Friday, January 25, 2008 - The Progress & Freedom Foundation Blog

The Tax Threat to American Innovation

Key to America's preeminence in global innovation is our ability to attract capital of all types -- physical, financial, human, and what I call innovation capital, or entrepreneurial risk-taking. For most of America's existence we treated capital more hospitably than almost any nation or region. We enjoyed a massive capital surplus for 350 of those 400 years as investments and immigrants streamed to our shores. Simply put, over the last few hundred years the world gave us its money and its smartest people.

Although many factors govern capital hospitality, a chief measure is marginal tax rates. Low tax rates have long been a key global advantage for America. It is true that over the last 90 years U.S. tax rates rose dramatically from historical levels, albeit with healthy and successful reductions in the 20s, 60s, 80s, and 00s. But what critics of tax rate cuts so often miss is that during much of this period two-thirds or more of the world was either Communist (China, USSR), heavily socialist (India), quasi-socialist (Western Europe), or part of the "developing world." Even high U.S. tax rates were far lower than ROW -- rest of world. We vacuumed up capital -- and thus tax receipts -- from every corner of the globe. The twentieth century was an economic debacle in most of the world, except for the West, Japan, Hong Kong, and a few other islands of relative low-tax prosperity. The low-tax, capital-friendly West won both the economic battle and the Cold War.

The U.S., however, is no longer a low-tax nation.

Using the American supply-side boom economy as their template, the populous former communist nations of Eastern Europe and China are now among the leaders in low-tax, capital friendly policies. The important Bush tax cuts of 2003, which yielded robust growth in output and tax receipts, merely acted to keep us somewhat competitive on the world stage. Our complex tax code is no longer an acceptable (if infuriating) indulgence we can afford. Today it is a major, and unacceptable, drag on growth. At 35%, we have the highest corporate tax rate in the world, save Japan, another formerly low-tax nation that now faces many of the same challenges of complacent wealth.

At a time of both rising global competition and global prosperity, we should be moving to radically simplify our tax code and reduce marginal rates. With tax receipts running strong as we lower top marginal rates, this should be an obvious, uncontroversial, and urgent national priority.

Instead, we appear to be moving in just the opposite direction. Democrats are all committed to repealing the Bush tax cuts and in some cases raising tax rates to higher levels than prevailed under Bill Clinton. Meanwhile, many Republican politicians and conservative thinkers believe the GOP, with its political fortunes flagging, needs to abandon its spectacularly successful supply-side economic plank in favor of a long series of micro-targeted tax credits for the middle-class and higher tax rates on energy and on "the rich," who, after all, can afford it. In their search for the "new," however, these conservatives are turning their backs on the single most successful GOP strategy -- both in policy and political terms -- of the last 30 years. It is the elevation of cleverness over wisdom.

On taxes conservatives should go back to the supply-side source. They should listen to Art Laffer, who on Friday threw down the tax gauntlet.

Since 1980, statutory marginal tax rates have fallen dramatically. The highest marginal income tax rate in 1980 was 70%. Today it is 35%. In the year Ronald Reagan took office (1981) the top 1% of income earners paid 17.58% of all federal income taxes. Twenty-five years later, in 2005, the top 1% paid 39.38% of all income taxes.

There are other ways of looking at tax receipts by income bracket. From 1981 to 2005, the income taxes paid by the top 1% rose to 2.96% of GDP, from 1.59% of GDP. There was also a huge absolute increase in real tax dollars paid by this group. In 1981, the total taxes paid in 2005 dollars by the top 1% of income earners was $94.84 billion. In 2005 it was $368.13 billion.

In 2000 this teeny, tiny group -- 1% of all taxpayers -- actually paid income taxes equal to 3.75% of GDP, which is why President Clinton had a budget surplus. Much of this huge surge in tax payments by the top 1% of tax filers resulted from the huge increase in realized capital gains resulting from President Clinton's capital gains tax rate cut to 20% from 28% in 1997.

The evidence is in, and it proves the supply-siders' original tax insight that cutting the top marginal rates on income, capital gains, and dividends could boost growth and tax receipts. Fooling around with tax credits and lower brackets, while sometimes advisable, meanwhile, are pure revenue losers.

Using recent data, in other words, it would appear on its face that the Democratic proposal to raise taxes on the upper-income earners, and lower taxes on the middle- and lower- income earners, will result in huge revenue losses on both accounts [my emphasis]. But some academic advisers to Democratic candidates have a hard time understanding the obvious, devising outlandish theories as to why things are different now. Well they aren't!

In the 1920s, the highest federal marginal income tax rate fell to 24% from 78%. Those people who earned over $100,000 had their share of total taxes paid rise -- from 29.9% in 1920 to 48.8% in 1925, and then to 62.2% in 1929. There was no inflation over this period.

With the Kennedy tax cuts of the 1960s, when the highest tax rate fell from to 70% from 91%, the story was the same. When you cut the highest tax rates on the highest-income earners, government gets more money from them, and when you cut tax rates on the middle and lower income earners, the government gets less money from them.

Even these data grossly understate the total supply-side response. A cut in the highest tax rates will increase lots of other tax receipts. It will lower government spending as a consequence of a stronger economy with less unemployment and less welfare. It will have a material, positive impact on state and local governments. And these effects will only grow with time.

There is no upside to raising top marginal rates on labor and capital. Zero. None. It is a pure loser any way you slice it, an utterly punitive measure aimed at the entire American economy.

Today the world has adopted supply-side economics, and the result has been a dramatic rise in wealth and reduction in poverty. The world is freer and richer. But for investors, entrepreneurs, and would-be immigrants, the choice about where to deploy their money, effort, and talent -- and where to pay their taxes -- is no longer so obvious. Options now abound: China, India, Ireland, Eastern Europe -- even Western Europe is showing signs of life. When capital, labor, and ideas move around the world at the speed of light, George Gilder's insight is more true than ever:

"High tax rates don't redistribute income, they redistribute taxpayers."

Taxes too often are assumed to be a game of money-shuffling and political give-aways. In fact, marginal tax rates are crucial to American innovation.

posted by Bret Swanson @ 7:32 PM | Taxes