Trickle-down economics was very much in vogue on the political right in the 1980s, when Ronald Reagan in the United States and Margaret Thatcher championed the idea. It resurfaced in America under George W Bush and Donald Trump, and it is currently experiencing a revival in Britain under the new Prime Minister, Liz Truss.
The theory of trickle-down economics is simple. Governments should cut taxes for the wealthy and for businesses, as this is the key to faster growth. Entrepreneurs are more likely to start and grow businesses, businesses are more likely to invest, and banks will tend to increase lending if they pay less tax.
Initially, the beneficiaries are the rich, but gradually everyone wins because, as the economy grows, well-paying jobs are created for the workers. Governments should stop focusing on how the economic pie is distributed and instead focus on growing the pie.
Proponents of trickle down often cite the work of American economist Arthur Laffer as evidence that the theory works. Laffer said tax cuts for the wealthy had a powerful multiplier effect and any loss of revenue by governments due to lower tax rates would be more than offset by the fruits of higher growth.
Truss uses this argument to justify the £30billion in tax cuts to be announced in Kwasi Kwarteng’s mini budget on Friday, although Laffer was clear his theory worked best when personal tax rates were prohibitive , i.e. between 50% and 100%. At rates below 50%, Laffer found that cutting taxes led to larger rather than smaller budget deficits.
In practice, the runoff did not go as planned. Reagan and Bush cut taxes on high earners, but inequality soared: between 1979 and 2005, the incomes of the top 1% tripled, while those of the bottom 20% only increased by 6%. It was more of an upward trickle than a downward trickle.
Additionally, Reagan’s combination of tax cuts for the wealthy and a large increase in defense spending led to a threefold increase in US federal government debt between 1981 and 1989. The US economy experienced a strong growth during the last years of the Reagan presidency, but it was a time not only of higher military spending, but also of cheaper borrowing after the extremely high interest rates of the early 1980s.
In a 2015 assessment, the International Monetary Fund dismissed the fallout and said governments should instead focus on policies that would directly help low- and middle-income people.
“We find that increasing the income share of the poor and middle class actually increases growth, while an increase in the income share of the top 20% leads to lower growth – this is that is, when the rich get richer, the benefits don’t trickle down,” the IMF said. “This suggests that policies need to be country-specific, but should focus on increasing the income share of the poor and ensuring that there is no burnout of the middle class.” Joe Biden agrees.