Tax rates and innovation: are they as inversely correlated as some are claiming?

October 20th, 2015 at 9:49 am

Here we have Daron Acemoglu arguing the if the US were to impose Danish level tax rates, US innovation and entrepreneurship would be significantly diminished. I ran into similar arguments a few weeks ago in comments on a paper by Gary Hufbauer about why the OECD’s initiative (called BEPS) would also stifle innovation (you can hear my comments around minute 47).

As far as I can tell, this is all just assertion, folks. Daron’s a really interesting economist but his work on this issue tends to be theoretical, not empirical. He has a model in which cutthroat capitalist systems (that’s us) support “cuddly” systems (that’s Denmark) as our incentive structure generates innovation which the cuddly socialists then build off of.

“…some countries will opt for a type of “cutthroat capitalism” that generates greater inequality and more innovation and will become the technology leaders, while others will free- ride on the cutthroat incentives of the leaders and choose a more “cuddly” form of capitalism. Paradoxically, those with cuddly reward structures, though poorer, may have higher welfare than cutthroat capitalists; but in the world equilibrium, it is not a best response for the cutthroat capitalists to switch to a more cuddly form of capitalism.”

Interesting, right?

True? Maybe not so much.

–The Danes actually innovate pretty extensively in areas of pharmacology, wind power, shipping, and entertainment (h/t: Dean Baker).

–My CBPP colleagues point out that there’s little evidence that tax breaks here boost entrepreneurship, whether it’s favorable treatment of investment income or R&D-style tax credits. Yes, firms that get the tax credit do research, but analysis suggests they would anyway, making this another unnecessary transfer.

–There are a lot of low-tax countries out there. From where I sit, their main innovation seems to be selling themselves to higher tax countries as tax havens.

–Nor is there evidence, as implied by Daron et al.’s model above, that more unequal societies are more innovative.

–Finally, trace the history of the most notable innovations here and abroad and you’ll find the public sector, supported by tax revenue, conspicuously in on those innovations.

In other words, this is far less black and white than these guys claim. I agree that we’re not Denmark, but I strongly suspect we could raise our tax rates to some degree here and innovation would remain robust.

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5 comments in reply to "Tax rates and innovation: are they as inversely correlated as some are claiming?"

  1. readerOfTeaLeaves says:

    Acemoglu seems to think we are still in the Industrial Era, when the key to new wealth creation was vast amounts of capital that could fund steel plants, mills, factories. That is not the world we live in now; many very productive businesses do not require vast amounts of capital. They do, on the other hand, require strong social systems and an innovative culture.

    I’ll leave one link — I could leave 150, but time and space do not allow — about how to actually generate new ideas and new forms of wealth. IMVHO, Acemoglu should spend a bit more time reading Venture Capitalist’s blogs, and he’d be smart to follow @NickHanauer, just for starters. [a bit old, from 2013, but the larger patterns Graham identifies are still worth noting in relation to Acemoglu’s views.]

    There are two big forces driving change in startup funding: it’s becoming cheaper to start a startup, and startups are becoming a more normal thing to do.

    When I graduated from college in 1986, there were essentially two options: get a job or go to grad school. Now there’s a third: start your own company. That’s a big change….

    That kind of change, from 2 paths to 3, is the sort of big social shift that only happens once every few generations …

    One thing we can say for sure is that there will be a lot more startups. The monolithic, hierarchical companies of the mid 20th century are being replaced by networks of smaller companies. This process is not just something happening now in Silicon Valley. It started decades ago, and it’s happening as far afield as the car industry. It has a long way to run….

    The fact that startups need less money means founders will increasingly have the upper hand over investors. You still need just as much of their energy and imagination, but they don’t need as much of your money.

    In addition, a lot of these new companies and new technologies are focused on either:
    — data analytics (which did not exist in the Industrial Era, and which require social and intellectual capital), or on
    — leveraging existing resources (a la Uber or TaskRabbit).
    (It is true that the server and fiber networks necessary for data analytics require capital, but this is a different business structure from the old industrial mill: the old mill used up capital; therefore, discounting the value of aging capital made sense. In contrast, data analytics and other digital technologies **generate** capital (i.e., they ‘inform ate’) as information. These new forms of wealth do not degrade in the way that an old steel mill or factory degrades, and so they don’t need the same capital and tax structures that Acemoglu seems to ardently defend.)

    I don’t think Acemoglu has accurately factored in the value of social systems and social support in creating wealth in an economy where transactions and services are increasingly digital.

    Nevertheless, you can have all the money on the planet and if you don’t have an innovative culture, you still won’t create new novel forms of wealth. It’s not just about money; culture is a very important factor. Denmark, like the US, has a very good educational system and it has produced companies like Novo Nordisk. It is worth noting that Novo Nordisk now has an office in Seattle, located in the biotech hub in South Lake Union. IOW, Novo Nordisk could have put that new office in any city on the globe; however, they’re locating where the cultural and social resources are optimal for innovation. I don’t think Acemoglu quite grasps those key connections.

  2. Jill SH says:

    A while back I read about there being a much more robust small business sector, start-ups in particular, in Europe, in countries with universal health care, than in the US. The point is that many folks will take the chance to start their own businesses since they’ll have that coverage safety net. I think I’ve even heard that here in the US quite a number of people do the same thing, once they are 65 and get Medicare.

    In fact, we even have a term for the folks too scared to leave a job because they’d lose coverage: job lock.

    So might it be that single-payer — a Medicare for all program where you’re taxed proportionate to your income and that’s all the premium you pay — would actually unleash a lot of folks willing to strike out on their own and boost innovation?

  3. Smith says:

    The 1940s, 1950s, and 1960s featured much higher tax rates, much greater innovation, and greater increases in productivity and growth. That may be correlation instead of causation, but it certainly disproves the counter argument. Higher tax rates do not stifle innovation. But there is evidence that lower rates do.

  4. Scott F says:

    Start-ups are nice but fetishizing on them is not necessarily healthy.

    From the Washington Post:

    Small businesses, which represent 99.7 percent of all employers, generate less than two-thirds of the country’s new jobs — which means the 0.3 percent of firms that are large (one out of 300) punch way above their weight by creating one out of every three new jobs.

  5. spencer says:

    Take a look at this chart that shows business fixed investments as a share of GDP.

    It shows that the all time peak in capital spending was in 1981, just before the so called supply-side tax cuts kicked in. During the so called Reagan boom it fell to under 10% of GDP.
    Since then it has had cyclical swings that did not regain the previous peak.

    In other words he data shows that the Republican supply-side tax cuts led to a fall in business investment as a share of the economy — just the opposite of what the Republicans claim.