History shows that bad economic ideas almost never die, especially when they serve the wealthy and powerful. There’s no better example of this truth than trickle-down tax cuts. As we write this, the Trump administration is teeing up a tax plan that slashes taxes for the wealthy and the corporate sector, does little for everyone else (repealing the Affordable Care Act actually raises taxes on some with low and moderate incomes), and stiffs the U.S. Treasury to the tune of $6.2 trillion, according to the Tax Policy Center’s estimates.
Evidence does not hurt this zombie. We and others have shown the lack of correlation between tax changes and the indices of growth—GDP, jobs, incomes—touted by the trickle downers. Among those claiming that Trump’s plan will spur economic growth are the same folks who told us that a trickle-down tax cut experiment in Kansas in 2013 would bring an “immediate and lasting boost” to the state’s economy. Four years later, that immediate and lasting boost has not only failed to materialize, but the opposite has happened: Kansas’s economy has grown more slowly than surrounding economies and the national average. The state’s bond rating has been downgraded and its budget can charitably be described as being in shambles.
And yet, the evidence invites a question: Why don’t trickle-down tax cuts work as advertised? After all, much mainstream economics argues that tax cuts are growth-inducing. Students of introductory economics learn that taxes create a wedge between the supply of and demand for investment, goods, and labor and, in so doing, distort the behavior of producers, workers, and consumers. While economists grant that some taxes are worse than others, in the basic model, taxes almost always knock economies off of their “optimal equilibrium,” creating “dead-weight losses.”
The core of the tax cutters’ argument is that rate cuts reduce the after-tax cost of the economy’s “supply-side” inputs: labor, capital, and other forms of investment. That in turn boosts those inputs’ use by producers, leading to more hiring, more investment, improved productivity, and faster growth. The gains will then trickle down to the jobs and incomes of low- and middle-income people.
There are three main reasons this story is wrong.
First, the logic is incomplete. It’s certainly true that lower tax rates increase the amount workers earn each hour on an after-tax basis, which may incentivize them to work more. At the same time, however, that extra take-home pay means they can work a bit less and maintain the same level of income. In theory, someone who valued higher income should be induced by the tax cut to ratchet up their hours, while someone who values more leisure time should do the opposite. The theory can’t tell us which incentive would dominate, and in real life, most people don’t get to set their work hours like this anyway.
That said, some empirical research finds that workers and investors do tend to substitute work and investment for leisure and savings in response to tax cuts more than they tend to make the reverse substitution, but it’s a mistake to assume that will always be the case.
A focus on these monetary incentives is also too simplistic, as it ignores social and personal reasons that drive people’s decision-making about work—views about self-worth, prestige, and relationships can be more consequential than economic factors.
Second, a particularly pernicious assumption of the supply-side canon is that all government spending is wasteful relative to private spending, which gives rise to the prediction that tax cuts offset by spending cuts must be pro-growth. That assumption is clearly wrong. While there are of course examples of wasteful government spending, similar examples abound in the private sector, too, and there are in fact numerous instances—retirement security and health care are two of the most illustrative—in which public spending is demonstrably more efficient than private spending in this country.
Research also indicates that economies with high-quality public goods, including infrastructure and education, are more productive than those without (see chapter 6 here). In fact, according to surveys, entrepreneurs care more about access to an educated workforce and high-quality public transportation than they do about taxes when they’re deciding where to open their businesses. By reducing the revenue available to fund schools and transit systems, hacking away at corporate tax rates in the name of competitiveness can thus ironically make states and countries significantly less business-friendly in the long run.
Third, supply-side tax cuts, such as those that Trump proposed, exacerbate both pre- and post-tax inequality, and there are at least two channels by which inequality can hurt growth. First, if most of the economy’s growth goes to those with a lower propensity to consume the marginal dollar (that is, the wealthy), that will reduce consumer spending, which constitutes 70 percent of our GDP. Second, there is research that connects high levels of inequality with macroeconomic instability, as middle-class income stagnation combines with cheap credit to drive up debt accumulation, which is precisely what occurred during the housing bubble. If the credit bubble is large enough, as the housing bubble was, when it bursts it can lead to a devastating recession, as the housing bubble did.
To be clear, especially in the age of “alternative facts,” we recognize that research and evidence are not driving the tax debate (nor any other key debate, for that matter). But in our experience, there are a lot of people out there who instinctively know that trickle-down is garbage economics. If that describes you, then be assured: You’re right, they’re wrong.