Don’t Be So Sure That Tax Cuts Are Good for Startups

(Bloomberg Opinion) -- Thanks to a proposal by Representative Alexandria Ocasio-Cortez, the U.S. is thinking about the possibility of high tax rates for the wealthy. This is good. There are many important things that the government could use the revenue for — switching to green energy, establishing universal health care, providing housing, upgrading infrastructure and boosting research. And higher taxes on the affluent might help mollify the unease many Americans are feeling about growing inequality.

Of course, Ocasio-Cortez’s proposal — a tax rate of 70 percent on ordinary income of more than $10 million a year — isn’t sufficient, since the well-off tend to earn other types of income. Because high earners have many ways to avoid paying taxes, capital gains taxes, pass-through income taxes and dividend taxes would all have to be raised as well, and loopholes for shifting income offshore would need to be closed.

But suppose all that is done, and the U.S. manages to implement high effective tax rates on the rich in addition to high statutory rates. What might be the economic harm from this move? High taxes are unlikely to prevent prosperous people from working — both economic evidence and the U.S.’s own history show that the impact on work effort is small. Nor would raising capital gains taxes reduce investment by nearly as much as naysayers claim.

There is one kind of economic activity, however, that might be affected by high upper-bracket tax rates — innovation.

When we think of innovation, we often think of technological invention — researchers in a lab discovering the secrets of nature. Much of that gets done in government-funded university labs, and hence wouldn’t be impacted by higher taxes — if anything, the increased revenue would help to fund an expansion of basic research.

But lots of innovation doesn’t happen in labs. It happens in the office and on the factory floor, as workers figure out a bunch of small ways of doing things more efficiently. And it happens at the business level, as entrepreneurs figure out new business models, new ways to meet consumer demand, and new ways to bring the bounties of technology to the masses.

This last type of innovation is what economist Joseph Schumpeter called creative destruction, because it inevitably means incumbent businesses are displaced by newcomers. In recent times, when everyone is trying to launch a startup, and venture capitalists are throwing money at silly ideas, the notion that startups are crucial for national wealth might seem a bit far-fetched. But ultimately, a nation benefits from armies of entrepreneurs seeking their fortunes by bringing consumer products to the masses. Economics research bears this out — young, fast-growing businesses create more jobs and raise productivity more than other companies.

Would high taxes discourage people from engaging in this sort of entrepreneurship? It could. Research by economists Matthew Smith, Danny Yagan, Owen Zidar and Eric Zwick has found that much of the income earned by very wealthy people comes from “business profit [accruing] to working-age owners of closely-held, mid-market firms in skill-intensive industries.” Those are exactly the people liable to be hit by upper-bracket tax hikes.

Suppose a worker is choosing between keeping a lifetime job at Google for $200,000 a year (after taxes) and going off to found her own company. Suppose she could sell her company for $10 million if it succeeds. With a 20 percent capital gains tax rate, she’d get $8 million, which would be equivalent to 40 years of her Google salary. But with a 70 percent tax rate, she’d get just $3 million, equal to only 15 years of salary. That may not be enough to justify the risk of quitting her cushy job.

In this example, high taxes wouldn’t just deter the creation of a startup that would probably raise employment and productivity. It would also cement the dominance of big corporations by making it easier for them to retain top talent and deterring potential competitors. That could worsen the problem of industrial concentration and monopoly power.

But how large would this effect be? There’s surprisingly little definitive research on the subject. A few papers have found that high tax rates prompt some inventors and scientists to choose different countries to live in, and there’s evidence that high corporate taxes discourage patenting and research and development. These results are often cited to show that the effect of income taxes on entrepreneurship would be substantial, but they’re not really the same thing. Studies that measure the correlation between personal income taxes and entrepreneurship tend to find mixed results. The most recent research in the U.S. tends to find small effects.

That’s consistent with the U.S.’s recent experience. Top income tax rates have come way down since 1980:

Don’t Be So Sure That Tax Cuts Are Good for Startups

But at the same time, entrepreneurship has been declining:

Don’t Be So Sure That Tax Cuts Are Good for Startups

Much of that decline has come from a drop in small-business formation, particularly in retail. But evidence shows that since 2000, rates of high-growth startups have also fallen, despite cuts in the top tax rate and dividend tax rate under President George W. Bush.

So even if high taxes on the well-off do reduce the rate of business formation, the effect doesn’t seem to be enormous. The possibility that a higher tax rate like the one proposed by Ocasio-Cortez might affect innovation is worth worrying about, and if entrepreneurship goes into a free fall those tax hikes should be at least partially reversed. And more evidence is needed regarding the relationship of taxes and creative destruction. But as of now, the danger doesn’t look severe.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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