Just like the rest of Europe at the moment, the United Kingdom faces numerous economic challenges that threaten the standard of living of its population. Surging energy prices, rising food costs and increasing interest rates have resulted in a recession predicted to last until the middle of 2023 with GDP estimated to fall about 0.3% overall next year (Ernst & Young). The 56th prime minister, Liz Truss previously attempted to propose a solution, an unorthodox approach dubbed “Trussonomics” by media outlets across the UK to scrutinise the radical and controversial economic ideology, the “trickle-down economics” theory. The plan backfired so spectacularly that her tenure ended after only 44 days in office. This article aims to explore what “trickle-down economics” is, and why it failed so significantly, resulting in Liz Truss becoming the shortest-serving Prime Minister in British history.
Context
The UK economy has been facing low growth in labour productivity since the 2008 financial crisis. Labour productivity refers to the amount of economic value produced per worker and is calculated by dividing real GDP (goods and services produced in an economy) by the number of working hours supplied by the country’s workforce in a given year. According to the National Institute of Economic and Social Research, the UK had an annual productivity growth rate of 0.5% between 2008 and 2020 (NIESR, 2022). This is significantly smaller than the growth rate of 2.3% between 1974 and 2008. Many economists point to underinvestment in the public and business sectors as the cause of this lag in growth. These low levels of labour productivity growth negatively impact the growth in real wages of employees and consequently, their living standards.
As an addition to that, Russia’s invasion of Ukraine at the beginning of this year has further worsened the living standards of the UK’s population. This is mainly due to the effect that this conflict has had on European oil supply (Click here to read more about it). Essentially, the Russian-Ukraine conflict has severely disrupted oil supply through economic sanctions and damaged underwater pipelines transporting natural gas to Europe (Vakulenko, 2022). The UK has thus been facing an energy crisis as the limited supply of natural gas pushes up energy prices and forces people into ‘fuel poverty’, where they must decide between spending on food or heating their homes.
Source: https://tradingeconomics.com/united-kingdom/electricity-price
The figure above shows the change in price of electricity (GBP/MWh) in the UK from 2017 to 2022. There was a significant spike in electricity prices this year as the conflict started.
With the low growth in labour productivity compounded with increasing living costs, Liz Truss along with her Chancellor of the Exchequer, Kwasi Kwarteng, declared an emergency fiscal plan to boost economic growth. This ‘mini-budget’ heavily incorporated trickle-down theory as it included the following :-
- A cancellation of the planned Corporation Tax rate increase
- Reversal in the 1.25% increase in National Insurance (a form of income tax)
- The basic rate of income tax will be cut to 19% from 20%
- The additional rate of income tax of 45% on income above £150,000 will be abolished
- Cap on bankers’ bonuses will also be abolished
It is obvious that these policies will disproportionately benefit the higher earning individuals of society and further stimulate demand despite UK inflation already exceeding 10%, according to the Bank of England. So what exactly is trickle-down economics and the rationale behind it that has persuaded Liz Truss to implement such unorthodox policies?
What Is Trickle-down Economics?
It’s likely you have heard of the concept of trickle-down economics as it was greatly supported by the political right in the 1980’s. It was tested by President Ronald Reagan in the United States and also Prime Minister Margaret Thatcher in the United Kingdom during their term in office. The most recent attempts were during Donald Trump’s presidency and by the United Kingdom’s shortest-serving Prime Minister, Liz Truss.
The theory of trickle-down economics is straightforward. It claims that tax reductions for higher income earners and corporations result in economic advantages for the wealthy initially, but will gradually trickle down to everyone else in society (Amadeo, 2021). This is similar to supply-side economics which also states that all tax reductions spur economic growth. Supporters of the trickle-down and supply-side theory use the Laffer Curve to argue their stance because it shows that tax reduction creates a significant multiplying effect, indicating that economic growth over time would offset the revenue lost by the government (Amadeo, 2021). The Laffer Curve as illustrated below indicates that as tax rate increases, more revenue is generated until it reaches the optimum point of T* but as tax rate increases past T*, the increasing tax rates would discourage working and investing in businesses. Therefore, lowering the tax rate back to optimum level, T* will stimulate greater economic growth as people are more encouraged to work and invest while also increasing overall tax revenue (Hayes, 2022).
Source: Investopedia, 2019
Supporters of trickle-down economics believe vital economic contributors such as business owners, corporations and banks would use the additional funds from tax reductions to expand their businesses, willingly invest more and increase lending respectively (Amadeo, 2021). As a consequence, more jobs would be created for the workforce which allows for more spending in the economy, and hence further economic growth.
