Generating a steady flow of wealth through trickle-down economics

To anyone who lived through the years of Ronald Reagan's US presidency, the term “trickle-down economics” should already be familiar, writes UNSW Business School's Gigi Foster

While Reagan wasn't the first politician to say “trickle-down” with a straight face, the economic story signalled by the term was frequently invoked during the Reagan years, most famously to justify massive tax breaks that disproportionately favoured the rich. The origins of trickle-down can be traced back to William Jennings Bryan, but his phrasing – “leak through” – didn't really catch on. Through the years the same basic idea has also been known variously as “supply-side economics” and “Reaganomics”.

Critics of trickle-down policies haven't overlooked the fact that giving the rich a helping hand may yield political benefits for the politicians offering that help. Since Reagan's time, trickle-down economics has been derided by other politicians as “voodoo economics” and as “the rich pissing on the poor”.

The broad idea of trickle-down economics is that giving economic help to companies or people at the top of society should, through one of various possible mechanisms, generate benefits for those in layers further down. Let's look at the various mechanisms through which this is theorised to work.

Mechanism 1: Corporations that get tax cuts increase investments in the country that gives them. In theory, some companies may be drawn to expand operations in Australia because of lower company tax rates. If those expansions created jobs for previously unemployed people, or equal or better jobs for Australian workers compared with what those workers previously could get, then the benefits would be spread to workers. Plus, these companies could add to the demand for Australian-made intermediate goods.

If the expanding companies were more productive than other companies, due to using more efficient production processes, then this could also raise overall Australian productivity. In theory this would allow all of us to get more out from putting less in.

Yet many companies are more likely to look to other margins when making the decision about whether to enter or expand in Australia. These could include the cost of labour, the degree of red tape, qualities of relevant markets, and Australia's geographical location. This is partly because the tax breaks usually floated by politicians are modest, and also because the corporate tax rate differences between Australia and many of its peers are comparatively small anyway.

There is also a lemmings-over-a-cliff concern here: if our peer nations start taxing companies at rates below what is required to finance effective government, should we follow them?

More subtly, the incentive effects we would predict from a company tax break are complicated by the fact that no company operates like a person. Though we attribute human traits to companies routinely, in reality the decisions companies take are myriad and in many different areas.

Each is taken by some individual person in a particular department with particular, constrained information and decision-making authority. It's not guaranteed that each such decision-maker in a company will know about a bit of extra cash due to a tax break and be spurred because of it to take a particular decision in their realm that dovetails with decisions taken by other company workers.

To the extent that the company does not act as a unit, the hoped-for labour demand and productivity effects may not materialise. The same is true if that tax-break money is used for other purposes, such as funding dividends to shareholders or lining the pockets of the top brass.

Mechanism 2: Rich people who get tax cuts will use the extra money in a way that helps the country as a whole. The main idea here, as with Mechanism 1, is that more investment will create more jobs and potentially increase productivity (which results from those jobs). Some rich people may indeed invest the extra dollar directly into the stock of an Australian business. In fact, since rich people have a lower marginal propensity to consume than poorer people, they're more likely to spend an extra dollar on investment than on stuff.

Nonetheless, a rich person may choose to buy Australian-made products with that money, which should act as a stimulus to Australian businesses. Of course that person could instead shop online for an overseas product or take an overseas trip, in which case that extra dollar would flee the country.

A rich person may instead lend the bank that extra dollar by depositing it into a bank account. If the bank then promptly loaned that money out to domestic borrowers, then we might see a positive economic effect, if the main borrowers who benefit from this looser cash were businesses that went on to use the money for a productive purpose.

If the extra dollar ended up going to less productive businesses, we might see a temporary uptick in employment and intermediate goods sales that then melted away when the business was out-competed. If home buyers got the money instead, it may mainly fuel increased house prices.

Mechanism 3: Aggregate tax revenue will rise when taxes are cut. Perhaps the most radical notion in supply-side economics is that cutting taxes may, counter-intuitively, raise tax revenue.

Suppose a company were making $100 in profits and faced a company tax rate of 30 per cent (creating $30 in tax liability), but then the tax rate dropped to 28 per cent. The extra $2 of “found money” might be invested in the business in a way that generates a rise in profits, say to $110. This would then create a tax liability of $30.80, or $0.80 more than the government collected under the higher tax rate.

Notice how large the return on the investment of the “found money” had to be, in order to create even a tiny increase in corporate tax revenue, from this 2-percentage-point tax break.

More taxes could also be raised if the employees of that company, as it expanded, shared in its increased productivity in terms of their taxable take-home pay. An increase in government tax revenue could then in theory be allocated to welfare, infrastructure, and other progressive budget line items, benefiting more people indirectly.

Naturally, this is not necessarily how things will play out. The “found money” from the tax break may be used by a company in ways that do not yield an increase in productivity and profits of the required amount to create a tax revenue hike for the government; and any revenue hike may not be directed to progressive expenditures.

In sum, careful listeners may sometimes hear a gentle trickle in our economy, but many parts of the waterwheel would need to be positioned just right in order to generate a steady flow.

Gigi Foster is a Professor and Director of Education in the School of Economics at UNSW Business School. A version of this post appeared on The Conversation.