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My Latest Column: How Corporate Tax Reform Can Foster a More Competitive Economy

Recently, I touted the virtues of a new proposal for reforming the corporate income tax from Robert Pozen and Lucas Goodman. My latest column for Reuters Opinion does the same thing, and I elaborate on the idea that the tax deductibility of interest expenses tends to benefit large incumbents, thus giving them an advantage over start-ups that might otherwise seek to compete with them.

I begin with the premise that the standard Democratic and Republican prescriptions for fostering economic growth — increasing public investment and reducing marginal tax rates — fail to reckon with the fact that the rising cost of health entitlements limits our ability to sharply increase spending in other domains on reduce taxes. Then I advance the thesis, distilled by Ashwin Parameswaran of All Systems Need a Little Disorder, that the key to growth is more robust competition. Like Clayton Christensen, Ashwin has argued that we’re living in an era of high process innovation and low product innovation or, in Christensen’s terms, labor-saving efficiency innovations rather than empowering innovations: 

First, economies reorganise back to full employment in the long run not via increased consumption of existing goods and services but via consumption of entirely new goods and services. When process innovation drives down costs and prices, consumers may initially consume more of the existing basket of goods and services. But sooner or later, diminishing marginal utility and satiation sets in and consumption of existing goods and services stops increasing. At this point, new product innovation is needed to provide an entirely new basket of goods and services. Due to the uncertain nature of new product innovation, it is by no means a certainty that the economy will be able to provide the requisite amount of product innovation to maintain full employment, especially in the short run. It is precisely this combination of high process innovation and low product innovation that has made technological unemployment possible even in a period of stagnant productivity growth. In the short run, productivity growth can be sustained by process innovation. However, long run productivity growth requires bursts of product innovation along with persistent process innovation.

Yet this kind of product innovation tends not to come from incumbent firms. Rather, as Ashwin explains, it tends to be a product of firm entry:

Incumbent firms have very little incentive to invest significant resources in risky initiatives that aim to displace their existing cash-cow businesses. In many instances, they may face resistance not only from internal departments that feel threatened by the potential success of new products but also from customers who are reluctant to embrace disruptive change. In fact a great deal of the uncertainty in new product innovation arises from the fact that it is almost never driven by the customer. As the old adage goes, customers rarely know what they want unless they see it, a principle embodied by Steve Jobs’ time at Apple Computers. New product innovation requires constant trial and error and most of these trials are bound to fail. Incumbent firms are, quite rationally, primarily focused on protecting their existing source of profits and minimising the risk of failure rather than undertaking speculative risks where the odds of failure are greater than the odds of success.

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. [Emphasis added]

Regrettably, I didn’t have the scope to describe the dynamic Ashwin describes, but it is what motivated my sense that reducing the relative advantage of incumbents is an important cause. Making the world less “safe” for large incumbents might make the world better for consumers and workers, as there will be more competition to drive down prices and more firms competing for talent as new products are developed. Regulatory reform and patent reform can help in this regard. But so can reducing the debt bias in the tax code, hence my reference to Pozen and Goodman’s work. 

The conventional view is that the main reason the debt bias matters is that pushes firms to become excessively leveraged, and thus to become fragile. And it’s very possible that I’m exaggerating how big a deal reducing the debt bias would be for new entrants. But it does seem like a potentially important part of how we might facilitate the kind of new product innovation that leads to job creation. 

I should also note that there is a fascinating new working paper, which Arpit Gupta kindly recommended I read, on Belgium’s experiment in reducing debt bias. Frédéric Panier, Francisco Pérez-González, and Pablo Villanueva evaluated Belgium’s “notional interest deduction” (NID):

This paper shows that capital structure significantly responds to changing tax incentives. To identify the effect of taxes, we exploit the introduction of a novel tax provision (the notional interest deduction, or NID) as an arguably exogenous source of variation to the cost of using equity financing. The NID, introduced in Belgium in 2006, drastically reduces the tax-driven distortions that favor the use of debt financing by allowing firms to deduct from their taxable income a notional interest charge that is a function of equity. Our main findings are four. First, the NID led to a significant increase in the share of equity in the capital structure. Second, both incumbent and new firms increase their equity ratios after the NID is introduced. Third, the largest responses to these changing tax incentives are found among large and new firms. Fourth, the increase in equity ratios is explained by higher equity levels and not by a reduction in other liabilities. The results are robust to using data from neighboring countries as a control group, as well as, relying on a battery of tests aimed at isolating the effect of other potential confounding variables. Overall, the evidence demonstrates that tax policies designed to encourage the use of equity financing are likely to lead to more capitalized firms. [Emphasis added]

Essentially, Belgium took the opposite approach from Pozen and Goodman. Rather than reduce the subsidy for debt, they increased the subsidy for equity. The end result was that Belgium now has more capitalized firms, which are somewhat less vulnerable to bankruptcy. 


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