Employment increases after taxes are cut for most income earners — but not when tax cuts target the top 10% of earners — according to a recent paper in the Journal of Political Economy looking at data from the 1980s through the 2000s.
For decades, the political argument in favor of tax cuts for big businesses and wealthy individuals has boiled down to an assumption that they would invest their tax savings into jobs that would swell the wallets of ordinary Americans.
So-called “trickle-down” economics intuitively evokes an image of water moving from high to low ground, unable to fight the irresistible force of gravity, saturating one and all. Recent research from Princeton University economist Owen Zidar adds to past academic analyses and real-world experiments challenging the idea that tax cuts work anything like waterfalls.
The employment effects of tax cuts for different income earners
As a political rationale for tax cuts, the “trickle-down” argument is alive and well. Here’s how former White House economic advisor Gary Cohen made the case for the Tax Cuts and Jobs Act, speaking with CNBC in November 2017:
“When you take a corporate tax rate at 35 percent and move it to 20 percent, and you see what’s happened over the last two decades to businesses migrating out of the United States, migrating profits out of the United States, migrating domicile out of the United States, and hiring workers out of the United States, it’s hard for me to not imagine that they’re not going to bring businesses back to the United States. We create wage inflation, which means the workers get paid more; the workers have more disposable income, the workers spend more. And we see the whole trickle-down through the economy, and that’s good for the economy.”
Zidar’s research indicates instead that job growth is more likely to follow when legislators cut taxes for people earning a living somewhere below the income stratosphere.
“In fact, the positive relationship between tax cuts and employment growth is largely driven by tax cuts for lower-income groups and the effect of tax cuts for the top 10 percent on employment growth is small,” Zidar writes in ”Tax Cuts for Whom? Heterogeneous Effects of Income Tax Changes on Growth and Employment,” published earlier this summer.
The biggest federal tax cuts in the 1980s and 2000s went to top income earners while taxes increased for them — and decreased for lower-income earners — in the 1990s. Zidar uses tax data from 1980 to 2007 and exploits variations in income across states (some states have higher average incomes than others) to investigate how tax changes to different groups of earners affect employment outcomes.
Zidar finds that a tax cut equal to 1% of a state’s gross domestic product for the bottom 90% of income earners results in 3.4 percentage points’ growth in the number of people employed in that state two years later. He finds virtually no change in employment for an equivalent tax cut for the top 10% of earners.
Say a state has an annual GDP of about $100 billion — roughly the size of New Mexico’s economy. A tax cut totaling $1 billion is enacted favoring the bottom 90% of earners. Two years later, the state would expect to see job growth in the range of 3.4 percentage points compared with the year before the tax cut, according to Zidar’s analysis.
“If cuts at the bottom encourage more people to work — since working is now more beneficial — economic activity will be higher,” Zidar explained in an email. “If cuts at the bottom are spent at a higher rate, then demand for goods and services throughout the economy will increase more and generate more activity. This higher activity can also stimulate more investment.”
He further finds that a tax increase equal to 1% of a state’s GDP on the bottom 90% of income earners reduced labor force participation by 3.5 percentage points and hours by 2%. The same tax increase on the top 10% didn’t affect those numbers.
Zidar notes that the employment and labor force fluctuations he observes could be different if tax rate changes since the 1980s had been more substantial. The 2017 tax cuts weren’t included in this paper.
“It’s hard to know what will happen after a Category 5 hurricane if we’ve only experienced Category 1 and 2,” he explained. “It might be the same, but sometimes there are fundamental differences in responses based on the size of the shock.
“At this point,” he added, “the evidence suggests that trickle-down economics doesn’t happen the way people claim it does.”
Early returns from the Tax Cuts and Jobs Act of 2017
President Donald Trump reiterated the trickle-down theme after the Tax Cuts and Jobs Act — which reduced taxes for corporations and individuals — was passed in December 2017:
“When I signed the tax cuts six weeks ago, it set off a tidal wave of good news that continues to grow every single day,” Trump said during remarks in Ohio in early February 2018. “Before the ink was dry, companies were announcing thousands and thousands of new jobs and enormous investments to their workers.”
Unemployment remains low, but part of the Trump administration’s sales pitch was that the 2017 tax cuts would incentivize companies that had gone overseas to come back. Investment hasn’t been as strong as predicted, according to a working paper from International Monetary Fund economists. Numerous news outlets have reported companies that moved profits back to America — the 2017 bill reduced repatriation taxes — used that money largely to buy back stock.
