As America’s advantage in innovation erodes and levels of entrepreneurial activity decline, it is becoming increasingly important that tax policy does not further hinder economic dynamism. Unfortunately, a recent proposal by freshman Rep. Alexandria Ocasio-Cortez (D-NY) to increase the top income tax rate to 70 percent would unmistakably do this. In addition to making dubious claims about tax history, advocates of this proposal ignore that a high top marginal income tax rate would deter innovative activity, including the work of inventors and entrepreneurs.
The congresswoman’s proposal is arguably based on the work of economists Emmanuel Saez and Peter Diamond, who claim that the optimal tax rate for maximizing revenue is 73 percent. This work does not account for the incentive to enter high-earning occupations.
Individual decisions to enter an occupation include weighing the expected return of one’s effort and educational investments and the cost of forgoing alternative opportunities. Saez and Diamond consider this but say there is limited economic data to determine how high top marginal income tax rates impact long-run decisions such as investing in education or becoming an entrepreneur.
High top marginal income tax rates could make some people reconsider their plans to upgrade their skills or try to implement a risky business idea. There are at least two forms of innovative activity deterred by a higher top marginal income tax rate: the generation of new ideas and formation of entrepreneurial ventures.
New ideas are often formed and implemented by individuals working in applied research, such as a medical doctor researching a cancer treatment or a materials scientist building a smaller lithium-ion battery. It requires a significant investment in time and energy to discover and refine an innovative idea, but the expected return is high. A higher top marginal income tax rate reduces this expected return, and makes alternative opportunities look more attractive for would-be innovators. Fewer of them would think the investment is worth the expected return.
A 70 percent top marginal rate would also deter potential entrepreneurs, who must invest high levels of time and effort into an innovative firm. These entrepreneurs often take new ideas and merge them with a sound business model in search of profit. As Stanford economist Charles Jones explains, “High incomes are the prize that motivates entrepreneurs to turn a basic research insight that results from formal [research and development] into a product or process that ultimately benefits consumers.”
The economic literature confirms that higher marginal income tax rates have a negative impact on innovation. Marginal tax rates weigh heavily on inventors when deciding where to locate, and empirical evidence suggests that “higher personal and corporate income taxes negatively affect the quantity and quality of inventive activity and shift its location at the macro and micro levels.”
These activities benefit more than just the inventors or entrepreneurs. Innovative activity increases incomes across all levels, as a productive idea is replicated and circulates throughout the economy in the form of higher worker productivity, output, and incomes.
Advocates of a 70 percent top marginal income tax rate take high-income earners as a given, forgoing the costs and risks these earners incurred to obtain that income. While any tax on high earners may deter some innovative activity, it is important that we consider what trade-offs we are making when we consider raising the top rate. A 70 percent top marginal income tax rate would make many potential inventors and entrepreneurs abandon their plans to invest in human capital, invent technologies, and form innovative businesses, to their detriment and to the detriment of society.
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