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.