But the president’s economic program was not developed in a vacuum, without theory, precedent, or expectations. It was a fairly logical combination of his conservative background and bits and pieces of several economic theories, but supported by limited economic experience and policies of the past. President Reagan inherited an economy with a number of serious problems. Inflation and high interest rates were the major concerns, but unemployment, energy shortages, high taxes, and falling productivity also demanded immediate attention by the president and his economic policy advisors. But the Reagan program, which placed emphasis on reducing inflation and the size of the government sector, was also blamed for the largest budget deficits in history and a more than doubling of the national debt.
Just as Franklin Roosevelt’s New Deal program was associated with solutions to the problem of unemployment and raising incomes of the poor through increased government spending, Reagan’s Economic Recovery Program was associated with solving the problem of inflation and of raising after-tax incomes of the rich through tax cuts.
President Reagan’s policy concentrated on lowering inflation and interest rates, increasing personal savings, investment and the supply of goods and services. This “supply-side” policy could be successful only if those who were responsible for the majority of savings and investing were to receive a substantial increase in their incomes. Since most savings is done by those with high incomes, Reagan’s program was designed to increase their incomes first, and have the resulting increase in saving and investment create new jobs and higher incomes for the rest of the society. Such an economic policy has been characterized as “Trickledown” policy because income is increased at the top and then trickles down to lower income levels.
Trickledown policy was not a creation of Reaganomics. It has long been associated with Republican politicians. If trickledown policy is to be effective, the initial increase in incomes of the rich must lead to a future increase in incomes of the middle and lower income groups. It must expand business investment, create jobs, and improve economic welfare for more than just the rich who receive the initial benefits. But if the rich are simply made better off at the expense of everyone else, the policy is a failure.
Trickledown is designed as a stabilization policy to deal with problems of inflation and unemployment, but it has obvious impacts on the distribution of income, the levels of saving and investing, economic growth, the role of government, and the size and composition of the government budget. Each of those impacts must be examined before a judgment can be reached on the success or failure of the policy.
The underlying logic of trickledown is quite simple: Proponents argue that the majority of saving and investment is done by corporations and those individuals with large incomes; increases in savings and investment create jobs, increase personal incomes, and stimulate economic growth; therefore, public policies designed to create jobs, incomes, and growth must be directed toward initially increasing incomes of corporations and of individuals with the highest incomes. As incomes of the wealthy increase, so will savings and investment. New investment will create new capital and new jobs so ultimately incomes and well-being for all of society will improve. The fact that the rich get richer as a result of public policy is not viewed as detrimental because it is only by making the rich richer that the economy reaches its ultimate goals.
Those who would advocate trickledown as public policy must also advocate tax and expenditure policies which reach the goals of stimulating savings and investment. For example, appropriate tax policies would be those which lowered high marginal tax rates and/or exempted or excluded from the tax base that income most likely to be earned by the wealthy. Appropriate expenditure polices would be those that provided direct or indirect subsidies to corporations or the wealthy. A defense contract, for example, would provide large amounts to defense contractors, who would in turn create new jobs, incomes, etc. for those hired to work on the project. Appropriate supply-side policy then is any policy designed to stimulate the supply of goods rather than the demand for goods.
Equally important is the consideration that policy must avoid tax and spending policies that increase consumption at the expense of savings and investment. For example, a tax cut for the poor would lead to an increase in the demand for goods and services without a corresponding increase in investment to increase the supply of such goods and services. An increase in Social Security benefits or unemployment compensation would likewise increase the ability to consume relative to the ability to produce. Inappropriate supply-side policy then is policy designed to stimulate demand rather than supply.
If trickledown logic is correct, the result of public policy will be to improve living standards for everyone. Not only will the rich get richer, but the poor will have more jobs and greater income as well, so the unemployment rate will decrease. The major weapon in the trickledown supply-side program is a tax policy designed to stimulate economic growth.
The ability of tax policy to create positive supply-side incentives has long been recognized by both economists and politicians, since both saving and work incentives are inversely related to high taxes. That is, high taxes discourage both saving and work effort. Thus, cuts in tax rates can be used to increase private sector incentives to save and to produce, and therefore increase the total supply of goods and services. But President Reagan’s version of trickledown logic was based on a controversial economic theory called the “Laffer curve”, named after Dr. Arthur Laffer. It is the Laffer version of trickledown that we call voodoo economic.
