Taxes and Trickle-Down: Challenging Economic Misconceptions

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Often have I heard that “Trickle down economics doesn’t work” thrown around, usually by those who have done little, if any, actual research into economics and the function of tax incentives. To view this in a North American lens, these are usually the sort of people who have never even so much as heard of the Laffer curve that hold court over fundamental economic policy, while patting themselves on the back about how “Democrats always manage a better economy”.

While there can be no doubt that deregulation taken to the extreme can lead to perfidious situations, where banks are allowed to gamble away the savings of their customers on sub-prime mortgages, or encourage lending and credit in the extreme to desperate communities that aren’t capable of paying back the interest owed, this does not necessarily mean that Republican tax policies are wrong when one comes to understand the nature of tax incentive.

Understanding supply-side economics, or “trickle-down economics” as it is often jokingly called, comes first through examining what is meant by the term. Initially brought forward by President Ronald Reagan as an answer to the stagflation problem of the 1970’s, believed to be caused by President Nixon’s mishandling of wage and price controls, as well as the 1973 oil crisis, “Reaganomics” as it is often referred to, was the practice of cutting taxes to incentivize business growth, and to lessen the burden of starting up new businesses.

This was done with the hope of encouraging new growth in the economy, which did indeed happen. Coming out of the slump in the 70s, Reagan provided new life to middle America, causing a boom of growth. This was done with the hope that by allowing new businesses the means to take off, through lessening the burden that they suffered, that more tax revenue would result.

This is understood by acknowledging that in the relationship of tax rates, there is a point at which raising taxes produces less net tax income than lowering them does, due to economic incentives to avoid paying taxes being more lucrative than doing business in a place with higher tax rates. This phenomenon, as earlier mentioned, is measured by what is called the “Laffer curve”. The term in question was coined by Jude Wanniski following a meeting with economist Arthur Laffer, though Ibn Khaldun and others first noted the phenomenon centuries before Laffer, which he has acknowledged

Of course, the major problem with Reagan’s policy at the time was that even though he had cut taxes, he did not account for the fact that government spending had not been properly adjusted to account for the lack of income that the government was receiving in the meantime. Despite cutting various social programs, Reagan invested massively in the US Military, so much so that he ballooned the US deficit three times over within six short years.

It must logically follow that cutting tax revenue will always hurt the deficit if we accept that the government is spending all of the tax money that it is bringing in, and that it must borrow to continue the programs that it is running. However, we must also recognize that running a deficit should be avoided when at all possible. It is far from responsible fiscal planning to let the debt of a country grow out of control as it has in recent years, or worse yet, to encourage the growth of the national debt, simply because interest rates are low. One does not borrow one’s way out of debt.

There are of course benefits that come with cutting taxes; unemployment tends to fall. Interest rates tend to go down (at first at least) and investment tends to increase. Of course, this can lead to inflation rates rising as workers demand pay raises, once skilled labor becomes more scarce and workers become harder to replace. With newfound money, workers then drive up the price of goods by purchasing more, which then leads to lack of supply, further driving scarcity of the resources, which naturally leads to a market recession over time.

With that said, the opposite is also true; when raising taxes, there are benefits, but there are also costs.

If we look at the example of the Second World War, tax rates in the United States were as high as they have ever been, with the marginal tax rate on income over $200,000 (2.5 Million adjusted for inflation) was 94%. This also corresponded with the greatest period of economic growth in America’s history, quite possibly owing to the fact that money was changing hands so much, because the government was involved in all-out war and thus had to keep funneling the money they brought in on defense, which then further fed the growth of the Military Industrial Complex, as it is today often referred to.

Then again, without the threat of imminent extinction from an enemy keeping the country and her people loyal, there can be problems with excessive taxation. Unemployment goes up, as employers are no longer able to offer to pay as much out in order to keep quarterly profits up for the sake of shareholders and investors, and thus seek to cut corners by laying off non-essential staff and consolidating duties.

If taxes go up too much, it can cause economic flight, where some companies will simply pick up their roots and move to a new area where tax rates are lower, to ensure that they are still earning what they feel like they deserve/what they need in order to maintain profitability.

Higher taxes can also provide a disincentive to new start-ups and business owners, who would not be interested in taking out a high-interest loan while also being expected to pay such a hefty chunk of their profit margin in tax. These sorts of controls over the market may lead to a temporary increase in tax revenue, but over time, they lead to economic stagnation and a growth in unemployment.

That said, so long as the government is pulling in enough to keep programs paid for, it will look good in terms keeping the deficit down, even if it incentivizes businesses to search for ways to cut corners on labor costs, like automating, outsourcing, or by hiring cheaper labor wherever possible.

In reality, all of these factors are a delicate balance; there is no one simple solution that makes an economy magically better or worse. Everything is interconnected and has payoffs and dividends that will make their effects felt at some time, either in the short or long term.

The point I hope that I have addressed here is that raising or lowering taxes are both ideas that have merits depending on the scenario in question, and that these ideas are not so simple as one is good, and one is evil. Running a budget surplus is preferable, but not if it causes the GDP of the nation to fall into stagnation or to decline. Likewise, cutting taxes is preferable, but not if it causes the debt to skyrocket out of control.

These ideas of economic policy do not exist within a vacuum and require more forethought and much more engagement than simply writing one idea off because the party that you don’t like adopts it as part of their platform. People would do well to understand, and see eye-to-eye with others as to why they seek the solutions that they do, and try to compromise on the problems that both sides inevitably face as a result.