How Trickle-down Economics Works

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­Why anyone would give huge tax breaks to the wealthy eludes many of us. Some would argue that because the rich have used the freedoms of an ec­onomy to make much more money than they need, they should give back a larger share than those who are struggling. This is the very idea behind the progressive income tax in the United States: When income reaches higher brackets, the government taxes that excess at a higher rate. But under the logic of trickle-down theory, tax breaks for the wealthy benefit all.

To understand the reasoning behind this, let's take look at the history of the idea and the basic principle of supply and demand. In an economic slump, some say the government should make efforts to increase the supply (output or production) of an economy. Others argue the opposite: Lack of consumer demand is the root of the problem, and government should encourage consumer demand.

Nineteenth-century French economist Jean-Baptiste Say argued the former. Say's Law states that the way to economic growth is to boost production, and demand naturally follows. This flew in the face of the belief of the time, which was that a lack of money -- and thus lack of demand -- caused bad economic times [source: Skousen]. Say asserted that there will always be a demand for the right kind of products.

You could think of it this way: If there are people willing to work during a recession, they obviously want money in order to consume something. They must already have a demand that is not being met -- what they demand is either too expensive for them to afford or is not being produced. Producing in-demand products and driving down costs will create profit for the seller, and thus the means for him to satisfy his or her demand. Hence, production greases the wheels of the economy. This logic made sense to major thinkers of the time, including Thomas Jefferson and James Madison [source: Acton Institute].

A century later, the tide had turned in the United States. By the time the Great Depression hit in the 1930s, many legislators held the opposite view. The most notable opponent to Say's Law during this time was John Maynard Keynes, a British economist. Keynes argued that there are such things as overproduction and lack of demand, and the key is to increase demand rather than supply. Government should promote consumer demand rather than entrepreneurial production. When people consume more, they create more jobs and production.

Arguing that "in the long run, we are all dead," Keynes pushed for short-term fixes for immediate economic stability. He encouraged governments to adjust monetary policies (interest rates and the availability or amount of money circulating) and fiscal policies (government spending and taxes) to boost demand. Part of these adjustments includes increasing taxes on the rich and reducing taxes on the poor. While the rich would invest their money on making more products, the poor would be more likely to spend, consuming the oversupply that was the source of the problem [source: Wanniski]. Keynesian economics continued as the predominant philosophy in the United States for decades to come.

By the 1970s, trickle-down ideas were percolating in the minds of some economists who sought a return to Say's principles. Next, we'll learn how economists were able to garner support for trickle-down theory.

 

­Why do trickle-down economists think that taxing the wealthy less leads to an increase in production? That can be explained in terms of tax revenue. Some argue that giving tax breaks to the wealthy can actually increase tax revenue for a government. This might seem difficult to believe, but Arthur Laffer argued otherwise. Working off ideas posed by 14th-century Muslim philosopher Ibn Khaldun and John Maynard Keynes, Laffer concluded that government tax rates and revenues don't have a directly positive correlation.

In what became known as the Laffer Curve, Laffer showed that the relationship between taxes and revenues looks like a curve rather than a straight line. In other words, tax revenues don't rise consistently like tax rates do (which would look like a straight, positive correlation). Laffer's curve shows that when tax rates are at zero, revenues are zero as well -- the government makes no money when it taxes nothing. But it's the same result if the tax rate were 100 percent. Think about what would happen if the government demanded every cent in your paycheck. Why work -- or why tell the government what you're making? The government would bring in no money because there'd be no incentive to work or to report earnings.

So tax revenues are zero when the tax rates are at zero and 100 percent -- most agree about that. The question is, what does it look like between these extremes? The Laffer Curve postulates that once the rates get too high, the steep taxes discourage work to an extent that the revenues themselves suffer. Take another scenario: By June, you've already made a million dollars, and the progressive tax system promised to tax that income 50 percent. However, anything you make over a million will be taxed 90 percent. Why work the rest of the year when you know you can only keep 10 percent of your income? You'd probably take your half a million and retire to your beach house until next year. At this point, the taxes are discouraging work and tax revenue.

The range in which taxes are too high for maximum revenues is called the prohibitive range. When taxes are in the prohibitive range, a tax cut would produce an increase in tax revenues, according to Laffer [source: Laffer]. But the ideal tax isn't necessarily 50 percent; rather, it depends on the taxpayers [source: Wanniski].

Through Laffer's Curve, we can visualize how tax rates could discourage people from producing, which results in fewer jobs and a hurting economy. On the flip side, lowering taxes at the right time can reverse these effects. Laffer points to examples in U.S. history where lowering high tax rates increased not only government revenue, but also increased gross domestic product (GDP) growth and lowered the unemployment rate [source: Laffer].

Jude Wanniski built on Laffer's idea and argued for a return to ideas centered around Say's Law -- in other words, increasing production. If Laffer's Curve is correct, then cutting taxes for the wealthy can encourage investment and production to promote general economic health. Wanniski explains in "The Way the World Works" how boosting the supply side of the economy rather than the demand side is the way to economic prosperity. He also makes clear that cutting the prohibitive, high taxes of the wealthy will encourage more economic activity and growth for all. Redubbed supply-side economics (which supporters find a less polarizing name), trickle-down economics found new life in the United States in the 1980s. But before we get to its implementation, let's sum up the basics of trickle-down economics.

