Innovation, Capital, Jobs and Taxes

We have high unemployment in part because our financial system misallocates capital.  This post starts to explore why and what to change.

I’ll use terminology from Clay Christensen’s forthcoming book, “The Capitalist’s Dilemma” because his “The Innovator’s Dilemma” is among the most illuminating I’ve ever encountered.  Why, he wondered, was the industry leader in 14 inch computer disk drives not the leader in 8 inch, and why did leadership change again in the next generation?  Why did the same thing happen in all fast-developing industries?  It’s because, he realized, industry leaders innovate only at the high end of their market.  Innovation below their market that results first in products for new markets continues to develop until it replaces products for existing markets.

Christensen terms these revolutionary innovations that transform complex, costly products into simple, cheap ones “empowering”.  Examples include the Ford Model T, the Sony transistor radio, and the IBM PC.  These innovations require long-term capital and, when successful, they create many new manufacturing, sales and service jobs.

“Sustaining” innovations that replace existing products with new versions create few if any new jobs because those who worked on the replaced products now work on the new ones.  Sustaining innovation is attractive because it offers a faster, and in the short-term less risky, return on capital than empowering innovations.  It is insufficient in the longer term because its products will be replaced by later products of empowering innovation.

“Efficiency” innovations cut the cost of making and distributing existing products and services. They cut jobs because they streamline processes.  They also free up capital.  Toyota’s just-in-time production system, for example, enables them to operate with much less capital invested in inventory.

What we want our financial system to do is encourage capital freed up by efficiency innovation to be redeployed as investment in new empowering innovations.  We want empowering innovations because they create new consumption.  We want enough of them so they create more jobs than efficiency innovations cut.  That way, we’ll have enough jobs for our increasing population.

What is happening in the US today is too much capital liberated by efficiency innovations is being invested in more efficiency innovations.

Part of the remedy is to change how we tax capital gains.  Gains from investments held less than a year are now taxed like personal income while gains on investments held more than one year are taxed at a much lower rate, 15%.  We should change that because gains from empowering innovations come, if at all, only after considerably more than one year while efficiency innovations pay off sooner.

We should tax capital gains at a set of decreasing rates depending on how long the capital remains invested.  Rates should start at the personal income rate, drop slowly in years two and three, then faster, maybe even to zero after five or eight years.  This would have little impact on the Federal budget in the short term because capital gains generate only a small part of Federal tax revenue.  In the longer term, by encouraging more investment in empowering innovation that creates new jobs, income tax revenue should grow and Federal spending on unemployment should drop.

Unfortunately, I’ve realized I should resume exploring tax policy.  Ben Franklin famously wrote: “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.”  I’ll start with corporate tax because Ben did not foresee the rise of corporations, which are by nature exempt from the inevitability of death and by trickery can also escape taxation.

3 comments on “Innovation, Capital, Jobs and Taxes

  1. I’ve always felt that initial capital to create a company or even a building should not be taxed at all if those assets are held for more than five years. But if I buy stock in IBM today and hold it for five years I should be paying some tax on the gain in value, perhaps full earned income rate because I did not create an asset like the initial capital did.

  2. Low or no taxes on capital gains make sense only if the capital is allocated to a useful purpose. What pecentage of “investments” really go toward authentic creation of economic value Vs financial speculation and placing useless bets in the global financial casino (e.g. many credit default swaps)? I don’t see why capital gains, dividends and other passive income should be taxed at a rate lower then the much-maligned “earned income” that most of the people in the USA relies on for their survival.

  3. Good points, David and Harold. Christensen’s structure of three types of innovation offers what feels like an illuminating perspective on our economic problem but I leaped too fast into potential solutions.

    I lean toward the distinction you make, Harold, because I want to encourage speculation that aims to deliver empowering innovation. I don’t immediately see how to define the rule but your example feels right, no tax on “initial capital”, earned income rate on all other.

    Your point, David, is larger and I won’t be able to respond until I do the tax policy research that I keep avoiding. I’ll review what I already posted about taxes and see what’s worth linking to, then start a new series.

    It’s hard to know what to tackle first. I’ve been working with Harold on governance because that’s the biggest of all our problems right now, but I haven’t yet begun posting about that. I want to get back to healthcare because that’s the enormous problem at the root of unsustainably fast-rising Medicare spending. I should also go back to defense spending and offer some solutions, not just leave it at a summary of the problem. But maybe I’ll tackle tax next because that’s where I currently feel most ignorant.

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