The reality of trickle-down economics
Reinhold Liu
‘ Trickle-down economics ’ was introduced by Arthur Laffer as a theory for triggering economic growth, which suggests that reducing income tax rates for the wealthier tax brackets, as well as a reduction in corporate income tax, can incentivize the corporate sector and the wealthy to consume or to invest in the economy as they will have more money remaining post-tax. Since more consumption (C) and investment (I) are both components that contribute to higher Aggregate Demand (AD), 1 which means in principle the trickle-down theory will boost AD, which directly contributes to economic growth. In this essay, I shall attempt to assess the impact of Ronald Reagan’s tax cuts on economic growth , 2 as well as examine why Liz Truss and Kwasi Kwarteng’s ‘ Mini-Budget ’ tax cut policy failed. In 2022 when Liz Truss was UK Prime Minister, she vowed to bring back economic stability to the country through a massive tax cut package, reminiscent of the ‘ trickle-down ’ theory, to stimulate the UK economy. Her Chancellor at the time, Kwasi Kwarteng, put forward the notion that high corporate and income tax rates were obstructing people’s incentive to work and were hindering the growth of the country. A ‘ growth plan ’ was announced which involved £45 billion of corporate and income tax cuts aimed at the wealthy, claiming that the tax cuts could incentivize investment and consumption. The realities were stark as the pound fell to a 50-year record low against the US dollar, since the general feeling was that the government did not have the fiscal capacity to deliver the cuts. Such a policy was also likely to increase inequality in the long term, as the wealthy would receive a larger share of ‘ the pie ’ . Given that the Gini Coefficient of the UK was already at 0.345 – incredibly near the threshold of 0.4 which is considered as ‘ very high inequality ’ – that was a worrying prospect. In addition, interest rates also soared after BoE intervention, which ironically made it cost more for businesses to borrow, while shrinking bond yields made everyone’s mortgages more expensive. The harsh reality was that delivering such huge tax cuts implies enormous fiscal stress, which exerts uncertainty on future government spending capabilities. Sacrificing fiscal stability solely for funding a tax cut package is viewed negatively in financial markets, and this will force the central bank to intervene, just as the Bank of England did. It was evident that the trickle-down theory not only failed to kickstart economic growth, but it lost the confidence of global investors and pushed the UK economy into mayhem. These immediate backlashes halted the policy before its effectiveness could be evaluated further, though I remain skeptical of its effectiveness.
It is equally important to consider the economic and political context at the time. Truss was the third Conservative Prime Minister in five years, with her predecessors Theresa May and Boris Johnson being ousted for Brexit and Covid respectively – and the country hasn’t recovered economically since. The
1 Aggregate Demand (AD) = C + I + G + (X – M), see https://www.econlib.org/library/Topics/Details/aggregatedemand.html. 2 Reagan’s Tax Cuts refer to The Economic Recovery Act of 1981; see https://www.congress.gov/bill/97th- congress/house-bill/4242 .
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