Defenders of the trickle-down hypothesis frequently employ what my Crooked Tmber co-blogger John Holbo calls the

‘the two-step of terrific triviality’. Say something that is ambiguous between something so strong it is absurd and so weak that it would be absurd even to mention it. When attacked, hop from foot to foot as necessary, keeping a serious expression on your face.

The self-evidently weak version of the trickle-down theory starts with the observation that we all benefit, in all kinds of ways, from living in an advanced industrial society, with access to modern medical care, consumer goods, the Internet and so on. Stretched widely enough, the term ‘capitalism’ includes all advanced industrial societies, from Scandinavian social democracies to the Hong Kong version of laissez-faire. So, in this sense, the benefits of capitalism have trickled down to everyone.

The strong version of the claim is obtained by shifting the meaning of ‘capitalism’ to mean ‘the free-market version of capitalism favored by market liberals’. Relatively few of the benefits mentioned above can be traced directly to this form of capitalism. Advances in medical care have come mostly from publicly-funded research, and from innovations developed in the public health sector. The contributions of for-profit pharmaceutical companies have been modest by comparison. SImilarly, the Internet was developed by the publicly-funded university sector, and even now the most exciting developments are non-profit innovations like Wikipedia.

The crucial question is not whether technological progress and economic development yields benefits to everyone (clearly it does, at least in material terms), but whether market liberal policies generate more such progress than more egalitarian alternatives, so much more that everyone is better off in the end. It is this strong claim that was made repeatedly during the era of market triumphalism in the 1990s, and repeated, though with somewhat less conviction, through the 2000s.

The growth in US inequality during the Great Moderation was undeniable (though that didn’t stop some commentators and thinktanks trying to deny it). So, optimistic assessments of economic performance during the Great Moderation appeared to support the claim that rising inequality must be good for, or at least consistent with, economic growth that would ultimately benefit everybody.

Now, in the wake of the global financial crisis, this claim can be seen to be unambiguously false.


Income, inequality and taxation

The most obvious implication of the trickle-down hypothesis is that inequality in market incomes is not only harmless, but positively desirable, producing benefits for everyone in the long run. The general idea is that, the more highly owners of capital and highly-skilled managers are rewarded, the more productive they will be. This will lead both to the provision of goods and services at lower cost and to higher demand for the services of less-skilled workers who will therefore earn higher wages.

In the abstract language of welfare economics, the central implication of the trickle down hypothesis is that policy should be aimed at promoting efficiency, rather than equity since, in the long run, equity will take care of itself. Put in terms of a more homely metaphor, we should focus on making the pie bigger, rather than sharing it out more equally.

In reality, things are not that simple. It is easy to suggest that tax and other policies should apply neutrally to all sectors of the economy, but harder to define how this should actually work. It might seem that a ‘flat’ tax system in which all forms of income are taxed at a low, uniform rate would satisfy the efficiency criterion. But advocates of ‘trickle down’ have arguments to suggest that income from capital should not be taxed at all.

Going further, market liberals have claimed that, since everyone benefits from many of the services provided by government, the most efficient and equitable form of taxation is a poll tax 1. Such a policy was in fact introduced by the Thatcher government in the UK to finance local government services, but was abandoned in the face of massive protests and widespread rioting.

Once we turn from theoretical policy debate o the details of design, implementation and enforcement, the well-off invariably do better than the poor, while the rich do best of all. This was true during the postwar Great Compression - although the system appeared steeply progressive, the use of deductions, loopholes and tax minimisation schemes mean that it was, at best, only moderately progressive. Under the systems in force since the 1980s, which are only marginally progressive in their design, the actual outcome has been that upper income earners probably pay a smaller proportion of their income in tax than the population as a whole.

The absence of substantial progressivity in the tax system is obscured by the focus, in the US and elsewhere on the fact that high income earners (almost by definition) pay the bulk of income tax. A good deal of the material appearing on this topic in the Wall Street Journal and elsewhere gives the impression that income tax is the only tax in the system. In reality, income tax is not even the sole tax imposed on income - most countries, including the US, levy payroll taxes which fall on labour income. Unlike the progressive income tax, which does indeed fall most heavily on high income earners, payroll taxes are regressive, falling primarily on wage employees.

In most taxation systems, capital gains are accorded concessional treatment or not taxed at all. Unsurprisingly, a large share of capital income is taken in the form of capital gains, moving the tax system closer to the ‘trickle-down’ ideal where all taxes fall directly, or indirectly, on wage-earners.

Moreover, taxes on income and wealth only account for about half of government revenue in most tax systems. Consumption taxes typically make up about half of all government revenue, and these taxes are regressive. That is, those on low incomes typically pay a higher proportion of those incomes in consumption taxes than do those on high incomes. There are a number of reasons for this. Low income earners don’t generally save very much, so the ratio of consumption to income is higher for these groups. Taxes on items such as tobacco, alcohol, and gambling are levied at very high rates, and these items tend to make up a larger share of the expenditure of the poor (though absolute expenditure is higher only for tobacco).

