Home > Economic policy, Tax and public expenditure > Restating the case against trickle down (updated)

Restating the case against trickle down (updated)

September 2nd, 2017

I’ve just given a couple of talks focusing on inequality, one for the Global Change Institute at UQ, following a presentation by Wayne Swan and the second at a conference organized by the TJ Ryan Foundation (including great talks by Peter Saunders, Sally McManus, and others), where I was responding to a paper by Jim Stanford from the Centre for Future Work. Because I was speaking second in both cases, I didn’t prepare a paper or slides, but tailored my talk to complement the one before. That can be a high risk strategy, but in this case, I think it worked very well.

It led me to a new, and I hope improved, statement of the case against ‘trickle down’ theory. As always, the most important part of a refutation is a clear statement of the theory you propose to refute, so that it can be shown where it falls down. After the talks I wrote this up, and it’s over the fold. Comments and constructive criticism much appreciated.

The case against trickle down, restated

The trickle down theory relies on the following claims*

1. In the absence of taxes and other government interventions, high market incomes reflect, and elicit, high productivity, investment and effort.

2. More effort from highly productive workers and investors increases the productivity of workers in general.

The trickle down argument then starts with the claim that reducing tax on high income earners will lead them to work harder and invest more. Since they are (by claim 1) the most productive members of the community, their efforts will (by claim 2) make everyone else more productive, and will benefit consumers. So, reducing taxes on high income groups will make everyone better off.

Claim 1 is a restatement of the marginal productivity theory which is at the heart of neoclassical economics. In a general equilibrium model of a perfectly competitive economy with full employment, it can be deduced as a theorem. With constant returns to scale,

Claim 2 is generally assumed to be true, although it’s not usually spelt out. It is true either if there are external economies of scale such as information externalities (the most productive provide a model for others to copy) or complementarity in production (working with highly productive colleagues and managers makes people in general more productive). With economies of scale, Claim 1 needs to be interpreted carefully, The implication is not that everyone receives a payment equal to their marginal product, but that market incomes are (roughly) proportional to average and marginal productivity.

If Claim 2 doesn’t hold then all the benefits of increased effort from highly productive workers and investors is captured by the workers and investors themselves. This means that the there is no ‘trickle down’ except through the tax system. The policy implication is that tax rates for high income earners should be set at or near the top of the ‘Laffer curve’ where revenue is maximized, estimated by Piketty, Saez and Stantcheva at around 80 per cent.

The neoclassical model that gives rise to Claim 1 has never been a fully accurate representation of the economy. But it is even less accurate now than in the past. The crucial recent developments, likely to continue in the absence of radical policy change, are:
(i) wage stagnation, with the result that the link between productivity and incomes has been broken for workers as a group
(ii) the increasing proportion of profits derived from monopoly power and financial sector speculation
(iii) the rise of the information economy. Information is a public good, so imposing explicit prices on information or bundling it with undesired advertising reduces its social value
(iv) the likely emergence of a patrimonial society in which high incomes are derived from inherited wealth

These developments mean that cuts in the top rate of income tax will primarily reward ownership of capital, unproductive activity, or luck in choosing ones parents, rather than increasing productivity. They also undermine the second proposition underlying trickle down theory. The pursuit of monopoly profits (‘rent-seeking’ in the jargon of free-market economics) reduces rather than increases the productivity of the economy as a whole.

That’s the theory. The empirical evidence, which was in dispute for a long time, is now clear-cut, at least for the United States. Decades of pro-rich policies have, unsurprisingly, made the rich much richer. Contrary to the predictions trickle down theory, the result has been to reduce, rather than increase, the productivity and dynamism of the economy. The combination of slower growth and increased inequality implies, as a matter of arithmetic, that the majority of the population must be worse off.

*There are some other versions of trickle down that can be dismissed more easily. Most notably, there’s the idea that the spending of the rich will create employment. That’s true, but more employment would be generated if income were redistributed to the poor, who save less of their income and consume more.

  1. John Homan
    September 2nd, 2017 at 12:36 | #1

    Good afternoon John,
    I have given much thought to ‘Inclusive Growth’ since Joseph Stiglitz gave an address in Sydney, in which he said:
    “There has been a long held belief that inequality is a problem, but if we do anything about it, it will weaken our economy. However we now realise this is wrong. In fact inequality, and the magnitude it has grown in, actually undermines economic activity”
    http://www.cityofsydney.nsw.gov.au/council/news-and-updates/global-issues-ideas-and-conversations/city-talks/joseph-stiglitz-the-price-of-inequality
    Where Stiglitz looked at the socio/economic side of the argument, there is a paper “Creating Shared Values, in the Jan-Feb 2011 edition of the Harvard review that argues the same point of view from a hard nosed dollars point of view.
    I believe that they are the pieces that will change the government, private sector, and community services sector from a confrontational to a a collaborative model (as we have seen over many years in northern Europe) All sides will support a common outcome (even if different reasons)
    I believe Labor, state and federal are well on the way to make the awitch from supply side economics to inclusive growth. The uncertainties during this paradigm shift, I believe. are creating the Trump, Brexit, Hanson turbulence.
    Interesting times ahead!