According to popular legend, Dr. Laffer was sitting in a hotel restaurant sometime in the mid-1970s and began drawing diagrams on a napkin. In the process he developed a curve that has come to be called the Laffer curve. A direct outgrowth of his supply-side orientation, the Laffer curve implies that high tax rates destroy incentives to produce and force production out of the mainstream economy and into what economists call the underground economy, thereby reducing the total tax base. The underground economy exists when production and income are not reported for tax purposes. Incomes from flea markets, garage sales, babysitting, etc, are often used as examples. At high existing tax rates, raising rates further may push even more income into the unreported category, thus reducing the tax base by more than the increase in the tax rate, resulting in an actual decrease in tax collections. By the same logic, cutting very high tax rates may lead to an increase in collections.
Laffer argued that a decrease in tax rates will lead to an increase in the incentives for taxpayers to work and produce since they will keep a larger share of the income they earn. In addition, any production and income that has been unreported as part of the underground economy will also surface and become part of the tax base. But Laffer argued that this increase in the tax base will more than offset the decrease in tax rates, so total revenue will actually rise rather than fall. Politicians looking for a justification for either tax cuts or spending increases were obviously open to this type of proposal since it provides a theoretical argument for cutting taxes, while also increasing tax revenues and thus providing funds to expand expenditures. Laffer could therefore argue that it was possible to cut tax rates, raise spending, and still not increase the size of the budget deficit. Hence the now popular Republican phrase that “Tax cuts pay for themselves”.
Professional economists, however, have not reacted as favorably as politicians to the Laffer curve proposals. A number of questions and objections have been raised. For example, the curve is extremely difficult to test empirically. At tax rates below some “optimum” tax rate, increases would lead to increases in revenue, as the rate increases more than offset any fall in the tax base. At tax rates above the optimum, rate increases would cause a fall in the base that would offset the rate increase, so revenues would fall. Above the optimum the opposite is also true: a decrease in tax rates would lead to an increase in tax revenue. But even Laffer did not know for sure where the optimum tax rate was, and therefore did not know if rate increases would lead to revenue increases or decreases.
Further, Laffer did not argue that the process was instantaneous, i.e. that tax cuts would lead to instant increases in tax revenues. It takes time to create new investment and production incentives and for new income and tax revenues to be raised. But how long does it take? If tax revenues fall for the first few years is the theory disproved? If tax revenues after one year are equal to previous projections without a cut, has the theory been proved or disproved? What about two years or three years later? Many forces work on the tax system, and the incentives to produce more or less are some of the most difficult to measure.
It is important to note that Laffer argued for a cut in the “marginal” tax rates and not in “average” rates. Marginal rates are those that apply only to the last, or marginal, dollar of income earned. He argued that by cutting the highest, most burdensome marginal rates, the wealthiest taxpayers who have income subject to those rates would receive a substantial incentive to save, invest, and earn more income since they would be able to keep more of any additional dollars earned.
Few economists would argue with the contention that consumption and saving patterns vary with the level of income, with saving an increasing function of income. The wealthy save a much larger fraction of their income than do the poor. That is, an individual earning $5,000 a year may actually spend more than $5,000 by drawing down past savings or by borrowing. Someone earning $20,000 a year may save $500, while another individual earning $100,000 may save $20,000. In each case the percentage of income saved increases as income increases.
But while economists recognize the truth in the arguments that reducing high marginal tax rates will increase saving and investment, it is not obvious that the additional production and income generated by that saving and investment will yield enough new tax revenue to offset the revenue loss of the original cut in tax rates. For example, assume that the marginal rates are cut enough that tax revenues are decreased by $25 billion. If the tax system collects an average of 20 percent of income, total incomes must rise by $125 billion before the lost revenue will be recovered. In the extreme case, this would require that all of the original tax cut would be saved, invested, and then generate $5 in new income for each dollar invested. It is more likely that less than half would be saved and invested and that the new income generated would be less than $5 for each $1 invested. Thus, part, but not all, of the tax cut would be recovered during the first year.
That part of the tax cut not saved will, of course, be consumed, or spent on current goods and services. While this spending will also create a multiple growth in income (perhaps even to the $125 billion level) it does so by expanding demand rather than supply. An expansion in demand would be inflationary unless a corresponding increase in supply occurred. Supply-siders argue for tax cuts that will be channeled into saving rather than consumption, so funds will be made available for investment and a resulting increase in long-run supply can occur. After several years the lost tax revenue may be recovered, but only if economic growth is greater than it would have been without the tax cut because of the new investment and new incentives to produce. But once again these effects are difficult, if not impossible, to measure and assign to specific causes.
