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Explainer: trickle-down economics

The Conversation

Gigi Foster, UNSW

To anyone who lived through the years of Ronald Reagan’s US presidency, the term “trickle-down economics” should already be familiar. While Reagan wasn’t the first politician to say “trickle down” with a straight face, the economic story signalled by the term was frequently invoked during the Reagan years, most famously to justify massive tax breaks that disproportionately favoured the rich.

The origins of trickle-down can be traced back to William Jennings Bryan, but his phrasing – “leak through” – didn’t really catch on. Through the years the same basic idea has also been known variously as “supply-side economics” and “Reaganomics”.

Critics of trickle-down policies haven’t overlooked the fact that giving the rich a helping hand may yield political benefits for the politicians offering that help. Since Reagan’s time, trickle-down economics has been derided by other politicians as “voodoo economics” and as “the rich pissing on the poor.”

The broad idea of trickle-down economics is that giving economic help to companies or people at the top of society should, through one of various possible mechanisms, generate benefits for those in layers further down. Let’s look at the various mechanisms through which this is theorised to work.

Mechanism 1: Corporations who get tax cuts increase investments in the country that gives them

In theory, some companies might be drawn to expand operations in Australia because of lower company tax rates. If those expansions created jobs for previously unemployed people, or equal or better jobs for Australian workers compared to what those workers previously could get, then the benefits would be spread to workers. Plus, these companies could add to the demand for Australian-made intermediate goods.

If the expanding companies were more productive than other companies, due to using more efficient production processes, then this could also raise overall Australian productivity. In theory this would allow all of us to get more out from putting less in.

Yet many companies are more likely to look to other margins when making the decision about whether to enter or expand in Australia. These might include the cost of labour, the degree of red tape, qualities of relevant markets, and Australia’s geographical location.

This is partly because the tax breaks usually floated by politicians are modest, and also because the corporate tax rate differences between Australia and many of its peers are comparatively small anyway. There is also a lemmings-over-a-cliff concern here: if our peer nations start taxing companies at rates below what is required to finance effective government, should we follow them?

More subtly, the incentive effects we’d predict from a company tax break are complicated by the fact that no company operates like a person. Though we attribute human traits to companies routinely, in reality the decisions companies take are myriad and in many different areas.

Each is taken by some individual person in a particular department with particular, constrained, information and decision-making authority. It’s not guaranteed that each such decision maker in a company will know about a bit of extra cash due to a tax break and be spurred because of it to take a particular decision in their realm that dovetails with decisions taken by other company workers.

To the extent that the company does not act as a unit, the hoped-for labour demand and productivity effects may not materialise. The same is true if that tax-break money is used for other purposes, like funding dividends to shareholders or lining the pockets of the top brass.

Mechanism 2: Rich people who get tax cuts will use the extra money in a way that helps the country as a whole

The main idea here, as with Mechanism 1, is that more investment will create more jobs and potentially increase productivity (which results from those jobs). Some rich people might indeed invest the extra dollar directly into the stock of an Australian business. In fact, since rich people have a lower marginal propensity to consume than poorer people, they’re more likely to spend an extra dollar on investment than on stuff.

Nonetheless, a rich person might choose to buy Australian-made products with that money, which should act as a stimulus to Australian businesses. Of course that person could instead shop online for an overseas product or take an overseas trip, in which case that extra dollar would flee the country.

A rich person might instead lend the bank that extra dollar by depositing it into a bank account. If the bank then promptly loaned that money out to domestic borrowers, then we might see a positive economic effect, if the main borrowers who benefit from this looser cash were businesses that went on to use the money for a productive purpose.

If the extra dollar ended up going to less productive businesses, we might see a temporary uptick in employment and intermediate goods sales that then melted away when the business was out-competed. If home buyers got the money instead, it might mainly fuel increased house prices.

Mechanism 3: Aggregate tax revenue will rise when taxes are cut

Perhaps the most radical notion in supply-side economics is that cutting taxes might, counter-intuitively, raise tax revenue.

