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May 11, 2024Original Analysis

Innovation’s Silent Killer: Progressive Taxation

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. Because of Google, Honda, and Netflix, life is easier for billions of people around the globe. A Stanford study found that up to 85% of economic growth is due to innovation. But what if all of this innovation never happened? For that matter, how much innovation could have happened, but never did because of government policy? 

There is a culprit that has been a silent assassin of innovation for decades: progressive taxation. A progressive tax takes a higher percentage of one’s income the more money one makes. For many years the income tax was deemed unconstitutional. But in 1913, the 16th Amendment opened the door to a progressive taxation structure. Today, both the federal government and 21 individual U.S. states have a progressive income tax.

At first, the problem with this policy may not be evident. The rich have more money, certainly, they can afford to pay a little more, right? While this logic may appear innocent, it is the source of a major inhibitor of economic growth. A recent study found that for every percentage point increase in the upper-income tax rate, there is a 4% decline in patents, citations, and inventors, all of which are used to measure innovative activity. This means an even slight increase in taxes deals a heavy blow to invention and the consequent economic growth. But what creates this strong negative correlation between taxation and innovation?

How Does Progressive Taxation Stifle Innovation?

Progressive taxation is marketed as a way to help the poor by reducing wealth inequality. Politicians paint a picture of a greedy capitalist society where the rich vacuum up resources while the underprivileged are left destitute. In their view, a progressive tax structure helps the poor by providing government services that are funded by the rich’s tax money, reducing the income gap.

The problem with this policy is the effect on incentives. Because you have to pay more and more as your income increases, progressive taxation penalizes people for making more money. If people becoming wealthy had a negative effect on the economy, then this approach might be justified. However, getting rich in a market system is an undeniably positive activity.

To generate economic profit, you must create something consumers value more than the constituent materials. If the raw components of an iPhone were more valuable than the iPhone itself, it wouldn’t be produced. The more enjoyment producers can bring consumers while making efficient use of materials, the more profit they will generate. That is why the profit system is such a productive force in the economy.

But a progressive tax disrupts this process. When making profit and gaining wealth are penalized, there will be a decreased incentive to conduct these activities. Inventors will be less likely to undergo the inherent risks and costs of entrepreneurship if the incentive to gain wealth through innovation is diminished. Smartphones, laptops, and planes are all the result of innovators who had a profit motive to invent. Since progressive taxation discourages innovation, it discourages economic growth.

Exchanging Wealth Equality for Increased Poverty 

The “Eat the Rich” mentality has become a staple of American life. 61% of Americans believe that wealth inequality is too high, and one of the most prescribed solutions for this supposed “problem” is progressive taxation. However, this logic leads to dangerous conclusions. Margaret Thatcher once said that her political opponents “would rather that the poor be poorer provided that the rich are less rich.” The economy is not a zero-sum game. Instead, as entrepreneurs innovate and pioneer to gain wealth in the free market, the poor benefit from the resulting economic gains.

China’s remarkable growth demonstrates this principle. Between 1981 and 2015, China’s extreme poverty rate dropped from 88.3% to 0.7%, from 878 million poor people to 10 million. What changed? A new president, Deng Xiaoping, spearheaded several economic reforms, making massive strides toward a free-market economy. Under 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.

Progressive tax advocates claim that the rich do not pay their fair share to society in a flat tax system. In actuality, the rich give far more than their fair share to society through the problem-solving goods and services they provide. Alternatively, when entrepreneurs are disincentivized through a progressive income tax, the entire economy suffers, rich and poor alike. If politicians really have the best interest of the poor in mind, they should start by ending the progressive tax structure that stifles their advancement.

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