The success of the Laffer logic depends on three important connections in the tax-investment process. First, to what extent will the decrease in taxes be channeled into saving rather than consumption? Second, to what extent will any additional saving be channeled into the type of investment that will lead to new jobs and new output? Finally, to what extent will any new output result in higher tax revenues?
While most economists would accept the trickledown logic that says tax cuts for the rich will increase saving and investment incentives, few now accept the Laffer position that those incentives will be adequate to cause total tax revenues to rise rather than fall in the short-term. But incentives could certainly be great enough to cause output and incomes to rise and therefore to create other benefits in the trickledown sequence. The question is not whether the chain of benefits exits, but rather the magnitude of those benefits. If it requires an initial benefit of $1 billion to the richest 5 percent to generate secondary benefits of half a billion to the bottom 95 percent, the policy will be viewed and accepted differently than if the $1 billion in initial benefits to the 5 percent leads to secondary benefits of $5 billion to the 95 percent.
In a general sense the tools of trickledown are all those public policies designed to increase the economic position of the rich relative to the middle-class and poor. They are almost always controversial because few policies benefit only one group, and benefits are often not viewed by those receiving them as benefits at all, but only the opportunity for keeping more or expanding what they already have. And most policies that benefit primarily the rich can be argued to lead to some eventual benefit for others in society.
The most often used tool of trickledown is tax policy. The amount of any tax paid is the product of the tax base multiplied by the tax rate. The base is the thing taxed, usually income, wealth, or expenditures. The rate (called the “nominal” rate) is the percentage of the base paid in tax. The effective tax rate is the percentage of total income paid in tax. Since the tax base is not always total income, the nominal rate and the effective rate may not be the same. Taxes are classified by economists as being progressive if the effective rate increases as income increases, i.e. the rich pay a higher percentage of their income in tax than do the poor; as proportional if the effective rate is the same for all taxpayers; and as regressive if the effective rate decreases as income increases, i.e. the poor pay a higher percentage of their income in tax than do the rich.
While few people would argue in favor of a regressive tax system, the majority of taxes collected in the U.S. (including property, sales, and Social Security taxes) are regressive in their impact, while only the income and estate taxes are considered to be progressive. No taxes are proportional. Economists tend to favor progressive taxes, while many individuals (especially the rich) favor a proportional system. And most taxes are confusing since they have a proportional rate structure (like sales and Social Security taxes) combined with a declining base so the result is a regressive tax. But the federal income tax has a progressive rate structure and a base so confusing that it is impossible to classify. And that confusion makes it easy for politicians to structure a tax system that seems to distribute the tax burdens very differently than it really does.
The U.S. income tax has always had a progressive rate structure, with higher marginal rates for the rich than for the poor. Prior to the Kennedy tax cut of 1964 the highest marginal rate was 91 percent, but was lowered to 70 percent by the 1964 law, to 50 percent by the Reagan Economic Recovery Tax Act, and to 35 percent by the Bush tax cut in 2003. But the rich learned early that high rates were burdensome only if you had income subject to those rates. By having Congress vote to exclude certain income from the tax base, the high rates were meaningless. This led to the creation of what came to be called tax loopholes, or legal ways of reducing the base to avoid the payment of tax. All taxpayers receive benefits from loopholes in the form of personal exemptions and standard or itemized deductions, but for many years the most lucrative loopholes were those received by the very rich. Tax shelters and capital gains treatment are just two of the ways the rich have been able to pay substantially less in tax than the high rates seemed to imply.
Those who believe in the logic and tools of trickledown believe in the operation of the market economy and the ability of the market to regulate, to allocate efficiently, and to prevent the creation and adverse consequences of economic power concentrated in the hands of a few. They see the wealthy as the engines of society, providing the means for growth, jobs, and general prosperity for all. They do not see trickledown as just a vehicle to improve the lot of the rich, but rather as a means to eventually benefit all. But the initial shift must be to increase the wealth and incomes of those who have the knowledge and willingness to use it wisely. And they always hold out the incentive that in such an economic system, anyone who has the right combination of abilities and opportunities can join that select group.
Critics of trickledown see the whole process as a charade, a facade for increasing the power and wealth of the few at the expense of the many. At the very best they see a process that will take years to provide the benefits promised to the masses, but at the worst they see shifting economic and political power toward those who initially benefit, and who keep the benefits under tight control.
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