Suppose a company were making $100 in profits and faced a company tax rate of 30% (creating $30 in tax liability), but then the tax rate dropped to 28%. The extra $2 of “found money” might be invested in the business in a way that generates a rise in profits, say to $110. This would then create a tax liability of $30.80, or $0.80 more than the government collected under the higher tax rate.

Notice how large the return on the investment of the “found money” had to be, in order to create even a tiny increase in corporate tax revenue, from this 2-percentage-point tax break.

More taxes could also be raised if the employees of that company, as it expanded, shared in its increased productivity in terms of their taxable take-home pay. An increase in government tax revenue could then in theory be allocated to welfare, infrastructure, and other progressive budget line items, benefiting more people indirectly.

Naturally, this is not necessarily how things will play out. The “found money” from the tax break might be used by a company in ways that do not yield an increase in productivity and profits of the required amount to create a tax revenue hike for the government; and any revenue hike may not be directed to progressive expenditures.

In sum, careful listeners might sometimes hear a gentle trickle in our economy, but many parts of the waterwheel would need to be positioned just right in order to generate a steady flow.

The ConversationGigi Foster, Associate Professor, School of Economics, UNSW

This article was originally published on The Conversation. (Reblogged by permission). Read the original article.

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Universal basic income: the dangerous idea of 2016

The Conversation

Gigi Foster, UNSW Australia

The resurrection of universal basic income (UBI) proposals in the developed world this year gained support from some prominent Australians. But while good in theory, it’s no panacea for the challenges of our modern economy.

UBI proposals centre on the idea that the government would pay a flat fee to every adult citizen, regardless of his or her engagement in skill-building activities or the paid labour market, as a partial or complete substitute for existing social security and welfare programs.

Of the schemes run in developing places like Kenya, Uganda, and India, some have been evaluated statistically, delivering some evidence of positive impacts on educational investments, entrepreneurship, and earnings.

In the developed world, Canada is trialling a UBI scheme. Finland also just rolled out a UBI trial, involving about 10,000 recipients for two years and costing about A$40 million. While Switzerland’s voters just rejected a UBI proposal via referendum, a similar proposal is presently looking like a goer for Utrecht in the Netherlands.

Here in Australia, it has been suggested the government might hand out somewhere between A$10,000 and A$25,000 a year to every man and woman.

Can we afford it?

There are two big questions to ask before taking a UBI proposal seriously, and the first is the most obvious one: where would the money come from to pay for it?

The present Australian welfare system (excluding the Medicare bill of A$25 billion) costs around A$170 billion per annum. Our GDP is around A$1.7 trillion per year, so this welfare bill is about 10% of annual GDP.

Giving A$20,000 to every Australian adult (19 million people) would cost approximately A$380 billion. That’s a little over twice the present total cost we pay for the above-mentioned programs.

Economics journalist Peter Martin has suggested that abolishing the tax-free threshold would pay for a UBI scheme. Working out whether the abolition of the tax-free threshold would fully fund a UBI is non-trivial, given the complexity of changing marginal tax rates as income rises and the need to estimate how many taxpayers fall into which tax brackets, but one thing is sure: the income tax bill of most if not all earners would have to rise in order to fund a UBI.

One scenario

Let’s look at what would happen to someone earning A$80,000 per year if we were to implement a UBI, abolish the tax-free threshold, and leave the marginal income tax rate kink points unchanged.

This person presently pays about A$18,000 in income tax – made up of a marginal tax rate of 19% on dollars from the tax-free threshold of A$18,200 to A$37,000, and a marginal tax rate of 33% on dollars from A$37,000 to A$80,000.

Under a UBI scheme involving the abolition of the tax-free threshold, that same individual would receive the UBI (say, $20,000) but would then face a 19% tax rate on ALL of the first A$37,000 of income, and then a marginal tax rate of 33% on dollars from A$37,000 to A$80,000, yielding a total tax bill of A$21,220.

This person would be better off under the UBI in terms of take-home pay: instead of A$62,000, he would get A$79,000 in his bank account. But is the additional revenue increment from abolishing the tax-free threshold enough to pay for the UBI, if we spread it across all earners? I’ve yet to see a hard-headed answer to this question.

