Measuring the Trickle-down Effect and the Policy Implications

Insong Jang

Abstract

The “trickle-down effect” is not an academic concept; it is a loosely defined term used in
different meanings at different times. It has long been used in the press in different countries
including Korea, often becoming the subject of political debate as well. But for all its importance
in social discourse, it has not been accorded sufficient analysis. It may be due to the breadth of its
meaning, which hinders a quick conclusion after one or two rounds of research, but the main
reason for the gap is that mainstream economics rarely looked into the impact that each of the
different income classes can have on the macro economy.
Prior studies on the trickle-down effect have looked mostly at correlation between growth
and income distribution, or the reverse relations. It was rare that the studies looked at the different
income classes to understand how the spending pattern of one income class would affect the
income of the lower income class. Most studies used nationwide panel data or similar sources.
This study is differentiated from others in that it directly measured the impact of spending pattern
of each income class on the income of the low-income classes.
Chapter 2 of this study first defined the concept of the trickle-down effect and conducted
literature review. In the U.S., where the term was often used by politicians, it is defined relatively
narrowly. The trickle-down effect or trickle-down economics have been used mostly in relation
to the supply-side economics that espouse for tax cuts for the rich and corporations. In economics,
studies on the correlation between income distribution and growth are one of the most closely
related to the trickle-down effect. One of the best known early economics studies on equality and
growth is the hypothesis by Kuznets, who observed that degree of income inequality and
economic growth follow the reverse U shape, that income inequality worsens until growth reaches
a certain point then improves again afterwards. But a series of studies by international
organizations like the OECD, IMF and World Bank revealed that income inequality negatively
affects growth, even in developed economies. One of the main causes is that income gap deters
human capital development among the low-income group, hindering their social mobility and
skill formation.
Chapter 3 reviewed the role of consumption demand in economic growth from a mid/long-
term perspective. It also examined how the role and share of consumption and investment change
as the export/manufacturing-led high-growth era comes to an end, with changes in the economic
structure and slowing growth. Since the 1960s, the share of final consumption spending began to
decline amidst high growth and surge in export and investment, falling all the way down to 63.4%
in 2017, which is 10-20% lower than the share in other major economies. Estimating the
contribution of consumption, investment and net export to growth shows steady decline until the
1980s. Comparison with other major economies on consumption’s contribution to economic
growth showed Japan at the bottom with 55.6% in the 2010s, followed by Korea at 61.5%.
Consumption is highly sensitive to not only income but also wealth and debt. Net asset, as
part of permanent income, positively affects consumption, while debt can limit household
consumption as it causes liquidity constraint. International comparison of total household debt
out of net domestic product (NDP) shows that Korea’s household debt level, at 185%, is on par
with the world’s highest level seen in Nordic countries. It is considerably higher than 105.7% in
Japan, 108.6% in the U.S., 95% in Germany and 120% in France. And while the household debt
level has fallen in the U.S., Japan and Germany since the global financial crisis, Korea’s has been
on an unending climb. Private debt-to-GDP ratio and its growth rate are similarly high. And
household net financial asset-to-GNI ratio, which can be one of the indicators of liquidity, was
205% in Korea, also among the lowest.
Chapter 4 reviewed the characteristics of household income and consumption by income
decile, observing the differences in the propensity to consume and marginal propensity to
consume and analyzing the consumption spending by item. Despite the relatively low
consumption-to-GDP ratio and low spending contribution to growth, household consumption
capacity continues to fall. Granted, such structure can also work, as long as investment and net
export growth remain high and growth continues. But as is well known, Korea’s growth rate
continues to decline. And amid slowing export demand growth, domestic consumption becomes
even more important, with domestic consumption having to play a bigger role.
When the propensity to consume is calculated per equalized disposable income using cross-
sectional regression analysis on household income-consumption profile, the result showed lower
propensity to consume when income is higher. The propensity to consume was 0.65 at median
equalized disposable income of 21.66 million won, 0.93 at 25 percentile or 12.46 million won,
0.5 at 75 percentile or 33.77 million won and 1.13 and 0.43 respectively at 10 percentile and 90
percentile. Calculating the marginal propensity to consume per income level yielded 0.76 at the
median of equalized disposable income, 1.13 at 10 percentile and 0.39 at 90 percentile, again
confirming that the higher the income the lower the marginal propensity to consume.
Using structural VAR, Chapter 5 analyzed whether increase in high-income group’s
propensity to consume leads to income growth for the low-income group. Before the regression
analysis, the changes in the propensity to consume by income decile in the period of 1990-2016
were reviewed, which yielded a common trend of decreasing propensity among most of the
income groups. By decile, the 10th decile, the highest-earning group with the lowest propensity
to consume, had the biggest drop from 0.60 in 1990 to 0.49 in 2016. In contrast, the 1st decile,
with the highest propensity to consume, rose from 1.08 to 1.24 in the same period. But it also
showed the biggest fluctuation among all income deciles within the period, as it peaked at 1.49 in
2010 then fell by 0.25 since then. This pattern is also observed in other income deciles, more
pronounced in lower income deciles. In the period since 2010, the pace of decrease in propensity
to consume was faster in low-income groups than in the high-income bracket. The gap in
propensity to consume became even larger between 1990 and 2010, with the ratio between the
10th decile and 1st decile growing from 1.8 times to 2.7 times, but falling back to 2.5 times in
2016.
Two-variate and three-variate SVAR analyses on how a shock to the high-income group’s
propensity to consume would affect low-income group’s income revealed that it was unlikely for
policies aiming at stimulating consumption by high-income groups to create a trickle-down effect
(i.e. pulling up the low-income groups’ income). But such effect was found with policies to boost
the 6th income decile’s consumption, with the effect reaching its peak after 4-6 quarters. This
means that to maximize the benefits of short-term stimulus measures, what is needed is not
roundabout measures such as tax cuts for the rich. The policy should be targeted at the middle-
income group (who create a bigger consumption trickle-down effect), while being mindful of the
time lag in policy delivery. Such a policy, as a part of the aggregate demand policy, could help
increase income for the middle and low-income groups (with high propensity to consume),
stoking consumption growth for the short term and ensuring the effectiveness of policies to
improve human capital accumulation over the long term. These policies could gain justification
if the supply side channel is not sufficiently functioning (i.e. driving up high-income group’s
income to expand investment), or if the fundamental cause to growth slowdown is insufficient
domestic consumption (not shortage of investment resources, as was the case during the high-
growth era). But such measures must be accompanied by policies to curb household debt growth.

As was reviewed in Chapter 3, Korea’s household debt level has risen sharply, and now stands at

a high level even in comparison to other developed economies and acts as a constraint in driving
up household consumption.