The U.S. economy is hurting—GDP is estimated to have fallen by nearly 10% in the second quarter. This decline isn’t surprising since large portions of states’ economies have been shut down for months due to the pandemic, but it has worsened the country’s and states’ already bleak fiscal situations. Understanding the damage is important, but what’s more important is a plan for strong economic growth that will help repair our damaged finances. Raising taxes is a tempting solution, especially taxes on high earners, but doing so could stifle the recovery we need.
Right now, governments at all levels are focused on spending money to help people cope with the economic fallout from Covid-19. But we can’t spend trillions of dollars indefinitely. To get government budgets under control spending needs to be cut, taxes increased, or both.
The primary purpose of taxes is to pay for public goods and services that the private sector struggles to provide, such as national defense, some infrastructure projects like highways, and a legal system to maintain law and order. In more recent decades governments have also contributed to a basic social safety net people can use during hard times, such as the current pandemic.
Even though some taxes are necessary, we must be mindful of the effects taxes have on the economy. A new paper from economists Ufuk Akcigit and Stefanie Stantcheva discusses how taxes impede innovation. Both the quantity and quality of innovation—measured by patents and citations, respectively—decrease as personal income taxes rise. A 10% increase in personal income taxes reduces the quantity and quality of patents by about 6% and 8%, respectively.
The authors also note that inventors often move in response to higher state and federal taxes. Among U.S. inventors living in a state they are not from, a 10% decrease in the net-of-tax rate (the percentage of a dollar kept after taxes and equal to one minus the tax rate) results in a 12% decline in the number of inventors. So, when taxes go up, some inventors move to states with lower taxes or do other things with their time.
At the national level, superstar inventors—those in the top 1% of inventors based on quality—respond to top marginal tax rates, especially foreign superstar inventors living in America. A 10% decrease in the net-of-tax rate causes a 10% decrease in the number of foreign superstar inventors. Taxes also affect domestic superstar inventors, but the impact is smaller since domestic inventors have more non-financial reasons to remain in the country. A 10% decrease in the net-of-tax rate causes a 0.3% decline in the number of domestic inventors. In both cases, taxes reduce innovation by diminishing the financial incentive people have to create new products and services.
Less innovation hurts the broader economy. Business dynamism has declined since the early 2000s, and even the long recovery after the Great Recession wasn’t enough to fully restore it. One measure of the economy’s overall dynamism is “churn”, measured as the sum of the rates of establishment births and deaths. The figure below shows the churn of U.S. businesses over time. It was highest in the early 2000s and then trended downward. Churn increased more recently but was still below the peak.
Taxes are one factor that can deter new businesses and decrease dynamism. According to a recent study, corporate tax increases accounted for about 10% of the decline in America’s business dynamism from 1980 to 2010.
The country’s fiscal situation is a mess and the coronavirus and accompanying shutdowns have only made it worse. The figure below from the Committee for a Responsible Federal Budget (CRFB) shows America’s debt is projected to be around 120% of GDP by 2030, up from around 95% prior to the pandemic. The Medicare and Social Security Trust Funds are also projected to be insolvent by 2024 and 2031, respectively.
Both Republicans and Democrats claim to care about the nation’s debt, but neither party has any plan to get it under control. President Trump refuses to control spending while presidential candidate Joe Biden mistakenly thinks more revenue can solve the problem. Biden’s plan is to raise taxes by around $3.5 trillion dollars over the next decade by increasing the corporate tax rate, the top marginal tax rate for personal income, and other taxes.
These tax increases are unlikely to shrink the debt, though, since Biden also wants to increase spending by as much as $6 trillion, including $1.3 trillion on infrastructure, $1.5 trillion on education, and $750 billion on health care.
Worse, as just mentioned, higher taxes reduce the incentive to innovate and invest which decreases GDP and employment over time. According to a recent report from CRFB, estimates show Biden’s tax plan would reduce long-run GDP between 0.2% and 1.5% and likely shrink the labor force.
These negative long-term effects are bad enough, but since higher taxes reduce innovation any near-term increases are likely to stifle new business formations just when we need them most. Government shutdowns and consumer fears caused by Covid-19 have forced thousands of businesses to close, many of them permanently. A strong recovery hinges on new entrepreneurs and innovators replacing the businesses that are no longer viable in a post-pandemic world, while in the process creating jobs for the millions of people who are currently unemployed.
States that fail to account for how taxes reduce innovation will push inventors and entrepreneurs away, delaying their recoveries. Similarly, federal tax increases deter foreign inventors from creating their new products and businesses in America. Governments and voters that ignore these effects do so at their own peril.