Sowell Sets Us Straight on “Trickle Down” Economics

This is sure to come up in the elections, especially by Hillary and Bernie, so listen up….

I always thought that “trickle down” economics was a snarky reference to some aspect of Reaganomics. Turns out, I was only half right. While prepping this post, I discovered that Ronald Reagan’s disillusioned budget director, David Stockman, later told a journalist, “It’s kind of hard to sell ‘trickle down,’ so the supply-side formula was the only way to get a tax policy that was really ‘trickle down.’ Supply-side is ‘trickle-down’ theory.” Thus did Reagan’s ideological adversaries seize upon equating the two, and they were so effective that the idea persists to this day. But, it is a simplistic caricature of the theory behind supply-side economics, used to smear any tax cuts that somehow benefit “the rich” and/or “big business”. As the preeminent economist Thomas Sowell explains below, “trickle down” isn’t even a real theory.

Thomas Sowell

Thomas Sowell

There have been many economic theories over the centuries, accompanied by controversies among different schools of economists. But one of the most politically prominent economic theories today is one that has never existed among economists — the “trickle down” theory. Yet this non-existent theory has been attacked from the New York Times to a writer in India. President Franklin D. Roosevelt’s speech writer Samuel Rosenman referred to “the philosophy that had prevailed in Washington since 1921, that the object of government was to provide prosperity for those who lived and worked at the top of the economic pyramid, in the belief that prosperity would trickle down to the bottom of the heap and benefit all.” The same theme was repeated in the election campaign of 2008, when candidate Barack Obama attacked what he called “the economic philosophy” which “says we should give more and more to those with the most and hope that prosperity trickles down to everyone else.”

Whether in the United States or in India, and whether in the past or in the present, “trickle down” has been a characterization and rejection of what somebody else supposedly believed. Moreover, it has been considered unnecessary to cite any given person who had ever actually advocated any such thing.

The phrase “trickle down” often comes up in discussions of tax policies. As noted in Chapter 18, tax revenues have in a number of instances gone up when tax rates have been reduced. But any proposal by economists or others to cut tax rates, including reducing the tax rates on higher incomes or on capital gains, can lead to accusations that those making such proposals must believe that benefits should be given to the wealthy in general or to business in particular, in order that these benefits will eventually “trickle down” to the masses of ordinary people. But no recognized economist of any school of thought has ever had any such theory or made any such proposal. It is a straw man. It cannot be found in even the most voluminous and learned histories of economic theories.

What is sought by those who advocate lower rates of taxation or other reductions of government’s role in the economy is not the transfer of existing wealth to higher income earners or businesses but the creation of additional wealth when businesses are less hampered by government controls or by increasing government appropriation of that additional wealth under steeply progressive taxation laws. Whatever the merits or demerits of this view, this is the argument that is made — and which is not confronted, but evaded, by talk of a non-existent “trickle-down” theory.

More fundamentally, economic processes work in the directly opposite way from that depicted by those who imagine that profits first benefit business owners and that benefits only belatedly trickle down to workers.

When an investment is made, whether to build a railroad or to open a new restaurant, the first money is spent hiring people to do the work. Without that, nothing happens. Even when one person decides to operate a store or hamburger stand without employees, that person must first pay somebody to deliver the goods that are going to be sold. Money goes out first to pay expenses and then comes back as profits later — if at all. The high rate of failure of new businesses makes painfully clear that there is nothing inevitable about the money coming back.

Oil workers in North Dakota

Oil workers in North Dakota

Even with successful and well-established businesses, years may elapse between the initial investment and the return of earnings. From the time when an oil company begins spending money to explore for petroleum to the time when the first gasoline resulting from that exploration comes out of a pump at a filling station, a decade may have passed. In the meantime, all sorts of employees have been paid — geologists, engineers, refinery workers, and truck drivers, for example. It is only afterwards that profits begin coming in. Only then are there any capital gains to tax. The real effect of a reduction in the capital gains tax is that it opens the prospect of greater future net profits and thereby provides incentives to make current investments that create current employment.

Nor is the oil industry unique. No one who begins publishing a newspaper expects to make a profit — or even break even — during the first year or two. But reporters and other members of the newspaper staff expect to be paid every payday, even while the paper shows only red ink on the bottom line. Similarly, Amazon.com began operating in 1995 but its first profits did not appear until the last quarter of 2001, after the company had lost a total of $2.8 billion over the years. Even a phenomenally successful enterprise like the McDonald’s restaurant chain ran up millions of dollars in debts for years before it saw the first dollar of profit. Indeed, it teetered on the brink of bankruptcy more than once in its early years. But the people behind the counter selling hamburgers were paid regularly all that time.

In short, the sequence of payments is directly the opposite of what is assumed by those who talk about a “trickle-down” theory. The workers must be paid first and then the profits flow upward later — if at all.

[from Basic Economics, 4th ed., by Thomas Sowell]

So, it seems to me that there is a sense in which “trickle down” is accurate — i.e., the poor and middle-class do benefit after the “wealthy” and/or businessperson invests in a business, which is why many tax rules favor such people. But, the employees get paid first (along with suppliers/vendors, I suppose.) Don’t fall into the “trickle down” trap that assumes there is an actual “trickle down” theory or that laissez-faire capitalism is intrinsically designed to make the rich richer at the expense of the poor and middle-class. As Professor Sowell has made clear, it just ain’t so.

P.S.  Just f.y.i., I wrote about capital gains here.

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