What’s it: Trickle-down effect is an economic concept in which giving concessions to the rich or capital owners will ultimately encourage economic growth. Economic policy should focus on them. By doing so, they will create more jobs and income, which, in the end, will penetrate the poorest sections of society and benefit all.
How the trickle-down effect works
The trickle-down effect states that the best way to encourage economic growth is to let the rich or owners of capital (investors and entrepreneurs) develop. The government should relax economic policies that benefit them, not to the lower middle class.
Policies to promote trickle-down effects can be:
- Withholding capital gains tax
- Company net income tax relief
- A reduction in tax rates for wealthy individuals such as investors and entrepreneurs
- Reduction of capital gains tax
- Loosening of regulations for businesses
Proponents argue that such relaxation encourages the rich and the owners of capital to stimulate economic growth. Relaxation encourages them to develop new businesses and create more jobs. It will eventually flow to the lower middle class. They are easy to find work and earn an income.
Tax reduction effect
Entrepreneurs and owners of capital have more money when taxes fall. They then use it to increase their wealth by starting new businesses or scaling up existing business operations. They invest in capital goods such as buying factories, improving technology, and new equipment.
Investment in capital goods encourages higher output in the economy. Increasing the scale of operations also allows companies to achieve economies of scale, which, in turn, lower the prices of goods and services.
So when the owners of capital have more money, the business will expand and increase job creation. They employ more people, especially in the lower middle class.
The workers ultimately benefit from the trickle-down economy. Job and income prospects are improving, raising their standard of living. Thus, the benefits of economic growth will eventually flow from the top down.
As a result of expanding economic growth, the government can collect more taxes. The additional tax revenue compensates for tax cuts to the rich and the owners of capital.
Rich people have a higher marginal propensity to save than the lower middle class. When they have more money, most of the extra money they save or invest in.
In contrast, the lower middle class will spend more of their money on consuming goods and services. The money is used up once they buy the product.
It contrasts with investments by the rich. They use the money to create more money by establishing new businesses. Or, they can invest it in company stocks and bonds. The company ultimately uses the money from the issuance of shares or bonds for expansion and investment in capital goods.
The trickle-down effect basically assumes several things, including:
- The source of economic growth comes more from the investment of the owner of capital (resources) rather than through encouragement of consumption
- All members of society benefit from growth
- The pressure of external competition (from imports) is minimal
Criticisms of the trickle-down effect
Some of the basic assumptions of this concept may be less realistic. Investment has indeed become one of the drivers of economic growth. However, ignoring the role of consumption is a mistake. Build more factories, but nobody buys, what happens?
Consumption is another driver of economic growth. So, the role of the middle-lower class is also vital. They usually cover most of the population. So, cumulatively, they are the drivers of growth and production. Their consumption is the reason why businesses increase production.
Some other criticisms of the trickle-down effect are:
- Increase economic inequality. The concept benefits only a few wealthy people, making them even richer. That plants more money in the hands of the rich and corporations, encourages spending and free-market capitalism. On the other hand, those on low incomes do not receive a tax cut. This situation widens income and wealth inequality.
- Defining the rich. Complexity arises about which of the wealthy should receive tax cuts. The rich who are lazy and have no entrepreneurial spirit, will they create more jobs?
- A tax cut is more beneficial if it targets the lower-middle class. The lower-middle-income people cover a large part of the population. Thus, when they have more money due to lower taxes, they will increase the demand for goods and services. That encourages businesses to increase production and create more jobs and income. Thus, the scale of the impact of the tax cut is more significant.
- Budget deficit pressure. Taxes on the rich and corporations usually account for a significant portion of government revenue. If the government cuts it, it increases pressure on the budget deficit.