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NRO’s domestic-policy blog, by Reihan Salam.

A Schumpeterian Reason to Replace Corporate Income Taxes with Higher Capital Income Taxes on Individuals



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Apple CEO Tim Cook proved very effective in defending his company’s tax practices before the Senate’s Permanent Subcommittee on Investigations, and Josh Green of Bloomberg Businessweek has done an amusing job of breaking down Cook’s performance, which combined flattery and the deft exploitation congressional ignorance and beffudlement. Cook also emphasized that he is eager for corporate tax reform, a cause widely embraced by his questioners, but which of course means different things to different people. I’ve described my preferred model for corporate tax reform — let’s finance a substantial reduction in the corporate tax rate by capping the amount of interest firms can deduct from their tax bills, a measure proposed by Robert Pozen and Lucas Goodman. The basic idea is that this approach would tend to use the debt bias embedded in the tax code, which might help level the playing field for start-ups that raise money by selling shares in competition with large incumbents that can take greater advantage of borrowing.

But one might go even further by abolishing corporate income taxes and instead raising capital income taxes on individuals, an idea that has been embraced by, among many others, Megan McArdle, James Pethokoukis, and Matt Yglesias. Matt, however, raises an interesting wrinkle: relying on corporate income taxes might do a better job of encouraging firms to deploy their capital efficiently while relying on higher dividend taxes might encourage them to blow money on futile quests for market share. But like Matt and my guru Ashwin Parameswaran, I see this as a feature and not a bug. One of Ashwin’s central arguments (it’s not original to him, as he happily acknowledges, but he does an excellent job of distilling it) is that new product innovation is only rarely driven by incumbent firms:

In the absence of new firm entry, even a competitive industry with many players will focus on process innovation and cost reduction and avoid any potentially disruptive product innovation. When incumbent firms do undertake product innovation, they do when their existing source of super-normal profits is threatened by disruptive products from new entrants. In an environment where product innovation is high, not undertaking new product initiatives is the riskier option. Simply protecting existing revenue streams rarely works out. Despite this, many incumbent firms are rarely able to respond effectively to new entrants, primarily due to organisational rigidity. New entrants on the other hand face a different set of incentives. Having no existing profits to protect, the lure of capturing such super-normal profits drives their actions far more than the much larger possibility of failure.

Ashwin is talking about the virtues of start-ups. Something similar can be said of encouraging cash-rich incumbent firms in one sector to enter another sector. Spurring CEOs to attack rival firms in adjacent or even entirely new domains is rarely good for the bottom line, but it does the important work of keeping incumbents on their toes. Matt uses the example of Bing, Microsoft’s search engine that aims to displace, or at least to put pressure on, Google’s search engine, which remains the core of Google’s business. Google, in a somewhat similar vein, has made forays into delivering high-speed data connections, presumably in an effort to demonstrate the viability of doing so and thus to bait other firms into doing the same. If shifting from corporate income taxes to higher capital income taxes on individuals leads to more of this kind of reckless behavior, consumers, and workers, will tend to benefit. 



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