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Thomas Sowell on the “trickle down” myth: Workers are always paid first and then profits flow upward later – if at all

AEIdeas

From Chapter 23 (“Myths About Markets”) in Thomas Sowell’s book “Basic Economics: A Common Sense Guide to the Economy“:

The phrase “trickle down” often comes up in discussions of tax policies. Historically, tax revenues have in a number of instances gone up when tax rates have been reduced. But any proposal by economists or others to cut tax rates, including reducing the tax rates on higher incomes or on capital gains, can lead to accusations that those making such proposals must believe that benefits should be given to the wealthy in general or to business in particular, in order that these benefits will eventually “trickle down” to the masses of ordinary people. But no recognized economist of any school of thought has ever had any such theory or made any such proposal. It is a straw man. It cannot be found in even the most voluminous and learned histories of economic theories.

What is sought by those who advocate lower rates of taxation or other reductions of government’s role in the economy is not the transfer of existing wealth to higher income earners or businesses but the creation of additional wealth when businesses are less hampered by government controls or by increasing government appropriation of that additional wealth under steeply progressive taxation laws. Whatever the merits or demerits of this view, this is the argument that is made – and which is not confronted, but evaded, by talk of a non-existent “trickle-down” theory.

More fundamentally, economic processes work in the directly opposite way from that depicted by those who imagine that profits first benefit business owners and that benefits only belatedly trickle down to workers.

When an investment is made, whether to build a railroad or to open a new restaurant, the first money is spent hiring people to do the work. Without that, nothing happens. Even when one person decides to operate a store or hamburger stand without employees, that person must first pay somebody to deliver the goods that are going to be sold. Money goes out first to pay expenses and then comes back as profits later – if at all.  The high rate of failure of new businesses makes painfully clear that there is nothing inevitable about the money coming back.

Even with successful and well-established businesses, years may elapse between the initial investment and the return of earnings. From the time when an oil company begins spending money to explore for petroleum to the time when the first gasoline resulting from that exploration comes out of a pump at a filling station, a decade may have passed. In the meantime, all sorts of employees have been paid — geologists, engineers, refinery workers, and truck drivers for example. It is only afterwards that profits begin coming in. Only then are there any capital gains to tax. The real effect of a reduction in the capital gains tax is that it opens the prospect of greater future net profits and thereby provides incentives to make current investments that create current employment.

In short, the sequence of payments is directly the opposite of what is assumed by those who talk about a “trickle-down” theory. The workers must be paid first and then the profits flow upward later – if at all.

Discussion (19 comments)

  1. Che is dead says:

    You cannot beat Thomas Sowell for clarity. Maybe he could spend a few moments with these guys:

    Uber-libertarian billionaire Peter Thiel suggested he may support a spike in the minimum wage to $12 an hour because it could roll back the welfare state. …

    Thiel’s welfare-and-tax argument echoes the push by another California libertarian entrepreneur, Ron Unz, who says the government is skewing the nation’s economy downwards towards low-tech work by supplementing low-wage workers’ wages with welfare payments. — Daily Caller

    Great. So, now instead of paying for the welfare state through our tax dollars we can pay for it through increased prices. That is, of course, if the Left doesn’t just increase the threshold for benefits. If that happens we will simply have been fleeced. So much for libertarians wanting to rein in the welfare state.

    “It is not the employer who pays the wages. Employers only handle the money. It is the customer who pays the wages” — Henry Ford

    1. William Dunn says:

      So a higher minimum wage is, in fact, a consumption tax?

      1. Che is dead says:

        A wage increase, passed through to consumers, and given explicitly for the purpose of reducing ones welfare eligibility, as opposed to a demonstrated increase in knowledge and productivity on the part of the employee, is exactly that – a consumption tax as a means of funding the welfare state.

        1. juandos says:

          Speaking of pass throughs to the customers have you seen these types of stories?

          From CNNMoney: Now on your restaurant bill: Obamacare fee

    2. givemefreedom says:

      Thiel may like to call himself a libertarian and some people may take to calling him one, even calling him a Uber libertarian, but you are not a Uber libertarian or a libertarian if you are advocating a government min. wage at any price level.

      A libertarian would never support government interference in the labor market, for any reason.

      1. givemefreedom says:

        Also, a libertarian would never support government interference in any market, for any reason.

    3. Ron H. says:

      Che

      So much for libertarians wanting to rein in the welfare state.

      Are you really suggesting that one libertarian billionaire, and one conservative represent the views of all libertarians? Give me a break.

      Here’s the original SF Chronicle article and Peter Theil’s complete statement.

      It’s a lame “second best” argument for min wage, not quite the positive endorsement suggested by Daily Caller.

      As for Ron Unz, I wonder why the Daily Caller labels him a libertarian considering he formerly published the “American Conservative” and makes this argument on his own website.

      You’re right about Sowell, though.

      1. paul says:

        I think they’re trying to be too clever by half in an appeal to win the swarming masses of low information voters. There are other ways to do this.

        1. Ron H. says:

          Paul

          I think they’re trying to be too clever by half in an appeal to win the swarming masses of low information voters. There are other ways to do this.

          Could be, but suggesting paying people more than they’re worth in higher min wage to reduce welfare eligibility, or for any other reason, isn’t a libertarian argument, nor does it make economic sense.

          1. Paul says:

            Ron,

            Agreed.

  2. BigEd says:

    How does a reduction in the capital gains tax on passive investments increase real investment or, for that matter, lead to more jobs??

    1. Ken says:

      Increasing the cost of anything, decreases the demand. Increasing the cost of investing, by having and raising a capital gains tax, reduces investment. Decreasing the cost of investing, by lowering or eliminating a capital gains tax, increases investment. Increased investment means more jobs.

    2. mesa econoguy says:

      1. Opportunity cost
      2. Capital cost
      3. Legal cost (huge nowadays)
      4. Outright cost

      Plus, cap gains are usually taxed multiple times, and held by the “1%” so an easy target.

    3. morganovich says:

      big ed-

      investments are made based on expected returns. lower taxes mean higher expected returns.

      thus, lower capital gains taxes are one of the best and fastest ways to spur growth and investment, which is where jobs come from.

      this was highly evident in the 80’s and 90’s when cuts in cap gains lead to one of the greatest booms in us history and, interestingly enough, far bigger growth in tax revenues as well.

      i’m not sure how anyone could plausibly ague that higher expected returns do not drive more investment.

  3. mesa econoguy says:

    When an investment is made, whether to build a railroad or to open a new restaurant, the first money is spent hiring people to do the work. Without that, nothing happens.

    Economics 100.

  4. mesa econoguy says:

    Pile on restrictions, as Democrat leftists always do, and none of that happens.

  5. morganovich says:

    there seems to be a very interesting disconnect among the political class on this:

    the very same people who tout “shovel ready” infrastructure projects as economy boosters and job creators rail against cap gains tax cuts that have the EXACT SAME effect in the private sector by making new projects worthwhile at the margin.

    of course, because such projects do not require taxation first and are subject to market forces, they are positive, not zero or even negative sum, and so a greatly to be preferred.

    1. paul says:

      Liberal politicians don’t get the control and direct credit with a cap gains tax cut compared to what they think they’re going to get from infrastructure projects.

      Also, it’s about “fairness” as Obama told George Stephanopoulos in the 2008 Democrat debates. He’d rather burn the economy down than a rich guy get a tax break.

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