Tuesday, November 14, 2017

Trickle Down Tax Policy

Last week I wrote about the Tower of Babel we call tax reform. The main point was the incredible lack of clarity when it comes to changing or reforming taxes. Given all the deductions and other special preferences and the many conflicting goals of tax change, it is very easy to never meet a tax change you ever liked. It is hard to see how legislative progress can be made and even with it, how it might have a discernible positive impact on the country.

But there is even more to the story that I came across in some remarks I read by critics under the rubric of “trickle down”. As an elderly gentleman, I try not to be offended by terms like trickle down, but as an economist I get annoyed when I hear people throwing those terms around. These words are the heart of an argument made by those who are primarily motivated by issues of distribution of income. Trickle down is vivid. A lovely flow of benefits come to the rich folks and by the time they are finished gorging themselves, a couple of drops trickle down to the poor. We could switch the analogy to a lovely and delicious cake consumed by royalty with nothing left but a few crumbs for everyone else. But whether it is a trickle of water or a few nasty crumbs, the point is the same. It is all about how any policy tilts the flow of income or benefits towards the rich. No matter what the intended impacts of the policy might be, all we hear about is trickle trickle trickle.

Common sense allows for the possibility that the true or full impact of a policy could differ from its initial incidence. Let’s suppose a professional team has always done poorly. Its players are paid commensurately. Then the owner decides to bid for a new quarterback. The immediate impact is the apparent unfairness as the new player makes much more money than the others. If the new QB is as good as heralded, the team will win the championship and all the players get bonuses and a big raise. The ultimate impact is what counts despite the apparent unfairness of the initial one. While it is true that these other players still earn considerably less than the handsome, young, sensation with TV contracts and important friends, they are making more than they did before and most would not vote to fire the new player.

Think about one of the many elements of tax reform – significantly reducing the rate of taxation on corporate profits. The immediate impact is easy to envision – a bunch of very rich company owners or stockholders in their condominiums in Vail smoking fine cigars and drinking Spanish brandy. While I cannot deny that owners of corporations will get richer, there is obviously more to the story. Think accounting. I was not a stellar accounting student in Professor Gamoneda’s class at Georgia Tech in 1966, but I do know that if you apply a smaller tax rate to a company’s profits, the company has some additional money to play with. What can that company do with that extra money afforded by the lower tax rate? Here are some examples in no particular order:

            Bribe a government official
            Give it to the owners
            Give it to the employees
            Give a new or improved benefit to employees 
            Add a new wing to the factory
            Buy new production equipment
            Buy new software
            Lower price to get a competitive advantage
            Give more to the local Boys and Girls Club
            Pay off debt faster
            Save it
            Give it to Larry

I am sure I missed something in that list but you get the point. It is tempting, and there might be times when giving most of the extra proceeds to the owners might make sense. But most companies have to compete, and it is pretty clear that they will spend a lot of money to gain an advantage over their adversaries. 

Though this list is long, keep in mind that if your concern is employees, many of those items in the list contain indirect impacts on the incomes of those employees. Any expense – whether it is to better train the employee or it gives that person better equipment to work with  should result in higher productivity. Higher productivity makes it easier for firms to pay them more.

The above can be extrapolated to any element of tax change. There is an immediate and obvious impact followed by less certain and/or less obvious ones. If a tax cut for a higher income person leads to more saving and lower interest rates, that might reduce what a middle income person pays to borrow for a house or a car. Maybe you want to call that trickle down. I just call it economics. To ignore these subsequent but undeniable impacts is folly. 

It is very bad economics to pretend that the only impacts of a tax change make rich people richer and poor people poorer. My advice for those of us who care about the income distribution and poverty is to quit harping on tax reform and spend a few minutes focusing on the real problems that prevent people from leaving poverty status. Or maybe that is too hard to do. If Lyndon Johnson were around and saw the results of his War on Poverty, he might wonder who won the war. 


  1. When Jim Kelly of the Bills was hired in 1986 the players were outraged at his salary-- except for Fred Smerlas who happened to be the biggest guy on the team. He got everyone but Kelly together in the stadium and told them without Kelly we put this many people in the stands -which was about half the stadium. Then he said with Kelly we got the other half. The players got the point and enthusiastically went to four Superbowls in a row--

    1. Thanks Mr Yachts. And I am guessing the appearances at those Superbowls was good for the salaries of the other players...

