Trickle Down Theory

Yes, yes, I know, no one likes the trickle down theory of tax cutting any more.

Currently known as the Cable-Clegg plan (no one has yet come up with a snappier title), it reflects the economic reality that the lowest paid sectors of society put more of their money back into circulation. Tax cuts for the poor are virtuous: a declaration that people can be trusted to spend their own money, as well as a boost to the economy for everyone else. One way of looking at the plan is as the polar opposite of the trickle-down theory, so beloved of the Conservatives. The idea that the wealthy would spend their tax cuts to the benefit of the wider society has turned out to be wide of the mark. It proved a grand cash-in for the offshore accountants of Belize and Monaco, but no one else.

And yes, I\’m also in favour of tax cuts being aimed at the poor by raising the personal allowance.

However, it\’s still a little odd to criticise trickle down by getting it completely wrong.

Yes, the poor spend more of their marginal income than the rich do. Cut taxes for the rich and they\’re not likely to raise their consumption spending by as much as the poor do (in %ge terms, or pence in that marginal pound). But this isn\’t a criticism of trickle down, it\’s the point.

When people save money that then goes off and gets invested somewhere. Savings do have to equal investment after all. No, of course, not all of the extra savings will be invested in industry (house prices will take a cut etc) but trickle down says that enough will indeed be invested in business to make a difference. After all, if you add capital to labour you make that labour more productive….and more productive labour tends to get higher wages. We can see this for example in poor countries. When foreign companies are allowed to invest directly (so called FDI) we see a rise in manufacturing wages in that country.

Now, whether trickle down really works or not isn\’t my point here at all. And certainly I\’m not arguing that it is preferable to reducing the tax burden upon the working poor.

Only that the description of trickle down given above is absolutely the opposite of what the theory actually is. It doesn\’t fail (if indeed fail it does) because the rich save more of their marginal income than the poor. If it succeeds (if indeed it does succeed) it is because the rich save more of their marginal income than the poor.


6 thoughts on “Trickle Down Theory”

  1. Daft argument either way.

    A business is just as happy to earn £1 from extra ‘spending’ as it is to have another £1 from extra ‘saving’ invested in it.

    Difficult to argue which is preferable.

  2. Extra spending is OK for companies with a strong cash flow. Startups andd companies that are looking to invest in large Capex on a new project need access to fresh money ie somebody else’s savings.

  3. Tim, I think what seems to have been the problem with trickle-down is that the rich didn’t spend their money on slate bathrooms and luxury yachts, stimulating employment and wages in Bethesda and on the Hamble. Or if they did, they didn’t spend a high enough proportion.

    Instead it went on assets like shares and (especially) property. Which is now unaffordable for those on average incomes. As the Pub Philosopher pointed out a year or two back, the great post-war property-owning democracy has gone into reverse, and we may be heading back to the pre-war days when most working people rented.

    Now I don’t see how being unable to afford a house any more is a gain for Joe Average.

    Tim adds: Assets like shares are a good idea. Means more investment, as above.

  4. Why does investing in shares necessarily mean more investment ? Unless the company issues new shares, the capital the firm raises from them is fixed at issue time and surely doesn’t depend on the current share price ?

    Tim adds: Because higher share prices mean that companies will indeed issue more shares….and other new companies will start.

  5. Instead it went on assets like shares and (especially) property. Which is now unaffordable for those on average incomes.

    Hmm. A couple paid the median wage can spend £240k on a house – that doesn’t strike me as especially unaffordable…

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