Like HowStuffWorks on Facebook!

How Trickle-down Economics Works


The Logic Behind Trickle-down Economics: The Laffer Curve
With the Laffer Curve, economists argue that if current tax rates are in the region of declining revenue (the prohibitive range), cutting taxes will both increase revenue and improve the economic situation.
With the Laffer Curve, economists argue that if current tax rates are in the region of declining revenue (the prohibitive range), cutting taxes will both increase revenue and improve the economic situation.
Image courtesy

­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.