What About Taxing Our Way To Innovation?

The status quo doesn't work. Let's explore new approaches.

Happy Wednesday! I hope everyone has had a good few weeks while I was on vacation. I’m not sure I’m back more rested (is a vacation with a toddler restful or just parenting in a different place?), but it was a lot of fun!

Somewhat on the parenting front, before I left, I joined

AJ Tibando

to record an episode of

The Midpoint Review

. We covered a lot, from the weight of parenting amid the climate crisis and a livestreamed genocide, through to questions of corporate profiteering, building inclusive societies, AI chatbots as the end-game atomization of society, and our generation’s responsibility to step up.

It was a heavy talk at times, but also really enjoyable. Do check it out:

"We don't have to accept the world as it is. We can reshape it." (with Tom Goldsmith)

Now, on to today’s post.

What About Taxing Our Way To Innovation?

Photo by Jon Tyson on Unsplash

When we look to boost productivity, accelerate growth, and increase innovation, we tend to revert to some orthodox economic approaches.

We often provide more subsidies to businesses, whether one-time ones, like those for EV and battery manufacturing or indirect ones, such as through SR&ED.

Alternatively, we tinker with the tax code by reducing corporation tax rates. Since 1980, the federal net corporate income tax rate on general income has fallen from 36% to 15% today.

This week, the C.D. Howe Institute released a “six-point productivity focused tax reform plan” representing that economic orthodoxy. The plan proposes cutting the federal corporate income tax rate from 15% to 13%. As the authors argue:

Corporate income taxes are particularly harmful to investment. Higher CIT rates reduce the after-tax return on new projects, lowering their appeal to foreigners and Canadians alike. Conversely, lower rates make Canada more attractive to investors, a crucial consideration given ongoing trade tensions with the United States.

But self-evidently, the orthodox approaches aren’t working. If corporation tax cuts really did boost productivity, then the decades of reductions would have yielded very different results.

So what if we turned things on their head?

Put A Tax On Operations

In a 2018 article, Innovation, Reallocation, and Growth, Daron Acemoglu, Ufuk Akcigit, Harun Alp, Nicholas Bloom, and William Kerr build a model that does just that and found that taxes far surpass the benefits of subsidies for increasing innovation.

They built a model based on industrial data covering 98% of industrial R&D conducted in the US from 1987 to 1997. The key market failure they explore is around the allocation of skilled labour, where too much is wasted in the operation of low-type firms. Instead, to maximize welfare, you want to move those people to work on R&D for high-type firms.

They conclude that the “optimal policy should free up resources from the operations of low-type firms to be used for R&D by high-type firms, and this can be achieved by encouraging the exit of low-productivity firms, for example by taxing the operations of all firms.” While this reduces the R&D from those firms who exit, it increases the R&D of high-type incumbents by moving more skilled labour to firms with higher productivity, creating significant spillovers.

Meanwhile, they find that “industrial policies (subsidies to incumbent R&D, incumbent operating costs or entrants) are either ineffective or tend to reduce growth and welfare.”

A rather different approach to the usual arguments.

Applicability To Canada

Of course, this is an academic article based on US data, not a policy prescription for Canada. Given our issues with capital flight and brain drain, we need to explore what impact this kind of tax would have here.

Nonetheless, it is a valuable thought experiment. That it goes against the policy status quo over the past 40 years should not disqualify it. As Kelly Hayes has argued:

A lot of things people say ‘cannot be done’ have not been meaningfully attempted in our context or our lifetimes. It’s easy to maintain myths of impossibility when you crush all experiments.

And, there are reasons to think such a tax would be effective in Canada.

Not least is Canada’s substantial number of “zombie firms” or “businesses that perform poorly over a long period of time without exiting.”

A 2023 StatsCan report finds that while some estimates of Canada having the largest share of zombie firms among advanced economies are exaggerated, we still have many, and they are “increasingly lowering aggregate productivity in Canada, upwards of 5% in 2019.”

The report finds that:

their performance relative to healthy firms has been declining and the resources that they account for have been rising. The latter finding has particular importance because the regression evidence presented in this study shows that the increasing presence of zombies in an industry negatively impacts the productivity and growth of healthy firms.

It supports some of the findings of 2018 article, finding that:

Labour hoarding by zombies (as opposed to capital hoarding) is particularly burdensome on healthy firms, indicating that zombies could exacerbate labour shortages.

Given the evidence in that report, it isn’t unreasonable to expect that measures to force these firms to exit could yield similar benefits to Canada’s growth and welfare.

So, why not explore more of what a tax along these lines would look like? We could use the tax revenues and the productivity gains to reform Employment Insurance properly, rather than applying more stop-gap measures, helping ameliorate the real human costs of so many firms being forced to exit.

Thinking differently is certainly better than just following the same tired approaches.