Evaluating Trickle-Down Economics

In 1981, as President Ronald Reagan embarked on his first term, the United States was grappling with economic challenges. Unemployment rates were soaring, and inflation had reached unprecedented levels for peacetime in 1979. To address these issues, Reagan's administration implemented various economic policies, including tax cuts for large corporations and high-income earners.

These policies, commonly known as trickle-down economics, operated on the belief that tax savings for the wealthy would result in a trickle-down effect, benefiting everyone else. The following decades witnessed one of the longest and strongest periods of economic growth in U.S. history. Median income rose, and job creation rates increased. Consequently, trickle-down theory has been frequently invoked by politicians as a rationale for tax cuts. However, it is crucial to examine whether these policies genuinely succeeded in stimulating economic growth and improving the lives of Americans. Moreover, it is essential to consider their applicability in different circumstances.

To evaluate the effectiveness of tax cuts, several factors come into play. Firstly, it is necessary to determine if the reduction in tax rates harms the government's tax revenue. The underlying premise of tax cuts is that excessively high taxes discourage individuals from working, ultimately reducing tax revenue. Lower tax rates, in theory, incentivize individuals to work more, leading to increased tax income that could be utilized to enhance citizens' well-being. Nevertheless, there is a limit to how much taxes can be cut. At a zero tax rate, there would be no tax revenue, irrespective of increased work participation.

While reductions from exceptionally high tax rates may be beneficial, cuts from lower tax rates could be counterproductive, impairing the government's ability to fund essential initiatives. When Reagan assumed office, tax rates were exceptionally high. His administration reduced the highest income tax bracket from 70% to 28% and the corporation tax from 48% to 34%. By early 2021, those rates stood at 37% and 21%, respectively. Consequently, tax cuts for the wealthy from relatively lower rates can have detrimental effects. A case in point is the state of Kansas, where lawmakers slashed the top tax rate by almost 30% in 2012-2013, and certain business tax rates were reduced to zero. This led to an immediate deterioration of the government's financial position, with no recovery observed. Wealthy individuals and corporations did not reinvest in the economy, indicating that the anticipated trickle-down effect did not materialize. Similar patterns have been observed in a study by The London School of Economics, which analyzed multiple historical periods and 18 countries. It revealed that tax cuts primarily enriched the top 1% without significantly benefiting the overall economy.

For tax cuts to genuinely stimulate the economy, the savings must be reinvested, such as through spending on local businesses. However, in practice, this is often not the case. It is important to note that no economic policy operates in isolation. Each time and place present unique circumstances with multiple concurrent policies. Consequently, there is only one test case for each set of scenarios, making it challenging to definitively determine the efficacy of an economic policy, identify potentially superior alternatives, or ascertain its suitability in different contexts. Yet, the rhetoric surrounding trickle-down economics, both during Reagan's era and subsequently, often promises definitive outcomes, suggesting that the spending by society's wealthiest directly improves the financial situations of the less affluent. Unfortunately, the available evidence largely fails to support this claim.

By critically assessing the impact of tax cuts on economic growth and the well-being of individuals, we can gain a clearer understanding of the effectiveness and limitations of trickle-down economics. The complex interplay of economic policies and the absence of conclusive evidence emphasize the need for nuanced evaluation rather than relying on broad promises or generalizations.

Henrik Leandro