Finally, there is tax avoidance and minimisation. A vast industry of lawyers, accountants, money-launderers and other agents exists solely to ensure that no one with sufficient means should pay any more tax than the minimum they are obliged to pay under the most creative possible interpretation of the law, and that those who don’t wish to pay even this much should be free to make this choice without any adverse consequences.

In summary, no matter how favorably the well-off are treated, there will always be arguments to suggest that they should receive even better treatment. Trickle-down theory offers no limit to the extent to which the burdens of taxation and economic risk can or should be shifted from the rich to the poor. In the end, according to the trickle-down story, that which is given to the rich will always come back to the rest of us, while that which is given to the poor is gone forever.


The role of the financial sector

The financial sector is the crucial test case for trickle-down theory. During the era of market liberalism, incomes in the financial sector rose more rapidly than in any other part of the economy, and played a major role in bidding up the incomes of senior managers as well as those of professionals in related fields such as law and accounting. According to the trickle-down theory, the growth in income accruing to the financial sector benefitted the US population as a whole in three main ways.

First, the facilitation of takeovers, mergers and private buyouts offered the opportunity to increase the efficiency with which capital was used, and the productivity of the economy as a whole.

Second, expanded provision of credit to households allowed higher standards of living to be enjoyed, as households could ride out <a href="">fluctuations in income</a>, bring forward the benefits of future income growth, and draw on the capital gains associated with rising prices for stocks, real estate and other assets.

Finally, there is the classic ‘trickle-down’ effect in which the wealth of the financial sector generates demands for luxury goods and services of all kinds, thereby benefitting workers in general, or at least those in cities with <a href="">high concentrations of financial centre activity such as London and New York</a>.

The bubble years from the early 1990s to 2007 gave some support to all of these claims. Measured US productivity grew strongly in the 1990s, and moderately in the years after 2000. Household consumption also grew strongly, and inequality in consumption was much less than inequality in income or wealth. And, although income growth was weak for most households, rates of unemployment were low, at least by post-1970 standards for most of this period.

Very little of this is likely to survive the financial crisis. At its peak, the financial sector (finance, insurance and real estate) accounted for around 18 per cent of GDP and a much larger share of GDP growth. With professional and business services included, the total share was over 30 per cent.[1] The finance and business services sector is now contracting, and it is clear that a significant part of the output measured in the bubble years was illusory. Many investments and financial transactions made during this period have already proved disastrous, and many more seem likely to do so in coming years.In the process, the apparent productivity gains generated through the expansion of the financial sector will be lost.

fn1. Here I'm measuring the <a href="">ratio of gross FBS output to gross domestic product</a>, which is the figure most relevant to the argument. The value-added in FRB (which nets out inputs purchased by the FRB sector) is smaller, around 20 per cent, but still indicates a highly financialised economy.


Equality of outcome and equality of opportunity

The trickle down hypothesis is closely related to the distinction between equality of outcomes (like life expectancy) and equality of opportunity. This distinction has long been a staple of debates between market liberals and social democrats. Many market liberals argue that, as long as society equalises opportunity, for example by providing good-quality schools for all, it’s not a problem if outcomes are highly unequal. Even though some people may do badly, their children will, it’s claimed, benefit from growing up in a dynamic society where everyone has a chance at the glittering prizes.

Writing in the Wall Street Journal, Wisconsin Republican Paul Ryan attacked President Obama’s first budget saying

In a nutshell, the president's budget seemingly seeks to replace the American political idea of equalizing opportunity with the European notion of equalizing results.

A year earlier, following his victory in the Republican primary in South Carolina, John McCain said

We can overcome any challenge as long as we keep our courage, and stand by our defense of free markets, low taxes, and small government that have made America the greatest land of opportunity in the world.

As these quotations suggest, the trickle-down hypothesis relies on the claim that equality of opportunity and equality of outcome are not only distinct concepts, but stand in active opposition to each other. By removing disincentives to work such as high tax rates and elaborate social welfare systems, it is claimed, an economic system that tolerates highly unequal outcomes will also provide those at the bottom of the income distribution with the incentives and opportunities to haul themselves up into the middle class and beyond.

The idea that the United States is a ‘land of opportunity’ and ‘the most socially mobile society the world has ever known’ (Scott Norvell, in a piece calling for patriotic consumer spending in the wake of 9/11,2933,34378,00.html) is central to the American national self-image, and the belief that this high social mobility derives from free markets is widely shared.

As we will see, empirical studies of social mobility do not support such beliefs. But most economists are not engaged in studies of social mobility and many of them share these popular assumptions. This is true not only of self-satisfied American economists, promoting the merits of the status quo and calling for more of the same, but also of European critics of the welfare state, who accept the characterization of their own societies as rigid and sclerotic by comparison with the dynamic and flexible United States.

1 The word ‘poll’ means ‘head’, but is closely associated with voting. Poll taxes are typically levied using electoral registers to define the tax base and can therefore be used to disenfranchise the poor or, as in the US South in the Jim Crow era, blacks

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