The UK Conservative party caused consternation in the financial markets last year after plans to cut the top rate of income tax. The plans were intended to boost growth by encouraging entrepreneurship and investment by giving wealthier people more of their own money to deploy.
While the government quickly backtracked on the proposal after the adverse reaction it received, a recent study from Stanford Graduate School of Business explores whether the tactic was ever likely to actually work.
Restricting innovation
The researchers suggest that the debate around the top rate of tax is often framed in terms of whether raising it or lowering it encourages wealthier people to hide their income to reduce their tax burden. They wanted to see whether it also affects the creation of new ideas.
It transpires that innovation is a crucial lens through which to view this issue, as, without it, they argue that the top tax rate could be as high as 91% without impacting matters too much, although they suggest that an ideal rate should be no higher than 50%.
It’s also an interesting new perspective on a debate that seldom seems conclusive, with high top tax rates often seeming to produce both higher and lower economic growth, and without counterfactuals it’s hard to understand precisely what causes any change.
Sensitive to taxation
The researchers believe that what is clearer is that innovation is something that is inherently sensitive to taxation. The study shows that when the so-called “keep rate”, or the amount that remains after one has been taxed, is increased by 10%, then the rate of innovation grows by more than 20%.
What’s more, the researchers believe that because innovations tend to be beneficial to the incomes of those across the economy, a higher top rate of tax is likely to depress incomes across the board.
“When the top 1% produce fewer ideas, it reduces their income and tax revenue but also consumption of the middle classes,” the researchers explain.
Of course, raising the top rate of tax is also likely to increase the amount of money raised by the government, but this increase may be insufficient to compensate for any longer-term reductions in income as a result of lower levels of innovation.
Indeed, so great would the hit to living standards be that even if the government engaged in extensive redistribution using the additional tax revenue they generate, it wouldn’t be enough to reverse the decline in living standards caused by the reduction in innovation.
“If you want to maximize worker welfare, you might want a lower top rate of tax,” the researchers explain. “If you let the rich create ideas, that makes the middle class better off.”
While the state is undoubtedly also an important actor in terms of supporting innovation, the study also suggests that it wouldn’t be enough to siphon any additional tax revenue into R&D. This is because a lot of innovation occurs beyond formal R&D, so it’s difficult for any state to target innovation interventions effeciently.
For instance, the authors highlight that companies like Goldman Sachs and Walmart report spending nothing at all on R&D, although each are active in terms of commercializing new ideas.
“Research subsidies miss the important stuff,” the authors explain. “Think about the creation of new firms like Amazon or Uber, or the application of machine learning and artificial intelligence to all sorts of business and consumer problems. This is often not covered under formal R&D.”
While there has been considerable doubt about the value of “trickle down” economics, the researchers are confident that lowering top tax rates could indeed stimulate economic growth via the discovery of new ideas. What’s more, this may also be a better way of improving the welfare of society more broadly than having higher tax rates and greater levels of redistribution.