We may need to increase taxes elsewhere to pay for a UBI – possibly corporate taxes, land taxes, etc. – and most of these other taxes disproportionately impact richer people. Would legislation to fund a UBI scheme via increasing taxes on the rich get passed?

Some might suggest taking the money we presently spend on social security and welfare payments and converting it to a UBI. This would be enough to fund payments of about A$10,000 to each adult. But it would be a reverse-Robin-Hood policy: instead of spreading a fixed sum across our neediest citizens, we’d be spreading that sum across everyone, making the neediest worse off in order to send cash to our more well-heeled citizens.

Question 2: What is the perceived “broken” part of our present welfare system, and would UBI fix it?

Any targeted (e.g. means-tested) social support payment must be clawed back as income and/or wealth rises. While arguably an efficient way to get money to where it’s most needed, means-tested social security payments inevitably depress the incentive to earn more, at least in the section of the earning distribution where social security payments are paid out. This is talked about a lot, but I haven’t seen a reliable cost estimate for Australia of the disincentivising effects of the claw-back of social security and welfare payments.

The administration costs of the present system of targeted payments, also an argument given for moving to a UBI, are estimated at about A$3-4 billion. Whether this includes all much-pilloried costs of “churn” is an open question. And a UBI scheme would also have administration costs, which have not yet been estimated.

Another frequent theme describes the modern economy as turbulent, with more part-time, casual roles and more employment uncertainty than in the past. The implication is that the way our present system compensates people in insecure work is inadequate. Yet a social support model like a UBI that makes it even easier for people to be precariously attached to the workplace carries the implication that the workplace is not good for them.

In fact, work is socially and psychologically supportive for many people. Studies have found negative psychological impacts from job loss and retirement that seem driven by the social aspects of working. Do we want to isolate our most vulnerable citizens even more?

Arguably the biggest problem in our current tax-and-transfer system is that the rich, and their organisations (like big companies), do not get taxed enough and/or benefit from special provisions (for example in regard to superannuation).

Instead of changing our present targeted welfare system into a diffuse scattergun money-for-all scheme, we could instead courageously tackle the worst part of the problem first.

What else is relevant?

Some worry that a UBI scheme would further depress the incentive to work. As I’ve stated elsewhere, I doubt that the drive to win in terms of labour market success is going to go away anytime soon.

Others have also found small impacts on work incentives from cash transfer programs, though this evidence is mainly drawn from developing countries.

In principle, two types of work incentives may be affected. People receiving unconditional handouts every year may feel less pressure to get and keep a job. Secondly, if the UBI were funded by the abolition of the tax-free threshold and/or increases to income tax rates, then people would be more strongly penalised for working additional hours and might hence work less.

Would people receiving unconditional handouts feel freer to explore their creative sides? To explore entrepreneurial ideas? To engage in more meaningful work than they presently do? These are all mentioned as possible benefits of a developed-country UBI, but we really don’t know whether they would materialise, nor do we really know how to measure them.

We do know that people adapt to new reference points (including income reference points), and there is good reason to expect that at least some of a long-term UBI would be soaked up in higher prices – particularly for goods that the poor buy most.

Watch and learn

A proposal to throw money at people, while wrapping that proposal in the flags of “equality” and “basic rights”, can be argued to be the lazy man’s face-saving response to the complex, entrenched problems of poverty. The poor arguably lack access and/or skills as much as or more than they lack money.

What’s more, the present Australian social security and welfare system can be viewed as a UBI scheme with exceptions for people who don’t need it. Some changes to the system that do not involve wholesale overhauls could address many of the problems discussed above.

My advice for Australia? Watch the policy experiments in Europe keenly. But don’t assume for one minute that universal basic income is a magic bullet. Compared to our current system, it is expensive, inefficient, and potentially regressive.

The ConversationGigi Foster, Associate Professor, School of Economics, UNSW Australia

This article was originally published on The Conversation. (Reblogged by permission). Read the original article.

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