Taxes and innovation

A new paper finds that tax rates (corporate and individual) have large effects on innovation:

Our main findings can therefore be summarized as follows. Taxation – in the form of both personal income taxes and corporate income taxes – matters for innovation along the intensive and extensive margins, and both at the micro and macro levels. Taxes affect the amount of innovation, the quality of innovation, and the location of inventive activity. The effects are economically large especially at the macro state-level, where cross-state spillovers and extensive margin location and entry decisions compound the micro, individual-level elasticities. Not all the effects of taxes at the macro-level are accounted for by cross-state business stealing or spillovers. Corporate inventors are most sensitive to taxation; and positive agglomeration effects play an important role, perhaps in offering a type of compensating differential for taxation.

This goes against my prior, at least to some degree. I would have said before that incentives do matter for innovation — and that that includes taxes — but that the effect of taxes on innovation may not be that large. Here’s what I wrote a few years ago:

Of course benefits are only one side of the ledger. Taxes are just as often held up as a threat to entrepreneurship and a dynamic economy. A lower capital gains tax rate does seem to be associated with a greater supply of entrepreneurs. But keeping the capital gains rate low to help startups is incredibly inefficient, since only a small portion of realized capital gains are from entrepreneurial activity. As Harvard Business School professors Paul Gompers and Josh Lerner write, “policies that increase the relative attractiveness of becoming an entrepreneur and promote technology innovation probably would have more of an effect on venture capital investments than an across the board cut in the capital gains tax rate.”

Instead of preserving low tax rates, entrepreneur-friendly tax reform would encourage startup investment by shifting the tax code away from its current bias for debt over equity, and could preserve or expand key tax credits like the exemption for long-term investment in small businesses.

Here are my notes on taxes and economic growth in general.

I remain interested in how efficient low corporate, income, and capital gains taxes are or aren’t for incentivizing innovation, and how the tax code and other incentives might provide more tailored options. But taxes do seem to have a meaningful effect.

What tech is for

There is a topic I occasionally try to write about, but which always seems to turn out poorly. It goes like this:

The development of technology is, broadly speaking, an important driver of progress in the world. That development depends on social context, including culture, incentives, and rules which can further technological development or impede it. Getting the culture, incentives, and rules right requires mutual understanding, cooperation, and trust. And so it is worrisome when the tech sector and the rest of society seem so distant from one another, and so at odds. In particular, it’s worrisome when most of society believes the tech world has little to offer them.

Now, a few loosely related digressions…

What is the central idea behind Silicon Valley? Here’s how The Economist describes it today:

The Valley is not just a place. It is also an idea. Ever since Bill Hewlett and David Packard set up in a garage nearly 80 years ago, it has been a byword for innovation and ingenuity. It has been at the centre of several cycles of Schumpeterian destruction and regeneration, in silicon chips, personal computers, software and internet services. Some of its inventions have been ludicrous: internet-connected teapots, or an app that sold people coins to use at laundromats. But others are world-beaters: microprocessor chips, databases and smartphones all trace their lineage to the Valley.

Next, a bit of a detour, to the founding of the venture capital industry, on the east coast:

The first modern venture capital firm was formed in 1946, when MIT president Karl Compton, Massachusetts Investors Trust chairman Merrill Griswold, Federal Reserve Bank of Boston president Ralph Flanders, and Harvard Business School professor General Georges F. Doriot started American Research and Development (ARD) [Lample, 1989]. The goal of the company was to finance commercial applications of technologies that were developed during World War II.

Doriot was the heart and soul of ARD and is justifiably called the “father of venture capital.” Doriot’s focus was on adding value to companies, not just supplying money. Companies funded by ARD were considered to be “members of the family” [Sexton and Kasarda, 1991.] ARD’s staff under Doriot’s direction began providing industry expertise and management experience to the companies they backed in order to increase their chances of ultimate success.

Doriot served as ARD’s president until it was acquired by Textron in 1972. During the course of his tenure at ARD, Doriot’s vision was not one of “making money” but rather financing “noble” ideas. The first investment made by ARD in 1947 was in High Voltage Engineering Company. The firm, founded by several MIT professors, was established to develop X-ray technology in the treatment of cancer. ARD invested in the company for reasons noted by Compton’s comment to Doriot:

They [High Voltage Engineering Company] probably won’t ever make any money, but the ethics of the thing and the human qualities of treating cancer with X-rays are so outstanding that I’m sure it should be in your [Doriot’s] portfolio. [Lample, 1989]

When High Voltage went public in 1955, the original $200,000 investment was worth $1.8 million.

Just one more detour…

I recently finished AMC’s Halt and Catch Fire, which was the subject of one of the first pieces I wrote on this topic, back in 2014. Here’s what I wrote, comparing the show, which begins in the 80’s, to HBO’s satirical Silicon Valley, set in the present:

Why the contrast? Why do we increasingly glorify the tech industry’s past while mocking or dismissing its present? One answer is that history has a way of filtering out the also-rans and focusing on the greats. That may be part of the explanation, but there’s more to it.

Despite the current pace of technological change, it’s hard to shake the feeling that today’s new products and services are somehow smaller than the innovation we saw 20 or 30 years ago. The companies have fewer employees and rarely push the boundaries of basic or even applied science. The ideas that get hatched and funded are apps masquerading as platforms, platforms masquerading as breakthroughs.

Whatever we think of today’s tech companies and however much we believe the industry needs to be reined in or reformed, we must continue to incentivize and celebrate the development of new technologies — something that historically the U.S. and, most of all, Silicon Valley has excelled at. That isn’t a little thing, or an afterthought. It’s arguably one of the most important ingredients for economic success. Doing this doesn’t mean just blindly lionizing entrepreneurs, or obsessing over every VC fundraising. It doesn’t even have to revolve so heavily around VC-backed startups; that’s been a very successful model, but one among many. What it means is focusing on the job the tech companies are supposed to be doing: turning cutting-edge technologies into useful products and services that make society better off. That’s what Halt and Catch Fire was about, and that’s what ARD apparently was about. That’s the history of the modern tech industry. It ought to be its future, too.

Getting that right isn’t trivial, and right now the U.S. is largely just coasting off path dependence. We were good at innovation before, so odds are we’ll keep being pretty good at it. Over time, though, culture, incentives, and rules change or decay. We need to think about what we want from technology and actively create the sort of society that can deliver it. That requires some level of trust between the people in tech and the rest of us.