The Trickle Down Economics Debate – Pro Argument One

I hope my regular readers who are here to learn about investing will indulge me for a while for a debate.  I’ll promise to inter-weave regular posts. 

On his very good blog, Mark puts forth the proposition that trickle down economics does not work:

If Mark is willing, I’d like to debate the topic.  I’ll take the Pro view, that Trickle Down Economics does work, or stated more clearly, “Reducing taxes on the wealthy, with all other factors being equal, will result in an increase in economic activity and an increase in the standard of living of the middle class and the working poor.”

To start, I’d like to give the example that Ronald Reagan used when first proposing tax cuts to spur the economy.  Also note that Reagan never liked the term “trickle down economics,” which was created as a way to ridicule the idea by members of the press at the time.

Before he became Governor or California and President, Ronald Reagan was a movie star.  He of course made a lot of money-making films (although not so much probably by today’s standards), which allowed him to buy nice houses and cars.  I picture a beautiful mansion in California with a beautiful, blue, sun drenched pool.  Let’s say that each movie paid him $0.5M, and let’s use an approximation to the 1975 tax rates: , as given below:

Income Range:                                         Tax Rate:

0 – $100,000                                              30%

$100,000 – $200,000                               60%

$200,000+                                                  70%

(I realize that these rates aren’t exact, and that the top rate on earned income was less than the marginal rates, but these factors don’t change my argument.)

For his first movie, Mr. Reagan grosses $500,000, of which he pays out $30,000 on the first $100,000, $60,000 on the second $100,000, and $210,000 on the next $300,000.  This makes a total of $300,000 in taxes, so he gets $200,000 and the tax man gets $300,000.

If he makes a second movie, the entire amount he makes would be taxed at the 70% rate, so he would get to keep $150,000 and he would pay $350,000 in taxes.  For the year, his take-home pay would increase from $200,000 to $350,000.  The following would then be his take-home pay, by number of movies made:

Movies Made                   Take home              Gross Pay

1                                            $200,000             $500,000

2                                            $350,000             $1,000,000

3                                            $500,000             $1,500,000

So if Mr. Reagan makes one movie, he gets to take home $200,000.  If he makes two, he gets a 25% pay cut for the second movie.  He has less incentive to make the second movie than the first.  He also sees that the government is making far more than he is from the films.  He might decide to stay sitting by that pool rather than make another movie.

So why does this matter to the little guy?  For every movie that Mr. Reagan, or Mr. Hanks, or Ms. Ryan makes there are hundreds of other people — producers, directors, prop handlers, prop makers, janitors, assistants, writers, even caterers and restaurants in the area of the filming.  More films also mean more fodder for the movie theaters.  This means more movie goers, which keeps the people at the theaters working.  Not to mention the gas station people stop at on the way and the video store that rents the movies after they leave the theaters.  If Mr. Reagan decides not to make that next movie, the other people, middle class people, don’t get to work either.

The thing is, while giving out extended employment benefits to out-of-work folks may result in them spending money they would not otherwise (although they might pick up a job delivering pizzas or something to pay the rent while working to get their next full-time job if they were not receiving unemployment benefits), cutting taxes for those whose working creates jobs for others would aid the out-of-work as well by creating more middle class jobs.  Note that the current tactic of economic stimulus is not working.

See the Response:

One comment

  1. You have made a very strong case on how lowering taxes for President Reagan circa 1975 would have resulted in job creation. That’s a solid and strong argument, especially when tax rates for the very wealthy were 70%.

    For my side of the debate, I would respectfully suggest we fast forward from 1975 to 2010. Instead of the highest tax rate being 70%, it is now 35%. Letting the current tax cuts expire for the top 2% in our country would increase their tax rate to 39.6%-back to the rate under President Clinton. Yes, it’s an increase of nearly 5% and yes it’s true, the top 2% pay about 50% of the income taxes collected in our country, yet in my opinion, not enough to deter an entrepreneur from starting a new business, making a new movie or hiring additional employees.

    If we were in fact having a debate in the country about raising tax rates on the highest income earners back to 70%, then we would be flirting with disaster. But as a financial planner, I work with many business owners that have done very well financially over the past decade. Yes, a nearly 5% tax increase will pinch, but will it deter business owners/job creators from making a new investment in their business which in turn could mean adding new staff? I have yet to see evidence of that stopping anyone from moving forward with a new venture.

    There’s no doubt that there’s a fine line between tax rates and job creation. Yet with tax rates on the highest income earners at 39.6% during the Clinton years, not only did the middle class see strong job and real income growth, but as a country we managed to put ourselves in a surplus situation financially.

    Finally, since we’re mentioning President Reagan, I was happily surprised to read David Stockman-Regan’s Budget Director, recent op-ed in the NYT call for letting the tax cuts on the wealthy expire as planned.

    Respectfully yours,
    Mark Zaifman
    Spiritus Financial

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