Innovation has a silent killer…a scourge that America has aided and abetted for over a century.
Innovative activity is the backbone of the economy. Thanks to Google, Honda and Netflix, life is easier for billions of people around the world. A Stanford study found that up to 85% of economic growth is due to innovation. What if all these innovations had never happened? Besides, how much innovation could have happened but never happened due to government policy?
There is a culprit that has been silently killing innovation for decades: progressive taxation. A progressive tax takes a higher percentage of a person's income, the more money they earn. For many years, the income tax was deemed unconstitutional. But in 1913, the 16th amendment opened the door to a progressive tax structure. Today, the federal government and 21 U.S. states have a graduated income tax.
At first, the problem with this policy may not be obvious. The rich have more money, sure, they can afford to pay a little more, right? Even if this logic may seem innocent, it constitutes a major obstacle to economic growth. A recent study found that for every percentage point increase in the tax rate on top incomes, there is a 4% decline in patents, citations, and inventors, all of which are used to measure innovative activity. This means that even a slight increase in taxes is a major blow to invention and the resulting economic growth. But what creates this strong negative correlation between taxation and innovation?
How does progressive taxation stifle innovation?
Progressive taxation is presented as a way to help the poor by reducing wealth inequality. Politicians paint a picture of a greedy capitalist society in which the rich hoover up resources while the disadvantaged are left destitute. They argue that a progressive tax structure helps the poor by providing government services funded by tax dollars from the rich, thereby narrowing the income gap.
The problem with this policy lies in its effect on incentives. Because you have to pay more and more as your income increases, progressive taxation penalizes people who earn more money. If the enrichment of individuals had a negative effect on the economy, then this approach could be justified. However, getting rich in a market system is undeniably a positive activity.
To generate economic profit, you must create something that consumers value more than the materials that make it up. If the raw components of an iPhone were more valuable than the iPhone itself, it wouldn't be produced. The more pleasure producers can bring to consumers while using materials efficiently, the more profit they will generate. This is why the profit system is such a productive force in the economy.
But a progressive tax disrupts this process. When making profits and acquiring wealth are penalized, the incentive to pursue these activities diminishes. Inventors will be less likely to incur the risks and costs inherent in entrepreneurship if the incentive to get rich through innovation diminishes. Smartphones, laptops, and airplanes are all the result of innovators who had a profit motive to invent. Since progressive taxation discourages innovation, it discourages economic growth.
Trading wealth equality for increased poverty
The “eat the rich” mentality has become a staple of American life. 61% of Americans think wealth inequality is too high, and one of the most recommended solutions to this so-called “problem” is progressive taxation. However, this logic leads to dangerous conclusions. Margaret Thatcher once said that his political opponents “would prefer the poor to be poorer provided the rich were less rich.” The economy is not a zero-sum game. Instead, as entrepreneurs innovate and strive to get rich in the free market, the poor benefit from the resulting economic gains.
China's remarkable growth demonstrates this principle. Between 1981 and 2015, the rate of extreme poverty in China increased from 88.3% to 0.7%, from 878 million poor to 10 million. What changed? A new president, Deng Xiaoping, led several economic reforms, making considerable progress toward a free market economy. With this new policy, in less than 50 years, China went from zero billionaires to 324 billionaires. As the rich got richer, the poor… also got richer.
Proponents of progressive taxation argue that the wealthy do not pay their fair share to society in a flat tax system. In reality, the rich give far more than their fair share to society through the goods and services they provide to solve problems. Furthermore, when entrepreneurs are discouraged by a progressive income tax, the entire economy suffers, rich and poor alike. If politicians truly have the best interests of the poor in mind, they should start by ending the progressive tax structure that stifles their progress.
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