Innovation Economics: The Race for Global Advantage
By Robert D. Atkinson and Stephen J. Ezell
440 pages; Yale University Press, 2012

The phrase “industrial policy” comes with a lot of baggage, at least for those who can hearken back to Walter Mondale. Today, it connotes an activist government that shunts capital into favored industries, uses the tax code to reward friends, and generally gets involved in decisions that should not be made by government.

Anyone paying attention would say that is a spot-on description of our current government’s modus operandi, but no one who has helped create the leviathan devouring our taxes and freedom today (both sides of the political spectrum are to blame, incidentally) would admit to having been a party to the creation of anything as nefarious as an industrial policy. Like boiling a frog, it has occurred quite gradually, although the water in the pot has always been quite warm.

Blowing up the current arrangement would disappoint few economists. However, there is little unanimity on what should replace our current, convoluted industrial policy. While the natural conclusion of the libertarian-minded would be for government to drop corporate tax rates, tax expenditures, and anything resembling an explicit subsidy into the dust-bin and be done with it, Rob Atkinson and Steven Ezell argue—at times quite convincingly—to replace the current industrial policy with a smarter, leaner one.

Atkinson is the president and founder of the Information Technology and Innovation Foundation, where Ezell is a senior scholar, so their interest lies first and foremost
in figuring out how the government can leverage the gains from the information technology (IT) revolution. They argue—with plenty of data supporting them—that massive productivity gains in the U.S. economy in the 1990s were primarily the result of firms finally adopting IT en masse and using it to generate massive gains in productivity, driven primarily by Wal-Mart and its retail-sector competitors. Today, these gains have diminished and there’s ample evidence (that Atkinson cites elsewhere) that even
the diminished productivity growth of late may be overstating the little growth that is actually occurring.

The current plight of the economy means that economic growth may be more important now than ever, given the pressing need for economic growth to generate sufficient tax revenues to get us out of our fiscal hole.

If we’re going to do industrial policy (and make no mistake about it, we are—as anyone who’s spent even a smidgeon of time in the favor factory that is the U.S. Senate can attest), let’s think about doing it so that we get the most bang for the buck. A key way to do this is to tilt our tax code in favor of those industries that face the most competition from foreign entities. The vast bulk of those foreign firms receive their own share of subsidies, tax breaks, and favors from their own governments that
dwarf the advantages we proffer our own companies.

Unlike the libertarian ideal, Atkinson and Edzell’s proposal may be achievable. But how can a card-carrying libertarian not shout “J’accuse!” at the top of his lungs at such a thought? Because Atkinson and Ezell have a point—and because their reforms would represent a system markedly superior to the travesty currently in place.

Rates vs. breaks | Among other things, Atkinson and Ezell’s book serves as an opening salvo in the upcoming battle over corporate tax reform. Most people on the left and right now agree such reform should be a high priority for the next Congress, even if they disagree over how it should be done.

An oft-overlooked truism in economics is that the entity that writes the check to the government is not necessarily the one that bears the burden of the tax. For instance, the notion that employers and employees equally share the burden of the Social Security tax is an accounting fiction. In the tax’s absence, the incomes of workers could go up by the entire amount of the tax (depending on the labor supply), meaning that workers bear the full burden of the tax.

Similarly, the corporate income tax is not borne solely by the evil, faceless corporations or even their shareholders. To wit, the corporate income tax decreases the returns
to investment in plants, equipment, and machinery. As a result, less investment is undertaken and workers are less productive than they otherwise would be. Hence, wages
are lower, the company produces less (and earns fewer profits), and prices for whatever they produce are higher as well. Therefore, workers and consumers bear the burden of a corporate income tax along with the owners of the company, and the relevant question for policymakers is how the burden is split among the three. That answer is important regardless of whether the concern is to maximize economic growth or redistribute income: if the burden primarily falls on workers, then the corporate tax code isn’t going to be very effective at either one.

The bulk of research of the last decade suggests that labor bears the brunt of the corporate tax burden, making the tax an especially bad way to redistribute income— even the lefty citadels at the Tax Policy Center have accepted this. Therefore, a lower corporate tax rate would increase wages and ameliorate income inequality more than other tax changes.

But Atkinson and Ezell have other concerns. What worries them is that the U.S. corporate tax code stands out not only because of its high statutory rate (highest among the nations in the Organization for Economic Cooperation and Development), but also because it does a lousy job of incentivizing investment. Our corporate tax code ostensibly encourages investment via two “tax expenditures”: the research and experimentation (R&E) tax credit (which gives a tax break to companies that increase their spending on activities that fall under those labels) and “bonus” depreciation, which allows companies to deduct spending on equipment more rapidly than it actually depreciates in value. But the bonus deprecation isn’t especially generous, and neither is the R&E credit—and the latter is not designed particularly well to begin with.

