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Over the years we all have heard about trickle down economics (or supply side economics or Reaganomics). It is the idea that economic benefits granted to business and the wealthy will ‘trickle’ down to the rest of us. The argument is that by lowering tax rates on top earns will result in benefits to the society as a whole. This idea has been heavily promoted recently, first by Mitt Romney who wanted to cut top tax rates and then by his running mate Paul Ryan. In fact Ryan included tax cuts to the top rates in the budget he released just a couple weeks ago.

But the big question is whether or not trickle down economics works as proposed.

Well today I have been reading a study by Bertrand and Morse at the University of Chicago. In their study they examined the effects that changes in income by top earners have on the rest of us. Now the study is very statistically oriented so I will do my best to break it down into regular understandable language for those that don’t speak in statistics.

The first and most important finding I want to address is that the study “fails to find evidence that higher top income levels in a state are systematically predictive of higher future income for the non-rich”. Simple put higher incomes for top earners had no impact on future incomes for the rest of the populace. Now you might be asking how they came to that conclusion?

Well they started with the Panel Study of Income Dynamics (PSID) which measures economic factors over the life course of families. PSID has been run since 1980. An important feature of PSID is that it is a panel study. That means that they measured the same families at different times. This makes it possible to see how income changes at a household level as compared to looking at overall measures of income. Then they performed a statistical regression to examine the relationship of future income for the bottom 80% of households with the income of the top 20% of households. Furthermore they statistically controlled for the effects of age, race, gender, # of children and # of adults in the household. Statistically controlling for variables is a method where the effects of different variable can be removed from the analysis in order for a more accurate comparison. For example we all know that women make less money than men. When you control for gender you functionally remove that effect from the data so that you can compare both male and female earnings on an equal playing field. Simply put it allows for apple to apples comparison by removing variables.

Thus even when age, race, gender, # of children and # of adults are controlled for there is no evidence that the income for the lower 80% increases when the income of the 20% increases. This analysis was done using data from 1980 to 2007, so for the last 27 years increases to the wealthiest incomes has not had an effect on the rest of us. The pretty clearly demonstrates that the basis of trickle down economics is not true.

So what effect does increased income for the wealthiest have on the rest of us?

Well increases in the wealthiest incomes has a very strong correlation to the Consumer Price Index (CPI). Yet there was no correlation between lower incomes and CPI. Simply put increased incomes for the rich seems to drive up inflation. In the study the top 20% incomes were correlated with CPI while controlling for the state and year. It resulted in a R squared value of .95 which is extremely high. An R squared of 1 means a perfect correlation between two variable, you would see this most in areas like physics where there is a direct causal relationship. Though we can’t attribute true causation here because it is a correlation. We don’t know if a rise in wealthy incomes causes inflation or inflation causes a rise in wealthy incomes or if there is a 3rd variable causing both. But we can say there is a definite relationship.

Next the researchers looked different categories of spending to examine the relationship of increased income for the wealthy on spending by lower 80% of incomes. In order to look at this the researchers examined the percent of income spent on 29 categories of items including shelter, education, travel and health. Here they analyzed the change in spending for each category due to increases in income of the wealth while controlling for inflation, race, gender, age, # of children and # of adults. Some categories of spending went up and some went down. But two of them struck me; shelter and education. A 10% increase in wealthy incomes showed a 5% increase in spending on shelter by non-wealthy individuals. Now the 5% is a percent of total spending on housing. So if you spent 20% of your income on shelter then a 10% increase in wealthy incomes would mean you would be spending 21% of your income on shelter which is a 5% increase in shelter expenses. Next a 10% increase in wealthy incomes resulted in non-wealthy spending 11% less on education.

The final aspect of the study I wanted to focus on is the personal saving rate. Between the mid 1980s and the mid 2000s, the personal savings rate has dropped from 10% to 1%. That means that in the 1980s people were saving approximately 10% of their disposable income but now they are only saving 1% of their disposable income. In order to look at the relationship between the incomes of the wealthy and the personal savings rate of the non-wealthy the researchers performed a counter-factual or what-if study. Essentially they set up a scenario where the incomes of the wealthy grew at the same rate as incomes of the non-wealthy. Then examined the differences between the personal savings rates of the non-wealthy. “In 2005, the actual personal savings rate was 1.5 percent; we estimate counterfactual personal savings rates for that year between 2.6 and 2.8 percent.” That means that if the incomes of the wealthiest grew at the same rate as the rest of us then on average we would be saving 1.1 – 1.3% more of our income than we are now.

When we put all this together then we start to get a picture of what trickle down economics has accomplished. First we see that increasing the income of the wealthiest has no effect on the income for the rest. Second we see that incomes of the wealthiest are strongly related to inflation while incomes of the rest are not related to inflation. Third we see that increases in incomes for the wealthy result in shifts in the spending patterns of the rest of us, specifically non-wealthy end up spending more on shelter and less on education. Finally we see that the rise in incomes for the wealthy has led to lower personal savings rate for the rest. So trickle down economics has not done what is claimed it would which is benefit EVERYBODY. Instead it had resulted in inflation, higher housing spending, lower education spending and lower savings rate for non-wealthy households. It sounds to me like we got the short end of the shorted on this deal. The wealthy got paid more while the rest of us got screwed.