Few economic ideas have been as contentious as trickle-down economics. The belief that cutting taxes on the richest members of society boosts the economy became particularly prominent in the 1980s and motivated a series of tax reforms by President Ronald Reagan. The U.S. debate is typically divided along partisan lines, with Republicans claiming that cutting taxes on the rich is the key to wider economic prosperity and Democrats arguing that higher taxes on the affluent could raise revenue and reduce inequality.
This disagreement is not trivial. Over the last 50 years, it has led to substantial differences across administrations in tax policymaking.
This disagreement is not trivial. Over the last 50 years, it has led to substantial differences across administrations in tax policymaking. For instance, the Republicans’ Tax Cuts and Jobs Act of 2017 totaled around $1.5 trillion and disproportionally benefited the richest 20 percent of households, according to analysis from the nonpartisan Tax Policy Center. It was sold as “rocket fuel” for the U.S. economy by President Donald Trump, and Treasury Secretary Steven Mnuchin confidently stated that “the tax plan will pay for itself with economic growth.”
On the other side of the debate, President-elect Joe Biden has promised sweeping tax reform upon coming into office. He has pledged to raise corporation and capital gains taxes, increase taxes on household incomes above $400,000, and lower thresholds for inheritance and gift taxes. Whether these tax rises on the wealthy are implemented will likely depend on the results of the open Senate races in Georgia, but it’s clear Biden’s approach to taxing the rich will be diametrically opposed to Trump’s.
The academic literature has debated the effectiveness of trickle-down economics for some time. Recently, a growing body of evidence has shown that tax cuts for the rich do little to boost the economy. Reforms such as the Reagan tax cuts in the 1980s did not live up to their economic promises. Instead, decreasing taxes on the rich have gone hand in hand with soaring inequality.
Most of our knowledge on the economic consequences of tax cuts is based on specific countries and reforms. The academic debate has therefore been missing a more comprehensive study that looks at the effects across a broader range of countries and time periods. To address this gap, we constructed a new measure that combines important taxes on the rich including taxes on top incomes, capital and inheritances. We then looked at the economic effects of major tax cuts for the rich in the U.S. and 17 other advanced economies over a 50-year period, from 1965 to 2015.
The results show little evidence of trickle-down effects. We found that major tax cuts for the rich increase income inequality, with all the problems that brings, but do not provide offsetting gains in economic performance. More specifically, the income share of the richest 1 percent of individuals rises by 0.8 percentage points after a major tax cut for the rich. As a comparison, in the U.S. in 2016, the poorest 10 percent of income earners have a total income share of 1.8 percent. In contrast, we find no substantial, statistically significant effects on economic growth or unemployment in the short or medium term.
What do our results mean for tax policymaking in the United States in the post-coronavirus era? They strongly suggest that policymakers at all levels of the U.S. government should not cut taxes on wealthy individuals or corporations as a way to aid the economic recovery from the pandemic. Our research suggests this would deliver few benefits. It might also further damage the public finances.
The surge in government spending to combat the economic fallout from the Covid-19 pandemic has sharply deteriorated the government’s balance sheet.
The surge in government spending to combat the economic fallout from the Covid-19 pandemic has sharply deteriorated the government’s balance sheet. The federal deficit for the fiscal year ending Sept. 30 was a record $3.1 trillion and federal debt grew to greater than the size of the U.S. economy. And as Biden has proposed $5.4 trillion in new spending in the next decade across areas such as health care, education and housing, substantial tax rises might be needed to bring the federal government deficit and debt down to more sustainable levels.
Our analysis does not directly look at tax increases, because the past 50 years has overwhelmingly been a period of major reductions in taxes on the rich in the U.S. and the other advanced economies. There have simply been few instances of major tax hikes on the rich since 1965. When looking at those small number of cases, however, we do not find a negative effect on economic performance.
Coupled with our central finding that the economic rationale for keeping taxes on the rich low is weak, this suggests that once we are more firmly into the recovery phase from the pandemic, Biden and other governments across the advanced economies should not let worry about harming the economy stop them from raising taxes on the rich. Such reforms could help to ensure the sustainability of the public finances following the Covid-19 crisis.