High Taxes Can Spur Innovation

A blog about business and economics.
July 24 2012 3:15 PM

High Taxes Brought Us Xerox PARC and Bell Labs

Some enterprising wingnut took to the pages of the Wall Street Journal to argue that the government really wasn't that involved in the creation of the Internet after all. This is totally wrong. The basic infrastructure of the internet is very much based on Arpanet, the key protocols of the World Wide Web were written by a guy working for CERN, and public universities were key early elements of the Internet's backbone.

What's more interesting is that the counter theory says we should give the real credit to Xerox PARC, the Palo Alto Research Center that really was responsible for a lot of important scientific and technical innovation. The thing about this is that we ought to understand both PARC and its East Coast friend Bell Labs as in important respects outgrowth of the high marginal tax rates prevailing in postwar America. These were, lets recall, very high rates. If you look on the corporate income tax side (PDF) you'll see that during the Eisenhower, Kennedy, and Johnson years the top rate hovered around 50 percent. Dividends were taxes at a rate that maxed out at 91 percent before declining to "only" 70 percent as a result of LBJ's tax cutting.

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This created a dynamic where "earn a profit and pay the profits out as dividends to our richest and most influential shareholders" was not a very high priority for managers. And for executives to give themselves a raise was tantamount to handing money over to the government. There was nothing left to do but spend it on something, and various high-tech research labs and skunkworks' fit the bill. After all, if something really awesome emerged you'd get glory—and the government can't tax glory.

Eventually we moved away from this model of taxation. For starters, it's not a great way to raise revenue. It also would seem to discourage new capital investments by ensuring that even if a startup did become super-profitable in the future that wouldn't necessarily be lucrative to its early investors. Last and relatedly it was thought to be inefficient to keep corporate capital "trapped" inside the existing corporate structure, rather than flushing out where it might be reinvested into something new. On the other hand, it's pretty well-established that profit-seeking firms will tend to underinvest in basic research and pie-in-the-sky projects. One response is direct government funding. But the old corporate research center model had the virtue of being more decentralized and better hooked-up to the concept of commercialization. The downside is that looking back from 2012 what we remember are the corporate research labs that came up with important insights, not the ones that turned out to be big wastes of money.

But you see the importance of taxes and corporate governance for research undertakings today. Google is controlled by its founders, and its founders seem really interested in crazy schemes and not so interested in dividends so Google is a big investor in blue sky projects. Apple, by contrast, is paying a modest dividend and hording cash offshore where it's not subject to US corporate income tax. They're hoping for a repatriation holiday, at which point it'll probably be used for dividends or share buybacks. If somehow Apple got afraid that President O'Malley was poised to tax all that money at the old-fashioned 50% then 90% rate, then I think we'd quickly find out what kind of pie-in-the-sky research sounds cool to Tim Cook.

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.

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