Trickle Economics

Keith Rankin, 27 November 1998


With Roger Kerr and others (John Roughan column, 27 November) questioning the notion that "trickle-down" economics ever existed, it is opportune to take stock of one of the dominant ideas in the 1980s that was peddled by people who American economist Paul Krugman calls "policy entrepreneurs".

Trickle-down is simply a pejorative term for "supply-side economics", which was one of the central tenets of Reaganomics. Of course nobody espousing supply-side economics used the term "trickle-down", simply because it was coined as a pejorative term by the sceptics.

The 1980s' fad of supply-side economics is described in Dr Krugman's 1994 book Peddling Prosperity. In the United States, where only two academic economists promoted the idea, it was the subject of a crusade on the part of the business press. In New Zealand, the supply-side philosophy of the Wall Street Journal underpinned Roger Douglas's crusade for a flat rate of income tax set at around 23%.

Supply-side economics was based on the claim that tax cuts for the rich would increase rather than decrease total tax revenue. The corollary was that, following tax cuts, all would be better off as a consequence of both extra spending by the rich and extra spending by the government. Inspired by this piece of economic alchemy, the United States' government - through programmes such as "Star Wars" - managed to run budget deficits in the good years as well as the bad. By way of contrast, the Hawke-Keating government in Australia was running substantial budget surpluses in the late 1980s by following more orthodox fiscal policies.

The central theoretical insight of supply-side economics is a construct called the "Laffer Curve". The idea was that if you raised tax rates beyond a certain point, then people would work less and tax revenue would fall.

The Laffer Curve was introduced into the economic literature during the years in which most developed countries had income tax rates in excess of 50%. In the 1980s, the supply-siders, taking the converse position from the original theorem, claimed that cutting top tax rates from 40 something percent to around 30 percent would lead to an escalation of economic growth and to an increase in tax revenue. Needless to say, it didn't happen.

There is, however, an area where the insights of the Laffer Curve can be usefully applied. It relates to the situation of beneficiaries and workers on below-average wages supporting children. In New Zealand in the 1990s, many of our poor face "effective marginal tax rates" in excess of 70% and occasionally in excess of 100%. That means that, for every extra dollar earned, they lose over 70 cents in taxes, benefit claw-backs and levies such as child support and student loan repayments.

The reduction of benefit abatement rates can have the effect of cutting social welfare costs, while also increasing the disposable incomes of the poor. As a result, lower income recipients can then spend more, which means more profits to those who make and sell the goods and services that ordinary New Zealanders buy. Trickle-up can work.

In addition to increasing the demand for goods and services, relief for those on low incomes enables them to save more, and to repay debts. Indeed it did work in a quite spectacular fashion in New Zealand in the late 1930s, during the Prime Ministership of Michael Joseph Savage. The stimulus from restored wage and increased social wage expenditure was in fact much more than a trickle.

The Laffer Curve theory only applies to people facing effective tax rates on additional income in the order of 70%. In 1988 in New Zealand, the big cut in the top rate of tax from 48% to 33%, which gave huge cash windfalls to a small number of well-paid people, could not be justified by the theory. People in the top income decile were enabled to work less, thanks to that windfall.

In New Zealand today, there are still people who advocate supply-side economics. In fact the tax cuts of 1996 and 1998 were a reflection of such beliefs. 1990s' supply-siders are those people who simultaneously favour "fiscal responsibility" (meaning budget surpluses) and tax cuts. They are those people who believe in cutting social wage expenditure as a means to maintain at least a balanced budget, while arguing that increased disposable income in the hands of the top quintile of income earners will lead to the creation of more jobs.

The reality is that the trickle-up policies of Mickey Savage and Walter Nash in the 1930s did generate more public revenue and more private income to the rich as well as to the poor. Furthermore, the combination of higher taxes and cheaper credit enabled many new businesses to flourish in the 1930s. That contrasts sharply with the risk-averse environment of New Zealand in the last ten years, in which low taxes protected well-established businesses while high interest rates made life extremely difficult for those seeking to start new businesses.

The trickle down - aka supply-side - policies of Ronald Reagan, Roger Douglas, Richard Prebble and Bill Birch, in contrast to those of Messers Savage and Nash, have led to diminished rates of economic growth, to dramatic increases in inequality, and to significant shortfalls of public revenue. Those policies were for real, even if the policymakers did not themselves use the term "trickle-down".


© 1998

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