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.