What Do We Actually Know About “Trickle Down” Economics?

A recent study by David Hope and Julian Limberg has been making the media rounds in recent weeks for its finding that “trickle down” economics doesn’t work. More specifically, the authors look at data from 18 countries and find that tax cuts for the rich have only led to a higher share of income going to the top 1%, but have on average had no significant impact on either GDP or unemployment. In other words, tax cuts help the rich, but do nothing to help everyone else.

The study was cited in just about every major newspaper (a quick google search brings up articles from the New York Times, Washington Post, Bloomberg, and many more). I read a few of these articles and what I found most striking (although unsurprising) was how definitive they make this finding appear. Taking a quote from the Washington Post article as an example, they write: “The Tax Cuts and Jobs Act did not pay for itself, failed to stimulate long-term growth and did not lead to sustained business investments. According to one of the most comprehensive studies to date on tax cuts for the rich, this should come as no surprise. A London School of Economics report by David Hope and Julian Limberg examined five decades of tax cuts in 18 wealthy nations and found they consistently benefited the wealthy but had no meaningful effect on unemployment or economic growth.” From the article, one would think it’s settled science that tax cuts don’t work.

I don’t blame the media for a lack of nuance in reporting and I certainly don’t want to downplay the significance of Hope and Limberg’s new paper. However, given the totally unbalanced nature of the discussion of these findings that I have seen I think it’s important to set the record straight. Hope and Limberg’s study provides one piece of evidence against using tax cuts as an engine for generating economic growth, but it is by no means the definitive account of the effect of taxes on growth in the way the media is portraying it. Other studies (conspicuously absent from media coverage) have found conflicting results and the nature of the question makes it difficult to get enough observations to even test the hypothesis at all.

In this case, the headline finding is actually reported pretty well by the media. From their abstract: “We find that major reforms reducing taxes on the rich lead to higher income inequality as measured by the top 1% share of pre-tax national income. The effect remains stable in the medium term. In contrast, such reforms do not have any significant effect on economic growth and unemployment.” And the paper does appear to be well done overall. The authors should be credited for their contribution in collecting and analyzing a massive amount of data. Tackling a question of this magnitude is not an easy task. Their research design, which tries to match countries that look similar in almost every way except that one cut taxes and the other didn’t, seems to make sense for the question they are trying to answer.

While the media overall doesn’t seem to have misrepresented the paper, there is still reason to take the results with a bit of caution. Looking deeper into their data, the “5 decades of tax cuts in 18 wealthy nations” sounds a bit better than it really is. Maybe the most difficult challenge in tackling questions about tax policy changes is that tax policy doesn’t actually change that much. In their sample of 50 years and 18 countries, Hope and Limberg are able to pull out only 30 observations where taxes actually fell enough to count and that they could match with a country that looked similar enough but did not cut taxes. Even in simple applications, 30 observations sometimes isn’t enough to uncover effects even if they are there. With something as complicated as the relationship between taxes and growth and the number of factors needed to control for across a diverse set of countries, it is not much of a surprise that they can’t pick up a relationship in their small sample.

However, the bigger problem I have with the media (and Twitter) coverage of this study is the total lack of acknowledgement that this question has been asked before. An incredibly brief search pulled up a paper by Karel Mertens and José Luis Montiel Olea, published in the QJE in 2018 begins with the question “To what extent do marginal tax rates matter for individual decisions to work and invest?” and answers “Marginal rate cuts lead to increases in real GDP and declines in unemployment.” Looking specifically at tax cuts for the rich, they find that “Counterfactual tax cuts targeting the top 1% alone are estimated to have short-run positive effects on economic activity and incomes outside of the top 1%, but to increase inequality in pretax incomes.” In other words, a tradeoff. Tax cuts increase inequality, but do seem to positively effect economic variables for the economy as a whole.

My point in bringing up this other paper is not to suggest that it is better than Hope and Limberg’s or that we should ignore any new findings. But I was curious to find such a well published piece of research with opposing results because I don’t remember in 2018 reading a bunch of articles telling everyone that actually “trickle down” economics works. I searched around and was able to find one article in a mainstream source that mentioned the Mertens and Olea study – an op-ed in the Wall Street Journal by Robert Barro, who gives it exactly one sentence of attention (the article was mainly about Barro’s own research which also finds positive effects from tax cuts).

So a new study that has not yet been published or peer reviewed gets paraded around by the media as definitive evidence that “trickle down economics” has no positive effects. A published piece in a top 5 economics journal that finds positive effects of tax cuts gets essentially no media coverage. I’m not always sold on stories of media bias, but in this case it seems pretty clear. Don’t believe the headlines – the question of whether tax cuts for the rich benefit the economy is still very much an open question.