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Trickle-Down Effect

Updated on April 25, 2024
Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

Trickle-Down Effect Meaning

The trickle-down effect signifies an economic theory in which all financial leverage, tax benefits, and incentives given to the rich high-income earners, business owners, and corporates will result in overall economic growth. It will gradually benefit everyone in the hierarchy, including the middle class, lower class, and the poorest section of society. It intends to uplift all classes of societies and end the ongoing recession.

Trickle-down Effect

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Although it helps the government to promote economic growth and development, it has never worked in reality towards economic growth. In contrast, it has widened society’s income divide. Moreover, it harms economic growth as the rich, firms, and corporations save all the monetary benefits for themselves instead of using them for economic growth and development.

Key Takeaways

  • The trickle-down effect meaning describes providing tax cuts to the rich and corporations to increase production and jobs and improve the overall economic conditions of the country and its entities.
  • Its foundation is the Laffer effect. Economists and policymakers use it for overall growth and to improve the economic and social conditions of the masses. 
  • It has never worked as intended for economic growth; rather, it negatively impacts government revenue collections and widens economic disparity as the rich and corporates save the extra funds for personal use instead of spending on the economy.
  • To be effective, policymakers must supplement it with government spending and bank rate cuts.

Trickle-Down Effect Explained 

The trickle-down effect theory revives and invigorates the economy and social classes by providing financial benefits like tax cuts to the rich, investors, company owners, and corporations. The trickle-down effect in economics is analogous to supply-side economics advocating for tax for overall economic growth. It also aims to promote the overall development of every class of society. 

Economists had never considered it a good economic theory as they attribute its original corporate tax to the comedian Will Rogers who used it to deride the efforts of American president Reagan to tame the great depression of 1929  through tax cuts.

In the trickle-down effect, the government provides rebates in corporate tax rates to corporates and tax cuts to wealthy taxpayers, accompanied by a decrease in the government regulation of businesses. Moreover, as a result of these benefits, businesses spend this money on:

  • New investments
  • Increase production
  • Increase workforce via recruitments
  • Introducing newer technologies
  • Buying new machinery and land for establishing new factories 
  • Undertaking new marketing activities and
  • Working towards the economic development of the nation

Moreover, rich taxpayers get extra money to spend buying luxury goods and services. This action creates demand for products, which increases production, and the economy, in turn, gets into the growth model.

As a result of the spending by corporations and the rich, the workers and the middle class get more money to buy goods and services, creating additional demand for goods and making the economy grow. Moreover, since the government lowers the tax rates, the poor people get more money because of the above factors, and their living standards improve. Thus, the benefits of the tax rate cut trickle down from the top most rich class and corporates to the lowest class of the society, and growth of the economy takes place. 

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Laffer Effect

The trickle-down effect in economics uses the Laffer curve to justify its application and outcome on the economy. The curve shows the relationship between tax rates and total tax revenue. It assumes that economic entities will adjust their behavior according to the income tax rates’ incentives. It justified cutting income tax rates, which became important in the 1980s. 

Laffer Curve

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The Laffer effect was the brainchild of American economist Dr. Arthur Laffer, which correlated the tax cuts and the positive effects on an increase in government revenue and led to economic growth. However, the trickle-down effect promotes tax cuts only to the wealthy instead of applying it to all sections of society in the economy.

Moreover, it assumes that the benefits of tax cuts will trickle down to every section below the wealthy classes through increased investments, production, job creation, salary hike, and the lowest sections of the society. 

Example 

Here is a trickle-down effect example to understand the concept better. 

In the recent coronavirus pandemic, the world economy stood still for more than a year. After the coronavirus impact subsided a bit, various governments tried to boost the economy using the trickle-down strategy of rate cuts, tax cuts, less stringent control on the wealthy and businesses, dividends, and capital gains. The government did it to motivate the rich and big corporate firms to expand their production capacity, hire more people and raise the salary of the existing employees to benefit every section of society. However, the expected outcome of these measures is not visible because:

  1. Tax cuts fail to convert into increased job creation, consumer spending, and collection of government revenues.
  2. Investors do not necessarily invest in stocks. For example, banks do not necessarily lend, and business owners do not necessarily hire more workers or expand their operations.
  3. The lower and the middle class become drivers of the economy through their hard work in the production and services industry.
  4. Trickle-down leads to the increase in the riches of the wealthy. As a result, the divide of unequal income in society increases too.

Hence, the economy of many nations is yet to recover fully. Therefore, economists and policymakers can assume that the economic trickle down effect theory is only good on paper and ineffective in practice. However, if the trickle-down effect accompanies government spending and rate cuts, it can have some positive effects; otherwise, studies do not observe a positive effect on the economy.

Why Trickle-Down Economics Doesn’t Work? 

Trickle-down economics looks quite promising in tackling the slowing economy based on the following assumptions:

  1. Savers, business owners, corporations, and investors are the real drivers of the growth of an economy.
  2. Any tax cuts given to these drivers of the economy will give them extra funds to expand their business and production, generate employment, and increase salaries that will pass on to consumers.  
  3. As a result, purchasing power will increase, and the incomes of all the classes of the society will grow equally. It leads to economic growth.

However, in actual practice, the following opposite effects are observed of the trickle down effect theory that fails the theory in real-life application:

  1. The tax cuts only increase the wealth of the top twenty percent of a country’s population.
  2. Poor, lower-income, and middle-income classes do not experience significant growth in their income or wealth.
  3. The government also does not get enough funds from the corporations and the wealthy to do regular social welfare duties.
  4. The lower and middle class don’t get any discretionary income to spend on buying a product for increasing demand, so the production of goods decreases and the economy suffers.

All these outcomes of the trickle-down effect are dangerous to every economy of the world as:

  1. Wealthy corporates prefer saving obtained from tax cuts for their savings.
  2. They do not use tax benefits to increase production, job creation, and salary increases to increase the spending power of an average person.
  3. Hence no demand is generated, and production remains the same, negatively affecting the economy.
  4. Therefore, it has a net-zero effect on the economy; government revenue dwindles, affecting many social and government work.

Hence these are the reasons why the trickle-down effect does not work as expected in real-life situations.

Frequently Asked Questions (FAQs) 

What is trickle down effect in economics?

The trickle-down effect in economics assumes that the tax cuts and wealth of the rich and corporates will ultimately reach down to the working class and lower class to uplift their economic situation. Economists and policymakers assume that savings, businesses, and investors are growth drivers.

Did Reagan’s trickle down economics work?

Reagan’s trickle-down effect economics, or Reaganomics, did not work as expected from the theory. Instead, trickle-down economics led to an uneven income increase of 20% lowest class and the top 20% upper class. As a result, the top 20% of the upper class saw an increase of 80% in wealth. In contrast, the lowest 20% of the population only saw an increase of 20% in wealth. Thus, the differences between the lowest strata and the richest class widened significantly.

How effective is trickle down economics?

Trickle-down effect economics is ineffective without rate cuts and government spending. Lower taxes on the upper class do not necessarily create more job opportunities or regain revenue but rather increase the inequality gap between the upper and lower classes.

Is the trickle down effect real?

The trickle-down effect is real in increasing the wealth of the top fifth rich population and making the bottom fifth receive negligible benefits from tax cuts for the rich. Its actual effect is increasing social disparity in terms of wealth.

This has been a guide to Trickle-Down Effect and its meaning. Here we discuss how Trickle-Down Effect works with example and why it doesn’t work. You can learn more from the following articles – 

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