Trickle-Down Economics Doesn’t Work

Concerns are arising that South Korea’s potential for economic growth is plummeting. These concerns are followed by arguments that policies that emphasized growth were, in reality, focused on the benefits of the few and the wealthy, and therefore resulted in polarization and widened income inequality.

A fundamental doubt has been cast upon the so-called trickle-down effect; no longer will the increased incomes of large corporations and high-income earners raise the incomes of small and medium enterprises and medium-to-low income earners and, eventually, positively influence the overall growth of the economy.

These doubts about the trickle-down effect are not confined to the South Korean economy. The IMF’s report, “Causes and Consequences of Income Inequality: A Global Perspective,” published this June, argued that there is no such thing as the trickle-down effect, based on their empirical analysis of 159 countries.

Their research shows that when the ratio of the top 20 percent’s income as part of national total income increases by one percentage point, GDP growth decreases by 0.08 percentage point. When the ratio of the bottom 20 percent’s income as part of national total income increases by one percentage point, the GDP growth rate increases by 0.38 percentage point.

It should be noted, however, that the statistical significance of their findings relating to the top 20 percent is lower than the usual level of significance dee Imed appropriate in academia. Nonetheless, worsening of income inequality is clearly the most pressing issue of our time and, along with it, the reality of the trickle-down effect should be assessed.

The trickle-down effect argues that the fruits of economic growth “trickle down” from the haves to the have-nots, just as water “trickles down” from a higher point to a lower point. It is closely related to a hypothesis known in economics as the “Kuznets curve.” The Kuznets curve assumes an inverted U-shape as it explains economic growth and income inequality. Income inequality worsens in the first half of economic growth, with the gap between rich and poor widening, but later improves and narrows the gap after growth passes a certain point. But this curve is an expression of a mere hypothesis and has not been empirically proven. Numerous studies have yielded results in support of this hypothesis, but evidence refuting the hypothesis is also abundant.

Two reasons can be identified as we analyze why the trickle-down effect doesn’t apply to South Korea. First, the global value chain is expanding rapidly while the ripple effect of increased exports leading to increased domestic consumption is weakening. Second, South Koreans have experienced a steep fall in their household income growth rate since the Asian financial crisis of 1997-1998.

The expansion of the global value chain is a “global” phenomenon. But this expansion was much more rapid in South Korea than in other countries. While large corporations focusing on exports enjoyed the value chain expansion because they were able to cut production costs through it, SMEs lost business because they were marginalized out of the value chains. This prevented any trickling down from the growth of large corporations to SMEs.

For the past 30 years, South Korea’s exports have grown 10 percent annually on average, while the value added did not grow alongside exports. The ripple effect, in which export growth leads to domestic consumption growth, was weakened as large corporations and SMEs received unequal benefits from global value chain expansion.

For example, South Korea’s percentage of added value on its exports has been on a constant decline since 1995. In 1995, South Korea made 76 percent of its exports’ added value. The percentage dropped to 60 percent by 2009. This reflects the fact that South Korea’s export industries increasingly use their overseas production networks, increasing the ratio of overseas production factors while decreasing domestic ones. This phenomenon, of course, was not just a South Korean one. Other countries were experiencing similar patterns. But the drop was much steeper and the change much faster in South Korea than in other countries.

Moreover, the expansion of the global value chain changed the investment patterns of large corporations. Before the Asian financial crisis, large corporations, which accounted for most of the exports, invested their gains from exporting clothing or shoes, for example, in growing new productive industries such as semi-conductors, automobiles, iron and steel, or textile chemistry. After the financial crisis, large corporations began to search for cheap labor and big markets to drastically expand overseas investment in place of domestic investment. Yet foreign investment did not increase, so SMEs were isolated from the benefits that came with the expansion of the global value chain.

The rate of increase in South Korea’s household income has rapidly declined with the domestic credit card crisis that followed the Asian financial crisis. The first reason for this is that many laborers who lost their jobs due to restructuring during the financial crisis became self-employed. There was a huge shift in the labor market, which before the financial crisis guaranteed lifetime employment. Additionally, the number of non-regular workers increased with the implementation of the policy for flexibility in the labor market after the financial crisis.

In addition, large corporations succeeded in restructuring by effectively using the global value chain. Yet SMEs, which are responsible for 90 percent of employment, failed in restructuring and negatively influenced the wages and productivity of laborers. The low wages of the self-employed, non-regular workers, and laborers at SMEs drastically decreased the rate of increase in household income.

National income is the sum of household income and enterprise income. If the rate of increase of household income is lower than the rate of increase of national income, it follows that the rate of increase in the profits of enterprises is higher than the rate of increase in household income. When one takes into consideration that the majority of households is comprised of wage earners and self-employed businessmen, income inequality has rapidly worsened.

In other words, the benefits of growth did not go to the middle- to low-class income group, made up mostly of wage earners and the self-employed. The structural change in the labor market and the rate of increase in household income after the financial crisis explains why the trickle-down effect is especially not applicable in South Korea.

The expansion of the global value chain is not necessarily detrimental to only the trickle-down effect. In China and Vietnam, with inward foreign direct investment (IFDI) from large corporations, there was an increase in jobs and domestic SMEs actually benefited. Theoretically, this backs up the idea that expansion of the global value chain can positively influence the trickle-down effect. However, empirical research shows that in most countries the expansion of the global value chain has a negative impact on the trickle-down effect.

Due to this, after the 2008 global financial crisis, advanced countries such as the United States actively implemented reshoring policies, such as returning national companies to their own soil in order to promote job creation and growth in domestic demand. This policy does not expand the global value chain, but instead goes in the opposite direction.

In South Korea, the expansion of the global value chain has been asymmetric and, compared to outward investment, domestic policies for attracting investment have not been very effective, making the trickle-down effect an unrealistic situation in South Korea. This is related to the fact that South Korea’s investment environment is not very competitive compared to other countries.

If all the countries in the world engage in competition to attract FDI to induce domestic economic growth, without the creation of new industries, the situation will move towards a zero-sum. Theoretically, the expansion of the global value chain can have both positive and negative effects on the trickle-down effect. Yet, according to results from the small amount of early-stage research, empirically there is a high possibility for this effect to be negative. In order to determine what channel of the global value chain influences the trickle-down effect, there needs to be more research.

The June IMF report, “Causes and Consequences of Income Inequality: A Global Perspective,” highlights the need to newly analyze the relationship between growth and income inequality with the knowledge that the trickle-down effect does not function uniformly any more. Following the 2008 global financial crisis, countries throughout the world are placing a priority on solving the problems of job creation and income inequality.

In particular, there is emphasis on the importance of SMEs, which create the majority of jobs. This type of action, however, seems to dispute the idea that the trickle-down effect is no longer valid. Surely, income inequality can be relieved through redistributive tax policies. Yet, there is concern surrounding the persistence of low growth in the medium- to long-term.

In order to assure sustainable economic growth in South Korea, where the importance of trade is high, effort should be placed on enabling the trickle-down effect. To do so, SMEs should strengthen their competitiveness and formulate a plan to be incorporated into the global value chain. On top of this, restoration of the middle class and income increases for low-income earners should be a main policy target.

In addition, solving the problem of the dual structure in the domestic labor market, and abolishing unnecessary regulations, will develop a bond of sympathy within society and a public consensus about attracting foreign investment. This can be one step in solving income inequality in South Korea, the biggest challenge of our time.

This was originally written for the Seoul-based East Asia Forum by Chul Chung, the editor-in-chief of the Journal of East Asian Economic Integration.