  2. hc
    September 2nd, 2017 at 16:19 | #2

    It seems to me that the case for trickle down via tax cuts is identical to the case for believing Diamond on optimal income tax schedules rather than later writers. There seems to be an empirical issue here that there is evidence on. The key issue is whether tax reductions imply very (socially valuable) increases in income among the rich that can be used for redistribution. Empirically it depends on the number of the rich and – as you point out – on what they do. Those who are rich because of “rich daddy” won’t work harder although their spending will drive some limited (quite different) “trickle down”.

  3. John Homan
  4. Suburbanite
    September 2nd, 2017 at 20:33 | #4

    I’m not sure who is going to be one over by logical argument. I think the appeal of trickle down economics rests not on the idea that it will enrich everyone, but on aesthetic and moral grounds. Supply side economics fits the idea that smart “hardworking” and ultimately better people should be incentivised with rewards and lazy inferior people should be incentivised to improve themselves by the ever-present fear of poverty.

  5. Cameron Pidgeon
    September 2nd, 2017 at 21:50 | #5

    But wealth does trickle down. We just need to keep reminding people that it flows, gushes, FOUNTAINS up.

  6. September 3rd, 2017 at 02:05 | #6

    American and European managers have been helping to raise the wages of workers – Chinese workers. From a geostationary Olympian viewpoint, the improvement in the welfare of hundreds of millions of poor Chinese easily outweighs the stagnation in earnings and job losses of much richer first world workers. The trouble is that a case that can be made by a UN official becomes special pleading for the managers and shareholders of the outsourcing companies and their governments, who had asymmetric obligations to their initial workers, expressed in a different social contract.

  7. John Quiggin
    September 3rd, 2017 at 09:22 | #7

    James @6 I had the same comment made by someone else at Crooked Timber, so I’ll repost my reply which is itself a restatement of a point I;ve been making for a long time:

    Repost

    I’ve responded to this point before, as follows:

    In the wake of the GFC, some advocates of economic liberalism have sought to shift the ground of debate, arguing that, whatever the impact of financial globalisation on developed countries, it has been hugely beneficial for India and China which, between them, account for a third of the world’s population.
    There are all sorts of problems with this argument.
    The relatively disappointing economic performance of China and India in the postwar decades certainly provides strong grounds for criticising the economic policies of Mao Zedong and Nehru. But even in the days when some observers saw these policies as providing an appropriate development path for the countries that adopted them, no one seriously proposed their adoption by developed countries. And as more attention has been focused on the irrational aspects of these policies (such as the Great Leap Forward, in which people were made to melt down their cooking pots to provide scrap for backyard smelters, which presumably produced new cooking pots, or the dozens of licenses required to undertake the simplest economic activity in India) it has become easier to understand why their removal or relaxation
    At the same time, neither of these rapidly-growing economies come anywhere near meeting the standard description of a free-market economy. China still has a huge state-owned enterprise sector, a tightly restricted financial system and a closely managed exchange rate. India began its growth spurt before the main period of market liberalisation and also retains a large state sector. In both countries, as earlier in Japan and South-East Asia, the state has played a major role in promoting particular directions of development.

    In summary, while the development success stories of China and India, and, before them of Japan and the East Asian tigers, may have some useful lessons for countries struggling to escape the poverty trap, they can tell us nothing about the relative merits of economic liberalism and social democracy.

  8. sunshine
    September 3rd, 2017 at 11:14 | #8

    From posted comments threads on free market extremest blogs the argument is much simpler. It is normally something like 1. Those with the most power and wealth have it because they are superior. 2. We should free them up further and their efforts will ensure that even the worst off stay better off than they were 50 or 100 years ago. The bigger the wealth gap the faster the bottom end will rise from that base.
    What surprises me is that most of the people with this Darwinian view are not wealthy and powerful. On a more positive counter-note it is good to see the spontaneous mass outbreak of socialism in the Texas flood and how good it makes people feel to have a chance to help each other.

  9. Peter T
    September 3rd, 2017 at 11:15 | #9

    I realise #1 is a matter of orthodoxy, but to my mind it’s obviously false. Labour is cooperative, so any single person’s contribution is swallowed up in the whole. Distribution of the resulting benefits is therefore largely (not wholly) political. This is obvious historically in the shifts between groups as distributions are re-negotiated (craftsmen rising, or women). It’s also obvious to anyone who has negotiated wage classifications – productivity is never mentioned, because it’s un-calculable, but skill, experience, responsibility are all in the mix. It’s obvious as soon as one asks which of two stretcher-bearers is more productive.

    This is also relevant to the Nehru/Mao periods. Before India and China could undertake large-scale industrial production, they had first to sort out the social issues that had held them back. Greater equality in distribution was a large part of this. In China, this was education, health care, eliminating gentry power. In India it was nationalising banks to ensure wide access to credit, training, mobilising political groups to curb upper-caste dominance.

