The policy of lowering taxes on high incomes and business activity is often described as "trickle-down" (or supply-side) economics. Proponents of this claim that benefits to the rich will promote new investment and economic growth, thereby indirectly benefitting people who are called upon to pay the taxes that are high in proportion to their incomes.

The assumptions behind this are listed below:-

a) Higher taxes (and thus lower after-tax earnings) would cause top earners to work less and take fewer risks, thereby stifling economic growth. Conversely, lower taxes (higher after-tax earnings) would cause these sections to work harder and take greater risks; thereby boosting economic growth.

b) A more progressive tax system (high tax for the rich; and lower tax for the less rich) would kill the geese that lay the golden eggs.

Based on the above assumptions we can make the following predictions:-

a) Lower real wages induce people to work shorter hours; thus when real wages increase, we should see people opting for longer work hours and fewer holidays. According to this logic, the cumulative effect of the last century's sharp rise in real wages should have been a significant increase in hours worked.

b) Countries with lower real after-tax pay rates should have shorter work days; and shorter work weeks.

c) We would expect to see (around the world) a positive correlation between inequality and economic growth -- the idea being that income disparities strengthen motivation to get ahead.

Analysis of these predictions in the real world:-

a) Decline in after-tax wages among the rich (at many places in the world) was often seen to exert a second  effect, opposite to the expectation as per first Assumption above).

It seems that often reduced income (due to higher taxes) provided people with incentive to recoup their income loss by working harder than before. Economic textbooks do recognize both these mutually opposing effects of lowered after tax earnings.  Which among these would dominate, depends on a host of other factors.

For example, even though chief executives in Japan earn less than one-fifth what their American counterparts do and face substantially higher marginal tax rates, Japanese executives do not log shorter hours.

b) The work-week is much shorter now than in 1900, though there has been a sharp rise in real wages in the last century.

c) When the data within individual countries over time are subjected research, the finding is of a negative correlation between inequality and economic growth -- opposite to prediction c) above.

For example, in the decades immediately after the Second World War, income inequality in the West was low by historical standards, yet growth rates in most industrial countries were extremely high. In contrast, growth rates have been only about half as large in the years since 1973, a period in which inequality has been steadily rising.

The same pattern has been observed in cross-national data. For example, using data from the World Bank and the Organisation for Economic Cooperation and Development (OECD) for a sample of 65 industrial nations, the economists Alberto Alesina and Dani Rodrick found lower growth rates in countries where higher shares of national income went to the top five per cent and the top 20 per cent of earners. In contrast, larger shares for poor and middle-income groups were associated with higher growth rates.

Again and again, the observed pattern is the opposite of the one predicted by trickle-down theory.

Anand Nair

Inspired by the Article that appeared in the New York Times on 12 Apr 2007, "In the Real World of Work and Wages, Trickle-Down Theories Don’t Hold Up"  by Robert H. Frank.

Robert H. Frank is an economist at the Johnson School of Management at Cornell University.

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