The New York Times reported administration officials offer that, “those selling shares will soon invest their proceeds from the buybacks into start-ups, business expansions or other forms of economic activity.”
Whether that economic activity comes to pass remains to be seen. The second quarter of 2019 saw a decline in inventory investment, according to data from the U.S. Bureau of Economic Analysis — meaning businesses are keeping fewer goods and raw materials in stock, potentially indicating they are expecting fewer customers. Before the 2017 tax cut, Steven Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center, looked at tax and retirement data and commented that repatriation, “would mostly benefit high-income U.S. taxpayers and foreigners, not U.S. workers.” The Tax Policy Center is a nonpartisan think tank that analyzes tax policy. Their three co-directors have collectively advised or served in both Republican and Democratic presidential administrations.
Another recent paper looks at first-quarter 2018 earnings conference calls from 424 companies listed on the S&P 500 index, which tracks the largest publicly traded companies in the U.S., to explore how businesses said they were going to respond to the 2017 tax cuts. Ninety-five of those firms — about 22% — said they were going to increase investment of any kind because of the tax legislation, according to the paper, “Tax Reform Made Me Do It!” published earlier this year in Tax Policy and the Economy. Just 4% of firms said they would pass tax savings through to workers, while 2% attributed their share repurchase plans to the tax bill.
“The analysis suggests that firms with greater expected tax savings from the [tax cuts] are those most likely to announce payments to workers and plans to increase investment,” the authors write. “Firms with a Political Action Committee that donates more to Republican candidates are also more likely to announce benefits to employees.”
Recent research on trickle-down tax policy
A range of data and research show that trickle-down economic benefits appear to consistently dam toward the top of the income mountain. Starting with tax cuts that President Ronald Reagan signed in 1981 and 1986, income tax rates have generally fallen over the past four decades, sparking GDP growth in the short run while exacerbating income inequality in the long term. By the end of Reagan’s second term, those in the bottom half of the income distribution were making less in real dollars than they were at the beginning of the 1980s. Two-thirds of rising income inequality from 1968 to 1989 happened during the 1980s, according to research published in the mid-1990s from RAND Corp. senior economist Lynn Karoly.
A University of Connecticut School of Business research paper from July 2018 looks at 1986 tax cuts targeted to some steel firms, with results suggesting “that firms receiving the refund pay down debt in the years following [the tax cuts], rather than increasing capital assets, cash holdings, payouts to shareholders, or employment.”
Other recent research uses data on U.S. income from 1962 to 2014 from the World Wealth & Income database and finds that tax cuts didn’t much affect the overall income share for people in the bottom half of the income distribution.
“Claims that trickle-down economics lift all income shares through lower taxes are not supported by the empirical findings,” writes Montclair State University economist Edmond Berisha in that April 2018 paper, published in Economics Bulletin.
Internationally, a January 2017 study in Development Policy Review looking at economic data from 1995 to 2011 from 65 countries – not including the U.S. – finds that when incomes went up for top earners, so did incomes for lower earners, but the rich overall benefited more.
The Kansas experiment: “A cautionary tale”
There are four reasons most tax changes happen, according to University of California, Berkeley economists Christina and David Romer in their extensive historical examination of tax legislation published June 2010 in the American Economic Review:
- Balancing the economy
- Paying for government spending
- Shrinking an inherited budget deficit
- Promoting long-term growth
It was some combination of the last two that Kansas pursued in 2012 when it cut business and personal income taxes as part of the largest tax package in state history. Then-Gov. Sam Brownback argued the tax cuts would address a looming deficit, writing in the Wichita Eagle that the cuts would also, “pave the way to the creation of tens of thousands of new jobs, bring tens of thousands of people to Kansas, and help make our state the best place in America to start and grow a small business.”
Two years later, the tax cuts didn’t increase employment, according to a March 2017 paper in Public Finance Review. The Kansas economy slowed and the state government faced a fiscal crisis, according to a preliminary paper that examines data from the Kansas Department of Revenue.
“The Kansas Tax Experiment is widely reported as a dismal failure, and a cautionary tale for all future tax cuts,” conclude College of William and Mary economist Shi Qi and Federal Reserve Bank of St. Louis economist Don Schlagenhauf in that preliminary paper.
Facing a roughly $350 million revenue sinkhole, a super-majority of the Kansas legislature repealed the tax cuts in February 2017 over Brownback’s veto.