The “Trickle Down” Economics Straw Man

Among the suggestions being made for getting the American economy moving up again is a reduction in the capital gains tax. But any such suggestion makes people on the left go ballistic. It is “trickle down” economics, they cry.

Liberals claim that those who favor tax cuts and a free market want to help the rich first, hoping that the benefits they receive will eventually trickle down to the masses of ordinary people. But there has never been any school of economists who believed in a trickle down theory. No such theory can be found in even the most voluminous and learned books on the history of economics. It is a straw man.

This straw man is not confined to the United States. A critic of India’s change from a government-dominated economy to more free market activity in the 1990s accused those behind this change of having “blind faith in the ‘trickle-down’ theory of distributing the benefits of economic growth among different socio-economic groups in the country.” But free-market economics is not about “distributing” anything to anybody. It is about letting people earn whatever they can from voluntary transactions with other people.

Those who imagine that profits first benefit business owners — and that benefits only belatedly trickle down to workers — have the sequence completely backward. When an investment is made, whether to build a railroad or to open a new restaurant, the first money is spent hiring people to do the work. Without that, nothing happens.

Money goes out first to pay expenses first and then comes back as profits later — if at all. The high rate of failure of new businesses makes painfully clear that there is nothing inevitable about the money coming back.

Even with successful businesses, years can elapse between the initial investment and the return of earnings. From the time when an oil company begins spending money to explore for petroleum to the time when the first gasoline resulting from that exploration comes out of a pump at a filling station, a decade may have passed. In the meantime, all sorts of employees have been paid — geologists, engineers, refinery workers, truck drivers.

Nor is the oil industry unique. No one who begins publishing a newspaper expects to break even — much less make a profit — during the first year or two. But reporters and other members of the newspaper staff expect to be paid every payday, even while the paper shows only red ink on the bottom line.

In short, the sequence of payments is directly the opposite of what is assumed by those who talk about a “trickle-down” theory. As for capital gains, some countries don’t tax capital gains at all. They tax a business’ earnings, but not capital gains, which are harder to define and sometimes illusory.

The real effect of a reduction in the capital gains tax rate is that it opens the prospect — only the prospect — of greater future net profits. But that is enough to provide incentives for making current investments. Reductions in the capital gains tax rate tend to draw money out of tax shelters like municipal bonds and into creating jobs and productive capacity. That’s the point!

As with all taxes, a distinction must be made between tax rates and tax revenues. Tax revenues went up while tax rates went down in the 1980s. Similarly in the 1960s and the 1920s. That is because incomes rose more than tax rates fell. But still it will be claimed that we cannot “afford” to cut tax rates because it would create deficits. Spending creates deficits — and it is big spenders who fight hardest against cutting tax rates.

It is not faith but empirical evidence that is overwhelming on the actual track record of tax cuts and free markets. By the 1980s, this mounting evidence convinced even left-wing governments in various parts of the world to cut back government operations and sell government-owned enterprises to private industry. Faith had nothing to do with it.

In India, in the decade since the 1991 economic reforms which were condemned as “blind faith,” the country’s economic growth rate has soared. It has been estimated that the real blind faith — in government planning — had cost the average Indian hundreds of dollars a year in income during the decades when socialist dogma ruled. In a poor country like India, this was income they could not afford to miss. Even in a prosperous country like the United States, there is no need to forego economic benefits for the sake of a political phrase.

  • Recupero Faizal

    Nicely said as usual!

  • Fred Chittenden

    Liberals would think differently if the public unions, burros, and politicians were required to have market based pensions, instead of non-market based defined benefit pensions. Defined benefit pensions insulate liberals from the effects of high taxes and regulations with guaranteed benefits no matter how much they screw up the private sector prosperity.

    Liberal high tax and regulation baloney is a direct symptom of this policy. Change the policy for pensions to market based defined contributions 401ks and Detroit bankruptcies won’t happen, plus there will be a strong and persistent push by most of everyone across the political spectrum to reduce taxes and regulations — high taxes and regulations hurt private sector growth that fund pensions.

  • Brian Hughes

    “Tax revenues went up while tax rates went down in the 1980s. Similarly in the 1960s and the 1920s.”

    And more recently than that. Revenues increased following the Bush tax cuts, too, led by an almost unimaginable jump in capital gains taxes.

  • The Guru

    Well there is one huge part of this that nobody talks about. Financial independence for most people historically came from a 3 legged stool: Pensions, Social Security, and Investments.

    Long gone are the days of pensions and who knows if social security will even be around in 25-40 years. That leaves us with our investments. People do not become rich or move up the socioeconomic ladder working 9-5, they just don’t. When liberals attack investments and capital gains, they are just hamstringing EVERYONE’s ability (even the poor) to prosper.

  • Callawyn

    Brilliant, as usual. Thankyou!

  • historyspeaks10

    oh mr. sowell, please bring yourself to see a scintilla of reality for a moment.

    i am sure we agree that not everyone can be a business owner and organize and manage a successful business to return a profit for the owner/starter of the business. we agree that the company must employ people, some have an army of employees, numbering into the thousands, like GM, GE and others.

    yet on the same hand, not everyone can run and operate an asphalt plant, but we all want nice roads to drive on. not everyone can drive a 18 wheeler semi to deliver the fruits and vegetable that you eat every day. not everyone can be the wastewater technician at your local city’s plant, but we all want clean water to come into our homes and the dirty stuff to go away.

    when the people at the bottom feel that its become a plutocracy and the elite rule the day, these minions at the bottom you so despise will quit delivering your food, cleaning your water and building your roads. does not the downfall of Rome not ring a bell?

    was it the greedy union worker on the chariot that brought down roman society or was it the reckless, misguided management at the top? walk a mile in a mans shoes before you cast a scornful eye and throw stones at those you think are beneath you. remember the days when kings had people taste their food before they would eat it? history repeats itself over and over particularly to those that have failed to heed its advice.

  • historyspeaks10

    under GWB, the USA created the TSA, a huge government agency, started two wars while cutting taxes and then initiated TARP because as GWB said it himself, he had to “violate the laws of the free market in order to save the free market.” its on youtube.

    right wing wackoism.

  • writeby

    Bush made Obama possible (Obama’s shredding further the Constitution via the IRS, NSA, etc; his massive spending deficits, his Presidential edicts, etc.). Along with what you mention, don’t forget, too, GWB signed into law the largest increase in funding since LBJ with GWB’s Medicare prescription bill.

    So, what’s right wing and what’s left wing today? Repubs spend like drunken sailors while cutting taxes; Dems do double the same while raising taxes. Both wind up creating trillions in debt.

    As in Orwell’s _Animal Farm_, one begins to look like the other. And as alternative we’re offered the theocracy of (what’s left of) the Tea Party and the anarchy of Libertarianism.

    Why not try what’s never been tried? Pure capitalism under a truly limited (by rights) republic politics, in which property rights–beginning with one’s mind & body (i.e., one’s life (of those who actually *are* alive)–are strictly enforced?

    “I believe totally in a capitalist system, I only wish that someone would try it” -Frank Lloyd Wright