­Now that we have an idea of how the idea came about, let's try to put all the pieces together to understand trickle-down economics as a whole. According to Say's Law, boosting production is the key to crawling out ­of a recession. Tax breaks improve tax revenues, and according to Laffer's curve, they also boost production. Giving tax breaks to the wealthy stands as a policy meant to improve the overall health of the economy.

Opponents of this economic theory tend to believe that politicians who support it are in the pockets of wealthy businessmen. They often summarize trickle-down economics to something resembling Will Rogers' definition: The policy of giving breaks to the rich first and hoping the benefits will eventually make their way to the working classes. Proponents of trickle-down (or supply-side) economics object to this evaluation, calling it not just an oversimplification but a misinterpretation of what they hypothesize will happen.

Thomas Sowell, an ardent supporter of trickle-down theory, argues that the popular definition gets it backward. Instead of benefiting the wealthy first, the policy actually benefits the working class first. This may sound impossible -- after all, it's the wealthy who get the tax breaks, not the poor. However, Sowell maintains that because the wealthy make investments in order to make a profit, they spend the money first on expenses of the business venture. (In other words, spending money to make money.) These wealthy investors must pay workers, thus creating jobs, before they can expect to see any profits. Therefore, it's the workers who receive the most immediate relief [source: Sowell].

­While it might­ be true that some wealthy members of society seek tax breaks for self-serving purposes and might even bribe politicians into voting for these policies, trickle-down economists would consider this irrelevant to the question of whether the theory works for everyone. John F. Kennedy showed his support of the trickle-down economic theory when he said, "a rising tide lifts all boats" -- meaning that a growing economy benefits you whether you're rich or poor [source: Nugent].

Now that we know how it's supposed to work, let's take a look at the theory in action.

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Although some characterize the trickle-down theory as an experiment originating in the 1980s under the Ronald Regan presidency, the United States had actually used it before. The Harding, Coolidge and Kennedy administrations implemented supply-side tax policies before Reagan did.

The first instance of supply-side economics being implemented came even before the trickle-down idea was fully articulated. After World War I, top income tax rates had risen from a modest 7 percent to 77 percent to help pay for the war. This high rate would fall into the prohibitive range of the Laffer Curve, according to the theory. The Harding and Coolidge administrations passed a series of tax cuts to reduce wealthy citizens' tax burden, which had ballooned. Although opponents argue that this kind of policy contributed to the Great Depression, Arthur Laffer points to the resulting increases in tax revenue, gross domestic product (GDP) and employment as evidence that the tax cuts worked by boosting production [source: Laffer].

But this policy soon faced sharp criticism. When the stock market crashed in 1929 and the U.S. economy sank into the Great Depression, the idea of giving tax breaks to the wealthy was an unpopular policy. People blamed Herbert Hoover, who'd shown support for the tax policies of his predecessors. In 1932, voters replaced him with Franklin Roosevelt, who promised the New Deal that would help the economy from the bottom up. Keynesian economics took hold.

Wealthy members of society who'd enjoyed the low marginal tax rates of the 1920s would see a dramatic reversal in the next 20 years. During the Depression and World War II, the top marginal rate rose to more than 90 percent [source: Laffer]. Enter John F. Kennedy, who was sympathetic to the idea behind supply-side economics (recall his "rising tide" comment). He argued that lowering taxes increases tax revenue, creates jobs and increases profits [source: Nugent]. His tax cuts didn't pass until after he was assassinated, but Laffer argues that they had the positive effect on the economy that Kennedy had hoped for. Others say that the cuts hurt the gross national product (GNP) growth and resulted in rising unemployment [source: Friedman].

Until Ronald Reagan was elected president, no other administration in the United States championed supply-side policies. In the late 1970s, economists like Laffer and Jude Wanniski were touting the advantages of increasing production through tax breaks for the wealthy. What they said convinced many people and fit into Reagan's economic philosophy. In 1981, Reagan passed his Economic Recovery Tax Act (ERTA), which cut all marginal tax rates dramatically (the top fell from 70 percent to 50 percent) [source: Laffer]. Since then, trickle-down theory has been tied closely to Reagan's policies, collectively named Reaganomics.

Trickle-down economics remains highly controversial. Recently, George W. Bush faced harsh criticism for his tax cuts. Despite staunch political opponents to trickle-down policies, some maintain that the general consensus among economists today is that the theory works [source: Bartlett]. Nevertheless, you'll still find plenty of controversy surrounding trickle-down economics among politicians. Many, including Barack Obama, contend that it failed. During a hurting economy, Obama won the support of voters by promising to tax the wealthy and ease the tax burden on the lower-income bracket. So as of 2008, the tide of public opinion certainly shifted away from supply-side thinking yet again. Time will tell if opinion will shift back again.