Tax incentives: Boeing 707 edition

October 21, 2010

I’m going to a book party at a bar in Newton, Mass. tonight (yes, life here in metropolitan Boston is unspeakably glamorous) for Sam Howe Verhovek’s Jet Age: The Comet, the 707, and the Race to Shrink the World. It’s a great little book—and I don’t think the fact that Verhovek’s brother is a friend of one my wife’s best friends from high school (the reason I was invited to the book party) invalidates my positive opinion. I brought a galley along on a flight West a couple months ago and, despite being alarmed by Verhovek’s accounts of exploding jet airplanes, couldn’t stop reading. I had finished it by the time I landed in Reno.

The reason I’m bringing all this up (other than to impress you with the facts that I know Sam Howe Verhovek’s brother and have been to the Biggest Little City in the World), is because there’s a really fascinating tale in the book involving tax incentives. During the Korean War, Congress enacted an excess profits tax meant to keep military contractors from, well, profiteering. In its infinite wisdom, Congress defined excess profits as anything above what a company had been making during the peacetime years 1946-1949.

Boeing was mostly a military contractor in those days (Lockheed and Douglas dominated the passenger-plane business), and had made hardly any money at all from 1946 to 1949. So pretty much any profits it earned during the Korean conflict were by definition excess, and its effective tax rate in 1951 was going to be 82%. This was unfair and anti-business. If similar legislation were enacted today, you could expect U.S. Chamber of Commerce members to march on Washington and overturn cars on the streets.

It being 1951, Boeing instead sucked it up and let the tax incentives inadvertently devised by Congress steer it toward a bold and fateful decision. CEO Bill Allen decided, and was able to persuade Boeing’s board, to plow all those profits and more into developing what became the 707, a company-defining and world-changing innovation. Writes Verhovek:

Yes, it was a huge gamble, but for every dollar of the dice roll, only eighteen cents of it would have been Boeing’s to keep anyway. For Douglas and Lockheed, both in a much lower tax bracket, that was not so easy a call.

So that’s it! High tax rates—confiscatory tax rates—spur innovation! Well, at least once in a blue moon they do. Which is an indication that there might be some important stuff missing from the classic economists’ view of taxation, as summed up by Greg Mankiw a few weeks ago:

Economists understand that, absent externalities, the undistorted situation reflects an optimal allocation of resources. It is crucial to know how far we are from that optimum.  To be somewhat nerdy about it, the deadweight loss of a tax rises with the square of the tax rate.

Somehow I don’t think that formula held true in Boeing’s case.

5 comments

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

You can see the same effect today on the Norwegian continental shelf. The oil profits are taxed 78%, so the down side of experiments with new technology for enhanced recovery is very low for the oil companies. The recovery rate there is way above what you find most other places.

Posted by Gaute | Report as abusive

Has anyone looked at this in terms of landscape perturbation? It seems to be a good fit:

http://observationalepidemiology.blogspo t.com/2010/10/tax-increases-as-landscape -perturbation.html

Posted by MarkPalko | Report as abusive

It’s a good day when I read counterexamples to any conventional wisdom.

Posted by Curmudgeon | Report as abusive

[...] Justin Fox with an example of where high tax rates actually spurred innovation.  (Reuters) [...]

I don’t think this is the whole story.

Boeing knew that the war/legislation would end some day, so they took the gamble. If high taxation was permanent, they would have no incentive to do so.

Posted by Developer | Report as abusive

[...] Felix Salmon, on the economic impact of the socialist Truman government’s evil confiscatory tax policies: During the Korean War, Congress enacted an excess profits tax meant to keep military contractors [...]

i think you’re missing the point.

the reason why boeing invested is that they knew their tax rate was temporarily high. if it had been permanently high, they wouldn’t have done it.

also, i am surprised – the corporate income tax applies to earnings, and investment is not deductible. i guess boeing managed to make the investment look like an expense.

Posted by anonymecon | Report as abusive