  2. There is a precise process for a business to create more jobs or robots to do those jobs.....get more sales which is invest more in marketing and in making the production of service or product more efficient. Those sales have to bring in income that is disproportional to the norm. Then hold price so the margins increase or stay the same. This is done in the light of competition and or changing market technology which shifts demand. The efficiency of labor and machines has been done by out sourcing or offshoring. If you accept the fact that we all work in a global economy which has and will continue to have technology changes, then educated manpower is important....education has suffered over the past 25 years as the quality in the US is ranked below 10 countries in the G20. so maybe some of those taxes are needed to strengthen this necessary part of the algorithm. Assuming all of the above work....do we really trust self serving politicians to also help the middle and upper middle class....after all it takes a while for all of this trickling to happen....even if it is politically clean. I believe it can but the answer is to attached to the tax laws specific that each point along the trickle is forced to comply and not have dozens of loopholes as the proposed bill implies. By itself in my mind it will not produce jobs. BTW all may not realize that the Senate's version increases tax on the $80K to $200K sector who are the mid level managers and what used to be called the middle class. This tax bracket has been called the "hole in the doughnut " since the Reagan years.

    1. Nice discussion Hoot. The problem is that even if the government go more focused and tried to improve education so as to improve labor's share of income. I doubt they could do it. They care so much about simple redistribution schemes that they don't care or know a bit about how to use education policy to produce a more productive workforce.

  3. Dear LSD. You ask, “Can tax reform be used to improve the economic situation of a nation’s citizens?” I think it can. But there are caveats. Trickle down, aka voodoo economics, in theory looks good but several circumstances need to accompany or follow. My memory/facts may be off a little, but Reagan’s tax cuts resulted in increased deficit/debt due to highway construction costs, increased military spending to defeat Russia, and Congress not reducing other spending as they had promised. The story is that his economy grew nicely (not necessarily directly from “trickle down” as other factors helped, too) despite spending exceeding revenue. Note that he also had to subsequently increase taxes to mitigate the deficit spending.

    Today’s tax cut proponents say it’s a cut for the middle class, that jobs will be created, the economy will grow significantly, and that the economic growth will offset part of the increase to the already $20T debt—that the growth will reduce the debt-to-GDP ratio from 106% to a more “sustainable” level. Never mind that the actual dollar debt will continue to linger like an unwanted and unclaimed stinky for posterity to clean up—unless tax revenues increase very substantially. As much as I’d like to see that I think a lot of voodoo will be needed to make it happen.

    How can there be a tax cut for the middle class when 50% don’t pay any federal income tax now? Doubling the standard deduction, increasing the child tax credit, and lower marginal rates likely will increase that 50%. Whatever jobs creation there is had better be good, high-paying jobs—otherwise the alleged growth in tax receipts to offset the increase in the debt will falter and income disparity will continue. Robust growth will cause interest rates to rise, thus increasing U.S. debt service and creating a drag on that growth—Kevin Brady and Paul Ryan haven’t mentioned these likelihoods.

    I like the characterization that this “tax reform” is nothing but rearranging the deck chairs and when the music stops all sit down and pat yourselves on the back. I wish it weren’t so. I do hope this “tax reform” improves the economic situations of citizens despite the issues I mentioned. Hope is eternal despite not buying Brady’s and Ryan’s promos hook, line, and sinker. Com’on voodoo, work your black magic to align the right circumstances—especially and primarily good high-paying jobs.

    1. Nice work Tuna. The part I want to comment on is the difference between tax cuts and tax reform. Tax cuts are often designed to get people to spend more. Today the problem is not too little demand -- it is too little supply. Tax cuts are often proposed to redistribute income. But government spending is actually better at that than tax cuts. Tax reform is more focused on what we call the supply side. It is not meant to get people to spend more and it is not designed to improve the distribution of income. Rather, tax reform is more about creating incentives for more investment, productivity, and economic growth. Unfortunately our government reps are mixing tax cuts with tax reform and the end result will be an unrecognizable stew with mostly unintended consequences. Of course, they are most likely going to make the national debt even bigger and as you say this will be a drag on growth. There is not much to hope for here. Luckily you have lovely restaurants and bars in your neighborhood and a gout-affected buddy who you can commiserate with.