The Biden administration and congressional Democrats recently proposed a wide array of corporate and personal income tax increases. The standard argument against high individual income taxes is that they discourage the number of hours individuals are willing to work and also the amount of income they choose to save and invest. Similarly, high corporate tax rates lower the return to capital investment, so these rates reduce investment by existing businesses.
However, Biden’s tax plan is a bad idea for another reason: High corporate and income tax rates can also slow innovation and the production of new ideas—key determinants of productivity growth and prosperity. Productivity growth fuels economic growth both in the U.S. and abroad. Current research suggests that the overall impact of the proposed tax increases will slow innovation, limiting productivity growth and therefore long-term economic growth in the United States.
Understanding Long-Term Economic Growth
The U.S. has well-established and stable institutions that are vital to long-term economic growth. These include secure private property rights and the use of the rule of law to peacefully resolve disputes. The U.S. also has a large capital stock, including computers, machinery and tools, along with a relatively skilled labor force. Given the size of the U.S. capital stock and the emphasis on education and training, the economic payoff tied to expanding the country’s capital stock or expanding the average years of education is positive but getting smaller over time—what economists call diminishing returns to increases in capital and training.
In industrialized economies where there are diminishing returns to capital and education, productivity growth is the key to increasing prosperity over time. Productivity growth may be driven by improvements in production efficiency and technological innovation: Businesses can work to develop techniques to get more output from the same inputs or the same output using fewer inputs. However, there are limits to how much firms can improve efficiency without innovation—the production of new ideas.
Inventors may work for a corporation or be self-employed, but the innovation process is the same either way. Advancing new ideas or innovation requires a deliberate decision to apply resources to research and development rather than to expanding the current output. Short-run profits must be set aside in favor of expected, but uncertain, long-run returns. Self-employed inventors face similar tradeoffs.
While inventors often love their work, given the costs involved in research and development, the expected payoff is a key incentive in the process. Personal and corporate income taxes affect the size of the net (after-tax) payoff or return associated with a new idea or invention. Thus, higher taxes reduce the return on innovation, causing research and development of new ideas to decline. As a result, productivity growth can be expected to slow, resulting in more modest increases in our standard of living than we would see in a low-tax environment. In addition, we would lose out on a host of hypothetical new ideas and products, which make all people better off, not just the companies and the inventors who create them.
Taxes and Innovation
Current research confirms that tax rates affect both the amount and location of innovation. One recent study examined the impact of personal income and corporate taxes on (1) state-level innovation and (2) individual inventor behavior between 1940 and 2000. The researchers tracked inventors along with their patents, patent citations, locations, professional fields and companies at which the inventors might work over time. The study featured detailed data on personal income and corporate federal and state taxes.
After controlling for other factors (state economic conditions), the researchers found that lower personal income or corporate tax rates encouraged innovation in a state. Over the period they studied, at the state level, a 1% decrease in the personal income tax rate increased patents and the number of inventors in the state by 1.8%. Also, total state patent citations, a measure of patent quality, increased by 1.5%. A decrease in the corporate tax rate of the same magnitude (1%) increased patents by 2.8%, citations by 2.4% and the number of inventors by 2.3%. Only average quality, as measured by patent citations, was not affected by the tax rate changes. Finally, a rise in a state’s corporate tax rate decreased the corporate share of total patents in a state. These results are consistent with the idea that inventors respond to incentives created by the tax system.
The researchers also found evidence that inventors are more likely to locate in states with lower tax rates. What is the national net change in patents when differences in tax rates create incentives for inventors to relocate across state lines? If inventors are equally as productive in their new location as they were in their previous location, the quantity and quality of patents will not change. However, if their productivity declines because of a less satisfactory job match (or increases because of a more satisfactory match) in the new location, total patents in the U.S. would decline (increase). However, the productivity advantages of having a high concentration of scientists in one area can raise research productivity enough to offset some of the disadvantages of higher taxes.
Many ideas get patented each year in the U.S. and abroad. Only a small percentage of these patents have a big impact on future patents and have high value in the marketplace. Superstar scientists and inventors create these high-impact patented ideas. Inventors, especially superstars, are sensitive to changes in the top marginal personal income tax rates across countries.
A recent paper explores the sensitivity of superstar inventors to such changes in eight Organisation for Economic Co-operation and Development countries (Canada, France, Germany, Great Britain, Italy, Japan, Switzerland and the U.S.) for the period 1977 to 2000. These countries generate a large share of the world’s patents. Using data from the U.S. and European patent offices, the researchers were able to track inventors working at multinational corporations. The quality of a patent was determined using patent citation data from the U.S. and European patent offices.
Superstar inventors were in the top 1% of the distribution of citations by inventor. The average number of citations per patent for an inventor in the top 1% over the period studied was 147, compared with 24 for inventors in the bottom 95%. There was a strong positive relationship between the quality of an inventor’s patent and earnings. The average annual earnings of a superstar inventor were $2,285,405 compared with $230,774 for inventors in the bottom 25%. Therefore, superstar inventors would be affected by any change in the top marginal personal income tax rate in a country.
The decision to migrate to another country depends on after-tax earnings and other factors such as language or distance from the inventor’s home country. The researchers found that a 10-percentage-point decline in the top marginal personal income tax rate (using the U.S. rate in the year 2000) increased the number of home-country superstar inventors by about 1% over time. The impact on foreign superstar inventors was much larger. The same tax decrease would end up attracting 18.4% more foreign superstar inventors to the U.S. The large difference in percentages is partly because there are fewer foreign superstar inventors than native superstars in the country.
This research shows that changes in top marginal tax rates can significantly affect the number of superstar inventors in a country. As a result, tax changes at the national level influence the amount of innovation and economic growth in a country.
Tax Policy Implications and Alternatives
This research has clear implications for tax policy in the U.S. It shows that higher taxes will reduce innovation, the most important source for economic growth in the U.S. The evidence indicates that higher personal income and corporate taxes will result in fewer patent filings and make the U.S. a less attractive place for superstar scientists to locate.
The Biden administration and Democrats in Congress seem to have missed this important economic reality. Despite politicians’ concern about poor and middle-class residents of the U.S., the slower economic growth resulting from these policies will reduce the progress made in reducing poverty and promoting wage growth before the pandemic.
The administration and Congress should therefore seek alternatives to their proposed tax hikes. For example, to promote prosperity, it would make sense to expand the tax base so that any one tax has less of a negative consequence for behavior. Also, removing questionable tax breaks in the system would allow a lower tax rate for all. The same can be said for a tax on consumption rather than investment. Rebates to lower-income individuals, who end up paying a larger percentage of their income on the tax, could be used to offset this undesirable effect of a consumption tax.
In a world where the creation of ideas drives economic growth, tax policy should be designed to expand the tax base so that marginal tax rates can be low and competitive with U.S. trading partners. Efforts to widen the tax base by implementing lower tax rates would help create an environment that promotes rather than hampers economic growth. Such efforts would also expand revenues over time. By contrast, large tax increases on the most productive and innovative members of society will result only in less innovation and slower growth.