The Reality of Trickle-down Economics
Based on a comprehensive study by Hope and Limberg (2022), strong evidence was found against the idea that trickle-down economics would boost the overall economy. The study investigated 18 Organisation for Economic Co-operation and Development (OECD) countries between 1965 and 2015, focusing on income inequality, economic growth as measured by gross domestic product (GDP) and unemployment rate.
Source: Hope and Limberg, 2020
As seen in the chart above, tax reductions for the wealthy made them even richer, leading to a substantial increase in income inequality and this gradually became stronger over time. The income share of the top 1% rose by 0.6 percentage points three years after the significant tax decrease.
For instance, the Reagan and Bush tax cuts helped the bottom fifth increase household income by 6%, but on the other hand, the income of the top 1% actually tripled between 1979 and 2005 (Amadeo, 2021). The wealthy would face a disproportionate gain as compared to the lower-income earners when it came to tax reductions. This is because the wealthy would have a significantly greater disposable income as a result of lesser tax contribution, while the disposable income of the lower-income earners would not be increased as much. This comes to show that tax cuts for the rich disproportionately benefit the higher earning portion of society by putting more money in their pockets.
Source: Hope and Limberg, 2020
Secondly, trickle-down economics made an insignificant impact – close to zero – on the growth of GDP per capita. Though these quantities fluctuated slightly after the tax reductions, it did not lead to a higher economic growth when measured by GDP per capita. Meanwhile, the unemployment rate underwent fluctuation over time where the point estimates were negative immediately after tax reductions, but eventually returned to nearly zero. As shown in the study by Hope and Limberg (2022), both GDP per capita and unemployment rate did not show significant changes as a result of tax reductions for higher income earners and corporations. This is an indication that the benefits reaped by the higher earning portion of society did not trickle down into the rest of the economy, having no notable impact on economic growth (Ingraham, 2020).
A crucial element that needs to be taken into account when considering trickle-down economics is that this theory is heavily reliant on the investment patterns and economic action of the higher income earners and corporations. It depends on whether the type of investments made by businesses would even make an impact on economic growth and employment.
“For example, if businesses invest that in existing real estate or share buy-backs, there is probably not going to be much of an impact on employment or worker wages. However, investing in a new building or in new capital equipment will employ people and potentially increase worker productivity. In that case there will be a positive effect on employment and on worker wages.” says Robert P. Inman, Wharton Professor of Finance. (Knowledge@Wharton, 2017)
The Aftermath
The market’s reaction to Truss’s economic policies were swift, damaging to the UK’s economy, and indicative of how trickle-down theory is viewed as a far-too flawed ideology by a majority of people. One of the most notable effects of this fiscal plan was the volatility of the gilt market (government bonds in the UK are referred to as gilts). According to Fathom Consulting, the week following the mini-budget announcement saw the price of the 30-year Gilt fall by 24%, while its yield almost doubled. This sell-off of government debt by investors was fuelled by the deteriorating economic outlook of the country, in particular, the increase in government debt that would occur due to the unfunded tax cuts within the mini-budget. With global interest rates already at significantly high levels as countries battle soaring inflation, the cost of borrowing from abroad to fund further government spending would be high. Hence, future debt sustainability was at risk and this caused government bonds to be less attractive to investors. Higher gilt yields meant that the UK government would have to pay an even greater interest on their public debt, increasing their borrowing cost even further.
Furthermore, the value of the pound sterling had fallen to record lows after Liz Truss announced her fiscal statement. This is because with already high inflation, investors speculated that further injections of cash into the economy would continue to deteriorate the value of the pound. With that in mind, investors demanded a higher premium for UK assets via a cheaper currency (Goldman Sachs, 2022).
Source: exchangerates.org.uk
The figure above shows the exchange rate between the pound and the US dollar. It shows that there was a significant fall in the value of the pound relative to the dollar. This is a combination of two factors; the value of the pound decreasing due to speculation on higher future inflation rates and the increasing strength of the dollar as the US hikes interest rates (Forbes, 2022).
After the disastrous effects of the mini-budget announcement on the currency and government bond markets, Truss eventually scrapped her tax cut plans amidst scrutiny from her own political party. Furthermore, her approval rate amongst the UK population stood at only 10% based on a survey conducted by YouGov, an international research data and analytics group. This all culminated in her tenureship eventually coming to an end on the 20th of October with her resigning from her post, officially making her the shortest-serving prime minister in UK history.
Other Ways To Boost Economy Growth
As trickle-down economics has proven to be a flawed right-wing economic ideology that only further promotes wealth inequality, what alternatives can governments use to boost growth? For one, governments can create a more attractive business environment for large corporations through initiatives that encourage and incentivise business investments in the country to help grow the economy. As cash flow problems remain as a common concern for many businesses, grants, disbursements or zero-interest loans could thus be offered to assist these corporations (World Economic Forum, 2020). For instance, the Japanese government supports zero-interest unsecured loans for companies that experienced a loss of more than 50% of their annual sales due to the pandemic, while Malaysia offers SME Digitalisation grants to assist SMEs in adopting digitalisation in their business operations (World Economic Forum, 2020).
