Income inequality is perhaps one of the biggest and most pressing economic challenges of our times. Despite the rapid progress of our societies, there is a rising gap between the rich and poor that shows no sign of decreasing. Now, a new study has found that tax cuts for the rich may be a key factor to blame.
The study, by David Hope of the London School of Economics and Julian Limberg of King’s College London, comes at a critical time with the world reeling from the COVID-19 pandemic. Tax cuts have often been touted as a surefire method to inspire growth and revive sluggish economies, and will no doubt be considered again to combat COVID-19. However, such measures have only benefited the rich over the last 50 years the study reveals.
Why Tax Cuts are Used
Tax cuts are based on the theory of “trickle down economics”. The theory believes that tax cuts or benefits to the wealthy, or large corporations will “trickle” down to everyone else by driving investments and growth. It gained prominence during the Reagan administration, when the government introduced the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986, based on advice from Arthur Laffer.
American economist Arthur Laffer, who served as a member of Reagan’s Economic Policy Advisory Board, pioneered the “Laffer curve”. He used the curve to prove that tax cuts have a powerful multiplication effect. Laffer believed that the cuts would create enough growth to replace the lost revenue.
Since then, the idea has become very popular with conservative politicians. George W Bush used trickle down policies to address the 2001 recession, and Trump has done something similar with the Tax Cuts and Jobs Act of 2017. As data shows though, Bush’s policies did little to reduce income inequality.
The Effects of Trickle Down Policies
Trickle Down policies aren’t all bad. Data from the groups like the Congressional Budget Office (CBO) shows that tax cuts have increased after-tax incomes across all income ranges. However, the weathiest has benefitted the most. The Centre on Budget and Policy Priorities found that “real after-tax incomes jumped by an average of nearly $180,000 for the top 1 percent of households in 2005, while rising just $400 for middle-income households and $200 for lower-income households.”
Furthermore, the data from the CBO showed that the share of the nation’s total after-tax income going to the top 1 percent of households hit the highest level on record since 1979. All the data points to one thing: prosperity trickles up and not down with tax cuts.
Hope and Limberg’s research has found that to be true, across nations. The study uses data from 19 nations that are members of the Organisation for Economic Co-operation and Development (OECD). Over the last five decades, the duo found that “economic performance, as measured by real GDP per capita and the unemployment rate, is not significantly affected by major tax cuts for the rich.”
The paper shows that such cuts directly lead to income inequality, with each major tax cut resulting “in a rise of 0.8 percentage points in top 1% share of pre-tax national income.” Of course, tax cuts on their own are not to blame. There are other larger economic factors at play, like currency value, loan programs, trade deficit etc. that when combined together result in the data we see.
However, there can be no doubt that tax cuts as an economic policy, have little benefit across income bands. That begs the question – what now? How do governments respond to the economic crisis armed with this data?
The paper comes at a very critical time for the global economy. While there have been some signs of revival, we are still very far from returning to pre-COVID levels of economic activity.
In the US, the Bureau of Labour Statistics found the unemployment rate to be at 6.7% in November 2020. For comparison, the rate was at 3.9% in November 2019. A study found that 147 million people were left jobless and in need of aid due to the pandemic. To make matters worse, governments have already spent trillions on aid programs and handouts to combat lockdowns. The Institute of International Finance found that global debt would reach $277 trillion by the end of the year.
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To combat the coming debt crisis, it is vital for governments to shore up their incomes. Tax cuts are unlikely to become a common policy, especially in the US after Joe Biden was voted as President-Elect. On the campaign trail, he promised not to increase taxes for those earning below $400,000. Instead, Biden plans to target the wealthier, and large corporations.
In the UK too, there seems to be a change of wind. On the 2019 campaign trail, Boris Johnson and the Conservative party campaigned hard for tax cuts to stimulate growth. Now, a year later, Chancellor Rishi Sunak seems to be having a change of heart.
Earlier this year, the government set up a Wealth Tax Commission to look into the feasibility of the idea. The commission recommended a one-off 1% wealth tax at a flat rate of 5% on assets over £500,000. The move could raise at least £260 Billion. The government is yet to comment or move on the findings, but the fact that they commissioned such a report is telling.
Heading into 2021, it is uncertain how governments plan to tackle the economic crisis. However, it is clear tax cuts are not going to be a part of the equation. Governments will look at other ways to stimulate economic growth.
In the words of Dr. Limberg: “they (governments) should not be unduly concerned about the economic consequences of higher taxes on the rich.” If there is one thing the last few decades have shown us, it is that tax cuts do more harm than good.