While we know what tax reform generally does (trades the loss of various preferences for a lower tax rate), the question on the corporate side is how far can Congress take this process. Specifically, would it make sense to jettison the investment incentives for new plants and equipment (via the bonus depreciation) as well as the research and experimentation tax credit, in a quest to get the rate as low as possible, assuming the best we can do is a revenue-neutral reform?

The answer that a company pleading to Congress would give to that question depends on how much it benefits from these incentives, of course. A capital-intensive business that spends a lot of money on research and development perceives that the lower rates won’t make up for the lost incentives, so it is not particularly anxious to make that deal. Companies that undertake little R&D or capital investment are keen on such a tradeoff and have been diligent in letting the tax-writing committees know. Which firms do we disappoint?

The temptation is to choose the low rates and insist that the market can sort it out more efficiently than the tax code can. Atkinson and Ezell argue that this is a copout: to quote Geddy Lee, if you choose not to decide, you still make a choice—in this case, in favor of banks and financial companies, and against manufacturers. Atkinson and Ezell wouldn’t pass judgment for tilting the tax code this way because of its increase in inequality (although others would), but they would object to making U.S. businesses that compete against foreign entities operate under a tax code that renders them even less competitive. And make no mistake, the current U.S. tax code does them few favors.

Taxing tradable goods differently | This brings us to the second point of their book: We need a tax code that treats companies that compete globally, in the traded sector of the economy, differently than companies that have no international competition. Haircuts can’t be outsourced to India, but there is no tax on this service. Tractors can—and are—produced all over the world, and the tax environment for tractors is worse in the United States than almost anywhere else. It’s equally bad for U.S. companies operating abroad, for reasons that make absolutely no sense.

It raises an important philosophical question: Is tilting a country’s tax code so as to make it more favorable toward exporters akin to managing trade? Or how about funding an agency that makes loans to potential customers of major exporters? To some degree it undeniably is. Consider the complaint of Delta Air Lines, which argues that U.S. Export-Import Bank loans to foreign air carriers to purchase jets from Boeing put Delta at a competitive disadvantage, since it isn’t privy to the same cut-rate financing if it bought Boeing jets.

Atkinson and Ezell argue that unilateral disarmament in the high-tech jobs race, which is our current modus operandi, is a path to the eventual disappearance of the high-tech, high-value-added jobs in building aircraft, construction equipment, farm equipment, automobiles, and a host of other industries that China and Europe have been aggressively courting with their fiscal tools. The Chinese ex-im bank is 10 times the size of the U.S. bank, and direct government subsidies to their fledgling aircraft and construction equipment dwarf anything we do for our own companies. That does not even count the rampant theft of intellectual property that the Chinese government is (at best) ignoring or (at worst) abetting. A corporate tax reform that jettisons the R&E tax credit and bonus depreciation would exacerbate an already perilous environment for our manufacturers, they declare.

Economic growth rather than neutrality| The problem with the U.S. Ex-Im Bank lies largely in the micro-managing that Congress exerts over it: while the current mandate is for Ex-Im to make loans to overseas customers of U.S. businesses, it must make sure that a proportion of those loans go to support small businesses, women-owned businesses, and minority-owned businesses. No doubt, a congressional staffer is working hard this very minute to identify other aggrieved groups who deserve a loan support quota as well.

Our government tries to do too many things for too many groups. Telling it to do less is always a safe directive. But that may not be an option here: if we are going to fundamentally reform the tax code and have our government fund an export-import bank, we need to come to some sort of agreement on the goals of these efforts. Atkinson and Ezell argue—convincingly—that the goal of both should be economic growth, and the way to achieve that is to create a system that gives U.S. companies that compete in a global market as much of a competitive edge as we can, even if that means that companies that face no such international competition see their relative burden for funding government go up. The competing message, namely that we worship the vague totem of simplicity for its own sake, can respond only by labeling this reform as interventionist.

Simplicity should not be the goal of tax reform; economic growth is the metric that really matters. Atkinson and Ezell argue that a tax code that favors investment, research, and development produces more economic growth. Those who want a tax reform that merely simplifies the corporate code by jettisoning these incentives have to either explain why such a reform would produce higher economic growth than keeping pro-growth incentives, or else why simplicity is worth slower growth.

Simplicity and economic growth may go hand-in-hand when it comes to reforming the personal tax code, but Atkinson and Ezell present a compelling brief for why this is not the case when it comes to corporate tax reform. Here’s hoping we have a reason to pay attention to them soon.

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