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Thursday, April 12, 2007

Robert Frank: Trickle-Down Theories Don’t Hold Up

Speaking of supply-side economics and trickle-down, Robert Frank explains that trickle-down theory, which says that higher taxes on the wealthy will reduce incentives causing lower growth and hence lower employment and income generally, "is supported neither by theory nor evidence." Thus, contrary to what its proponents argue, trickle-down theory does not provide a valid objection to a more progressive tax code:

In the Real World of Work and Wages, Trickle-Down Theories Don’t Hold Up, by Robert Frank, Economic Scene, NY Times: When asked why he robbed banks, Willie Sutton famously replied, “Because that’s where the money is.” The same logic explains the call by John Edwards, the Democratic presidential candidate, for higher taxes on top earners to underwrite ... universal health coverage.

Providing universal coverage will be expensive. With the median wage, adjusted for inflation, lower now than in 1980, most middle-class families cannot afford additional taxes. In contrast, the top tenth of 1 percent of earners today make about four times as much as in 1980, while those higher up have enjoyed even larger gains. ... In short, top earners are where the money is. Universal health coverage cannot happen unless they pay higher taxes.

Trickle-down theorists are quick to object that higher taxes would cause top earners to work less and take fewer risks, thereby stifling economic growth. ... On close examination, however, this claim is supported neither by economic theory nor by empirical evidence.

The surface plausibility of trickle-down theory owes much to the fact that it appears to follow from the ... belief that people respond to incentives. Because higher taxes on top earners reduce the reward for effort, it seems reasonable that they would induce people to work less... As every economics textbook makes clear, however, a decline in after-tax wages also exerts a second, opposing effect. By making people feel poorer, it provides them with an incentive to recoup their income loss by working harder than before. Economic theory says nothing about which of these offsetting effects may dominate.

If economic theory is unkind to trickle-down proponents, the lessons of experience are downright brutal. If lower real wages induce people to work shorter hours, then the opposite should be true when real wages increase. According to trickle-down theory, then, the cumulative effect of the last century’s sharp rise in real wages should have been a significant increase in hours worked. In fact, however, the workweek is much shorter now than in 1900.

Trickle-down theory also predicts shorter workweeks in countries with lower real after-tax pay rates. Yet here, too, the numbers tell a different story. ...

Trickle-down theory also predicts a positive correlation between inequality and economic growth, the idea being that income disparities strengthen motivation to get ahead. Yet ... researchers ... find a negative correlation. In the decades immediately after World War II, for example, income inequality was low by historical standards, yet growth rates in most industrial countries were extremely high. In contrast, growth rates have been only about half as large in the years since 1973, a period in which inequality has been steadily rising.

The same pattern has been observed in cross-national data. ... Again and again, the observed pattern is the opposite of the one predicted by trickle-down theory.

The trickle-down theorist’s view of the world ... bears little resemblance to reality. In the 1950s, American executives earned far lower salaries and faced substantially higher marginal tax rates... Yet most of them competed energetically for higher rungs on the corporate ladder. The claim that slightly higher tax rates would cause today’s executives to abandon that quest is simply not credible.

In the United States, trickle-down theory’s insistence that a more progressive tax structure would compromise economic growth has long blocked attempts to provide valued public services. Thus, although every other industrial country provides universal health coverage, trickle-down theorists insist that the wealthiest country on earth cannot afford to do so. Elizabeth Edwards faces her battle with cancer with the full support of the world’s most advanced medical system, yet millions of other Americans face similar battles without even minimal access to that system.

Low- and middle-income families are not the only ones who have been harmed by our inability to provide valued public services. For example, rich and poor alike would benefit from an expansion of the Energy Department’s program to secure stockpiles of nuclear materials that remain poorly guarded in the former Soviet Union. Instead, the Bush administration has cut this program, even as terrorists actively seek to acquire nuclear weaponry.

The rich are where the money is. Many top earners would willingly pay higher taxes for public services that promise high value. Yet trickle-down theory, which is supported neither by theory nor evidence, continues to stand in the way. This theory is ripe for abandonment.

Here's a simple way to show that a an increase in taxes does not necessarily reduce effort. Suppose you have a summer job and you have to earn $2,000 for the summer. You don't need to earn any more than that, and don't plan to, but it is a necessity that you reach this goal. Also suppose that you have a job paying $10 per hour so that you can earn the money in 200 hours, or five 40 hour weeks. Let taxes be zero initially.

Now let the government tax you at 50%, surely enough to reduce effort. But in this case it won't. Instead, you will now work twice as long, 10 weeks or 400 hours at $5 per hour, in order to reach your goal of $2,000. So in this example, a tax of 50% doubles work effort rather than reducing it.

This is, of course, a special case and it is possible in the more general framework for the opposite to happen, i.e. for a reduction in the take-home wage to reduce effort, though as noted above the evidence is against the trickle-down story. But this does show clearly that the claim that higher taxes will reduce effort is not necessarily correct. If there is a strong incentive to recover income losses after an increase in the tax rate, effort will increase in contradiction to the trickle-down claims.

    Posted by on Thursday, April 12, 2007 at 12:06 AM in Economics, Health Care, Income Distribution, Taxes | Permalink  TrackBack (1)  Comments (45)



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