On trickle-down economics

I am writing this basic explainer post by request. The primary goal is not to criticize trickle-down economics, but to actually explain what it is. To do that, I think it is helpful to first explain what it is not.

For some reason, lay advocates of trickle-down economics often wrongly describe it as a demand-side theory. If you lower taxes on the rich, they will buy more goods and services, which will create more demand and therefore employment. Those paid in that employment will then spend the money elsewhere, and it will thus “trickle down.” In addition to being deeply confused in ways I wont pursue here, this is not the actual theory of trickle-down economics. A big hint here is that trickle-down economics is really a pejorative label for something called supply-side economics. It is a theory of how to increase supply, not how to increase demand. If you see someone arguing for trickle-down economics by focusing on the demand effects of the personal consumption of the rich, let them know that they are really just talking in a very clumsy manner about Keynesian multipliers, not trickle-down economics.

The actual theory of trickle-down economics is focused on capital accumulation and innovation. In simplified terms, it makes the following three claims to reach its policy conclusion:

  1. Cutting taxes on the rich and capital income will generate more investment (capital accumulation) and innovation.
  2. Capital accumulation and innovation increase productivity and grow the economy.
  3. Increasing productivity and growing the economy are the only ways to improve standards of living.

As you can see, this is about supply not demand. It is about putting in place tax policies that cause economic actors to invest and innovate more. The end result of that extra investment and innovation is supposed to be rising standards of living. The theory has nothing to do with the rich buying goods and services for their personal pleasure. In fact, the investment part actually tries to create conditions where the rich buy less goods and services for their personal pleasure, and invest that money instead.

It would be impossible to cover all of the objections to this theory here, but I can provide a small sample. First, the claim that cutting the taxes of the rich will increase investment and innovation is empirically disputable. We’ve had high-tax eras in the past where investment levels (and growth) did not seem to suffer significantly. In reality, people invest and save for all sorts of reasons, and the kinds of consumption trade-offs the economic models focus on probably do not adequately reflect real-life decision-making. Taxing high earnings — if done correctly — never makes it a wealth maximizing move to forego a capital investment or not develop new technologies and other sorts of innovation.

Second, capital accumulation and innovation do not need to come only from private actors. The government can make public and private investments that increase the capital stock. After all, the kind of investment most wealthy individuals do just involves purchasing existing financial assets. And as public pension funds have shown, the government is fairly capable of that. On the innovation side, the government has long been a big actor. Through the National Science Foundation, universities, and the military, the government has financed research generating huge productivity-enhancing innovations. The internet is perhaps the most famous.

Third, capital accumulation and investment are only two pieces of the growth puzzle. There is, as the right often likes the forget, the labor part. Labor productivity is increased through education and training, and the state takes a dominant and indispensable role in that. Increasing human capital — as it is kind of disgustingly called — generates economic growth just as capital accumulation and innovation does. Levying high taxes on the rich to finance increased education of the public could quite plausibly generate net economic growth.

Fourth, the last forty years should make it quite clear that economic growth and productivity do not necessarily benefit everyone. In that period, average market incomes for the bottom 90% did not grow at all, as the top 10% captured all of the gains. What is the point of making the economy bigger if the rich just grab all of the increase?

Finally (for me), while we need to grow the economy to increase the average standard of living, we do not need to do so to increase some people’s standard of living. By distributing economic output differently, we could improve the standard of living of the majority of Americans without increasing productivity at all.