Other schemes such as employment support could also be provided to companies,increasing their capacity to hire more employees that enables expansion of their business as well as allowing for better protection of current employees (World Economic Forum, 2020). Malaysia introduced Wage Subsidy Programme (WSP 3.0) in 2021 that provides a wage subsidy of up to RM600 per employee for 6 months (Krishnan, 2021). Another way for governments to create a more attractive business environment is by implementing friendlier trade policies to minimise the challenges that come with globalisation and trading. In Bosnia and Herzegovina, reforms made to promote cross-border trade were supported by a Bank operation whereby permits were made easier to acquire, the costs of approval were reduced, and streamlined government procedures for issuing export-import licences were implemented (World Bank Group, 2018).
References
Amadeo, K. (2021). Does Trickle-Down Economics Work? [online] The Balance. Available at: https://www.thebalancemoney.com/trickle-down-economics-theory-effect-does-it-work-330557 [Accessed 13 Oct. 2022].
Hayes, A. (2022). Laffer Curve. [online] Investopedia. Available at: https://www.investopedia.com/terms/l/laffercurve.asp [Accessed 13 Oct. 2022].
Hope, D. and Limberg, J. (2022). The economic consequences of major tax cuts for the rich. Socio-Economic Review, 20(3), pp.539–559. doi:10.1093/ser/mwab061.
Ingraham, C. (2020). Analysis | ‘Trickle-down’ tax cuts make the rich richer but are of no value to overall economy, study finds. Washington Post. [online] 23 Dec. Available at: https://www.washingtonpost.com/business/2020/12/23/tax-cuts-rich-trickle-down/ [Accessed 13 Oct. 2022].
Knowledge@Wharton (2017). Does Trickle-down Economics Add Up – or Is It a Drop in the Bucket? – Knowledge@Wharton. [online] Knowledge@Wharton. Available at: https://knowledge.wharton.upenn.edu/article/trickle-economics-flood-drip/ [Accessed 13 Oct. 2022].
World Economic Forum (2020). 4 ways governments can support start-ups and save their economies. [online] World Economic Forum. Available at: https://www.weforum.org/agenda/2020/06/4-ways-governments-can-support-start-ups-and-save-their-economies/ [Accessed 13 Oct. 2022].
Krishnan, D. (2021). Pemerkasa+: RM1.5 billion allocated for WSP 3.0 extension. New Straits Times. [online] 1 Jun. Available at: https://www.nst.com.my/news/nation/2021/06/695072/pemerkasa-rm15-billion-allocated-wsp-30-extension [Accessed 13 Oct. 2022].
The World Bank (2018). Stronger Open Trade Policies Enable Economic Growth for All. [online] The World Bank. Available at: https://www.worldbank.org/en/results/2018/04/03/stronger-open-trade-policies-enables-economic-growth-for-all [Accessed 13 Oct. 2022].
www.ey.com. (n.d.). UK economy expected to be in recession until summer 2023. [online] Available at: https://www.ey.com/en_uk/news/2022/10/uk-economy-expected-to-be-in-recession-until-summer-2023#:~:text=LONDON%2C%20MONDAY%2017%20October%202022
NIESR. (n.d.). Why is UK Productivity Low and How Can It Improve? [online] Available at: https://www.niesr.ac.uk/blog/why-uk-productivity-low-and-how-can-it-improve#:~:text=The%20United%20Kingdom [Accessed 13 Nov. 2022]
Vakulenko, S. and Vakulenko, S. (n.d.). Shock and Awe: Who Attacked the Nord Stream Pipelines? [online] Carnegie Endowment for International Peace. Available at: https://carnegieendowment.org/politika/88062.
Lipper Alpha Insight. (n.d.). News in Charts: Market reaction to the UK ‘mini-budget’ | Lipper Alpha Insight | Refinitiv. [online] Available at: https://lipperalpha.refinitiv.com/2022/09/news-in-charts-market-reaction-to-the-uk-mini-budget/# [Accessed 13 Nov. 2022].Goldman Sachs. (n.d.). Why the British Pound Fell to a Record Low Against the US Dollar. [online] Available at: https://www.goldmansachs.com/insights/pages/why-the-british-pound-fell-to-a-record-low-against-the-us-dollar.html.
Prepared by: Sylvia Chen, Ishmael Kamal
Reviewed by: Nasir Ali
Edited by: Julia Yazid
