Trickle-down Fairy Dust

Copyright, The New York Times Company

Generally, transfers do not expand the economy, regardless of whether the recipients are rich or poor. Rather, they confer benefits that are limited to the direct recipients of those transfers.

President Obama recently denigrated the Romney-Ryan economic plan by saying the Republican candidates believe that if Congress gave “more tax breaks to the wealthiest Americans, it will lead to jobs and prosperity for everyone else.” He called that approach “trickle-down fairy dust.”

The trickle-down theory says that a policy benefiting a specific group, like the wealthiest Americans, will somehow confer benefits on everyone else. One common version of this view is that the benefiting group increases its spending, which in turn benefits the industries whose products are purchased with such additional spending, perhaps leading to the hiring of more workers to meet the increased demand.

The Obama administration has its own version of this — what we might call trickle-up — which says that policies benefiting unemployed people even help people who are not unemployed, because the unemployed react to their government benefits by spending more.

Both of these views are flawed for two reasons. First, the transfer of resources from one group to another probably does not increase aggregate spending (if incentives are held constant), because we have to consider both the spending of the receiving group and the spending of the group that finances the benefits through tax payments or loans to the government.

Transfers may change the composition of spending to the extent that the benefiting group spends its resources differently than the financing group. Cutting taxes on the rich and raising them on the poor would probably, holding incentives constant, increase spending on fancy restaurants, investment goods and yachts, and decrease spending on, say, groceries and cellphones.

The altered composition of spending can have some interesting, but probably small, effects on the labor market, depending on the labor intensity of the various industries involved (as I noted in a previous post). But changing the composition of spending is not the same as changing the total.

Few transfer programs hold incentives constant. Unemployment insurance reduces the incentive to find work and (especially when it is federally financed) reduces the incentive for businesses to avoid layoffs, and in this way reduces aggregate spending. Sometimes so-called tax cuts and tax credits can reduce spending by discouraging work and redirecting economic activity to less-productive uses.

Even if a transfer from one group to another did increase aggregate spending and output, the second flaw of trickle-down theory is that the additional spending confers benefits beyond the direct beneficiaries of a transfer.

You might think that more spending on, say, groceries would benefit grocers and the farmers who supply them. It’s true that a grocer receives funds when a new customer comes to his register. But he also has to provide more groceries or have one of his other customers get by with fewer groceries, and groceries are not free to supply. The funds a seller receives from a new customer may just offset the total costs of the goods provided to the customer, so the seller is hardly better off.

A more nuanced analysis might assume that customers are normally charged more than cost (broadly defined) for the goods they receive, so that sellers are a little better off when aggregate spending increases. It might also consider that some industries are subject to economies of scale, so that other customers are better off when a new customer enters the market. Industries (and the workers they employ) sometimes pay more taxes when they expand, so the public treasury benefits when there’s more aggregate spending (the so-called Laffer curve is a special case).

None of this implies that a good public policy cannot transfer from one group to another. Transfers may intrinsically be good: we may enjoy helping the poor or value the freedom associated with limited taxation. Or the direct beneficiaries from redistribution may gain much more than the rest of us lose.

But until we know more about the magnitude of the second- and third-round effects of transfers on people who do not receive them, redistribution cannot be justified as helping those who finance it.