t happen. The rich don’t use this money to help the lower classes, they hoard their wealth. We see this exemplified again and again in Amazon’s employee treatment. Jeff Bezos has more than enough money, courtesy of tax cuts, to pay employees well. Instead, he increases his fortune through continual exploitation, abuse and underpayment of workers. No one benefits except him, and anyone other wealthy executives at the very top of Amazon.

Economies don’t require the rich to become even richer. Studies have shown that trickle-down economics is a colossal failure.

Hasn’t trickle-down worked before?

You might be wondering if this theory has seen success in the past. Well, let’s examine that.

Many believe that Reagan’s approach of slashing tax on the wealthiest from 70% to 28% ended the 1980 recession. However, during this time Reagan also increased government spending by 2.5% a year, almost tripling federal debt from $997 billion in 1981 to $2.85 trillion in 1989. Trickle-down economics was never actually tested, because it was paired with massive spending.

George W. Bush also addressed the 2001 recession by cutting income taxes. However the Federal Reserve simultaneously lowered the fed funds rate (the interest rate that banks charge other banks for lending them excess cash from their reserve balances overnight) from 6% to 1%. Once again, we can’t know what tax cuts achieved alone.

Conservatives maintained that the tax cuts would turbocharge economic growth; in fact, conservative think tank The Heritage Foundation predicted that growth would be so strong that the United States would entirely pay off its debt by 2010. Instead, the ensuing years saw weak growth, followed by the 2008 economic collapse. And as economist Danny Yagan has found, the steep cuts in dividend tax rates signed into law by President Bush in 2003 did not increase corporate investment or worker pay

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Compare this to 1993, when Bill Clinton raised taxes on top earners from 31% to 39.6%. 23 million jobs were created and the economy grew for 32 straight quarters in what was then the longest expansion in history. However, this number still sits below the Laffer curve’s prohibitive range. Between 1979 and 2005, after-tax household income rose 6% for the bottom fifth and increased by 80% for the top fifth.

Has wealth ever trickled down, or has it been accumulating at the top?

50 years of failure

 A study from David Hope from London School of Economics and Julian Limberg from King’s College London examined 18 countries in the Global North from 1965 – 2015. The countries were Australia, Austria, Belgium, Canada, Germany, Denmark, Finland, France, Ireland, Italy, Japan, the Netherlands, Norway, New Zealand, Sweden, Switzerland, the United Kingdom, and the United States.

They didn’t compile fresh data; instead reviewing data over the last half-century in advanced economies and using sophisticated statistical methods to look for patterns that others had missed (learn more about how the study was carried out here).

They found that, over this 50 year period, these tax cuts helped no one except the rich. Inequality grew, with no significant effect on jobs or growth. Nothing trickled down.

More specifically, they found that GDP per capita and unemployment rates were nearly identical after five years in countries that decreased wealth taxes and those that didn’t.

However, they also found that the incomes of the rich grew much faster in countries where tax rates were lowered. Instead of trickling down the rich just got richer.

We find that major tax cuts for the rich push up income inequality, as measured by the top 1% share of pre-tax national income. The size of the effect is substantial: on average, each major tax cut results in a rise of 0.8 percentage points in top 1% share of pre-tax national income. The effect holds in both the short and medium term. Turning our attention to economic performance, we find no significant effects of major tax cuts for the rich. More specifically, the trajectories of real GDP per capita and the unemployment rate are unaffected by significant reductions in taxes on the rich in both the short and medium term.”

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We’ve seen this exemplified during the pandemic. Low paid workers were hit hardest, white-collar workers were generally able to continue working remotely. However, in America alone, 651 billionaires gained $1tn of wealth while 8 million fell into poverty, 19 million were at risk of eviction, and 26 million went hungry.

Wealth did not trickle down, it simply grew at the top.

This comprehensive study also corroborated other studies in recent years. A 2017 working paper found that tax cus on the poor help the poor, while tax cuts on the rich don’t, while a 2015 analysis from the International Monetary Fund also found that benefits don’t trickle down. Additionally, a 2014 paper in the American Economic Journal suggested that lower taxes for the rich caused high earners to seek pay rises, rather than money trickling down to low earners.

Essentially, trickle-down doesn’t work because lower taxes on the wealthy doesn’t create more employment, consumer spending or regained revenue. Income inequality has reached its highest point in 50 years, and money keeps accumulating at the top.

The alternative

Robert Reich, professor of public policy at the University of California at Berkeley, has suggested an alternative termed build-up economics, where the rich invest in the public’s long-term wellbeing.
This would essentially look like raising taxes on the wealthiest similar to the rates after the second world war, where top marginal income tax rates were between 70% – 90%. This revenue funded massive investment in areas such as infrastructure, education and health, and average citizens were better off.

we know public investment pays off. Studies show an average return on infrastructure investment of $1.92 for every public dollar invested, and a return on early childhood education of between 10% and 16% – with 80% of the benefits going to the general public.

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People are catching on. According to a 2021 poll, 51% of adults believe that trickle-down economics has never worked in America, including 7 out of 10 Democrats and 4 out of 10 Republicans.

In July 2020 83 millionaires signed a letter asking for higher taxes on the most rich to pay for COVID-19 relief, and at the end of the year Argentina actually did introduce a one-off “millionaire tax” to pay for its pandemic response. Less than 100 people were eligible to pay the tax, but it was expected to raise $3.78 billion. 

At the same time as taxing the rich, there are clear benefits to getting more money to the middle and lower classes. Cutting taxes on middle and low earners (alongside progressive policies such as universal basic income) would actually be more successful to in stabilising economies while addressing inequality.

Even a mere 1% increase in wealth for 20% of low-income earners yields a 0.38% growth in gross domestic product (GDP). On the other hand, increasing the income of the top 20% high-income earners results in a 0.08% decrease in GDP.

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Overall it boils down to a simple principle. Stop wealth being hoarded at the top, redistribute it among the lower and middle classes, and society eventually benefits. Trickle-down economics have been, and always will be, a total fallacy.

Learn more about universal basic income and the pandemic here

Learn more about degrowth economics here

What is the theory of trickle

What is supply

Which theory of economics believes the only way to increase economy growth is to remove regulations and lower taxes?

Which economic theory could also have been called Reaganomics?