  10. September 3rd, 2017 at 11:48 | #10

    John, re this “(iii) the rise of the information economy. Information is a public good, so imposing explicit prices on information or bundling it with undesired advertising reduces its social value”

    That’s one part of it, but there’s more to it than that because network externalities in information provision lead to natural monopolies which, in cases like the large IT companies, concentrate wealth even more than financialisation.

  11. John Homan
    September 3rd, 2017 at 11:59 | #11

    I have great trouble accepting that the rich outsource to the developing world with lifting them out of poverty as their motif. More likely that they are driven by a desire to become richer faster!

  12. September 3rd, 2017 at 15:04 | #12

    @John Homan
    No – it’s all atruism. Srsly, the rich are always trying to figure out how to help out. What would be the point of being rich otherwise?

  13. September 3rd, 2017 at 18:52 | #13

    @John Quiggin
    The last sentence of your repost shows that you were responding to an argument quite different from, and much broader than, the one I made, which is basically an ironical snark.

    Mao’s and Nehru’s autarkic socialism (in very different flavours) is no longer how China and India are run. It is surely CW that the very successful and radical change of course launched by Deng and continued by his successors had two main components: the reversal of rural collectivisation, and export-oriented industrial growth. The former was a domestic matter, but the latter required the cooperation of the capitalist world. This was enthusiastically forthcoming. India started later on a similar path under Singh, and so far its exort success is limited, so one can’t make a “trickle-down but in India” case.

    I don’t think many apologists for the capitalist elite are making the hyper-globalist Davos Man “trickle-down works, but in China” argument. It’s diametrically opposed by populist Trumpian protectionism.

  14. Smith
    September 3rd, 2017 at 21:07 | #14

    Australia is at risk of becoming a patrimonial society because of something as prosaic as house prices. The lucky ones who got in early have property valued in the millions and no debt (yes it depends on the location, Sydney and Adelaide are different) while those who aren’t in will never get in unless there is a mighty crash. Those who are in will pass their property on to their children who will partner up (probably) with someone who also inherits property.

    This would be a fixable problem if we had inheritance taxes. I don’t suppose Wayne Swan advocated this at the conference.

  15. Blissex
    September 3rd, 2017 at 23:09 | #15

    «Decades of pro-rich policies have, unsurprisingly, made the rich much richer. Contrary to the predictions trickle down theory, the result has been to reduce, rather than increase, the productivity and dynamism of the economy.»

    But the “productivity and dynamism” of business and property owners have grown tremendously over the past few decades, and as far as property and business rentiers experience, “trickle down” has worked very well for them.

    Politically, people vote for or against “trickle down” depending on the impact it has had on their wallet, not the ludicrous claims of well-compensated “sell-side” Economists. Do people really think that voters say to themselves “well trickle-down has screwed me but because G Mankiw says it is wonderful I’ll vote for it regardless”?

    The political problem is whichever excuses are used by the advocates of “trickle down” it has fattened the wallets of many voters. The political problem is that we are in an era of mass rentierism.

    «Australia is at risk of becoming a patrimonial society [ … ] This would be a fixable problem if we had inheritance taxes. I don’t suppose Wayne Swan advocated this at the conference.»

    And lose the votes of all current and future patrimonial rentiers? How do supposedly “left-wing” parties deal with mass-rentierism and mass-incumbency? That’s still an unsolved problem, other than the so-called “third way” which simply says to pander to mass-rentierism and mass-incumbency just like the “right-wing” parties do.

  16. Whimsical Louie
    September 9th, 2017 at 07:51 | #16

    Hi John,

    I understand a guy called Arthur Laffer, was a key proponent of trickle down. The history of his curve has been described to me as follows:

    As a young rock star economist with Republican leanings in the early 1970s, Arthur Laffer liked to roll with the neocons of the future. Laffer’s Warren Beatty-styled bouffant and boyish enthusiasm for taxation reform must have provided a cheeky distraction for an equally youthful Donald Rumsfeld and Dick Cheney. Both were already preoccupied with Vietnam, and blue sky concepts for remaking the modern Middle East.

    According to legend, young Laffer sketched his curve on a napkin for Rumsfeld and Cheney one boozy afternoon in a Washington bar. On the curve there is a sweet spot, where a certain rate of taxation maximises government revenue. Laffer said this was at a lower rate than had previously been thought. In other words, lower taxes create greater economic activity. Which in turn generates greater profits, and therefore larger returns back to government. This was the ‘trickle-down’ effect.

    The curve was a sensation! With Laffer dubbed the “father of supply side economics”. Although he humbly shifted the credit to Keynes and Ibn Khaldun, a 14th Century Tunisian philosopher nobody had heard of. Starlets who had been demanding dates with Henry Kissinger, for his engorged foreign policy brain and unconventional looks, now shifted their lustful gazes in the direction of Laffer.

    However, it was Rumsfeld who was affected the most. Had Laffer’s curve revealed a previously unknown but now known known – that a certain tax rate maximises revenue? Or, given Laffer’s lack of empirical evidence for his theory, was this now a known unknown – there’s an ideal rate, but nobody knows exactly what it is. The paradox haunted Rumsfeld, and has driven his desperate search for clarity in language ever since.

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