To create growth, unleash the invisible foot
Across the political spectrum, there is a growing recognition that while short-term battles over government spending are important, they would be far less ferocious and intense if our economy were growing at a faster clip. But while conservatives and liberals alike clamor for more growth, they disagree about how to produce it. The key is unleashing what the economist Joseph Berliner once called the “Invisible Foot,” the neglected counterpart to Adam Smith’s “Invisible Hand.”
Before we turn to the Invisible Foot, let’s think through the prescriptions for growth offered by Democrats and Republicans. President Barack Obama and his Democratic allies often argue that substantial increases in public investment will deliver robust growth. Republicans, in contrast, emphasize the notion that reductions in marginal tax rates will spur growth by increasing the incentives to work and invest. These approaches are obviously far apart, yet they face at least two common obstacles. First, the aging of the population and the high cost of health entitlements severely limit the government’s ability to increase spending or cut taxes. Second, advanced economies have by definition already taken advantage of the most obvious sources of productivity growth and so are forced to innovate to find new sources of productivity growth. And innovation is a trial-and-error process that is far more expensive and arduous than simply following the leader.
So the question of the day isn’t whether we want growth (yes, we want it badly) or whether we can dramatically increase public investment or dramatically cut taxes (neither strategy is in the cards). Rather, it is whether there is anything we can do to make the American economy friendlier to the kind of risk-taking and innovation that will eventually yield productivity gains without breaking the bank.
Enter the invisible foot. Despite sluggish growth, large U.S. business enterprises have fared reasonably well in the post-crisis years. Corporate profits after taxes have hovered around 10 percent of gross domestic product, almost twice as high as they were during the Reagan years. High corporate profits aren’t an intrinsically bad thing. Yet we’d normally expect that they would over time be reduced by competition from new entrants enticed by the prospect of making their own fortunes. This invisible foot of new competition is what drives incumbent firms to either step up their games ‑ a process that often involves burning through stockpiles of cash and shrinking profits ‑ or go out of business.
Unfortunately, this reallocation of resources ‑ from inefficient incumbents to innovative upstarts and the incumbents that manage to keep up with them ‑ stops when incumbent firms succeed in erecting regulatory and legal barriers to shield themselves against competitors, which is why regulatory reform and patent reform are so important. It is also why we ought to take care not to give large incumbents any undue advantages in our tax code.
As it turns out, the U.S. tax code does give large incumbents an enormous advantage over start-ups by subsidizing corporate debt. When businesses want to raise money for operations, they can pour their profits back into the business, they can sell shares or they can borrow. In an ideal world, we’d want business enterprises to make these decisions on the basis of what makes the most sense based on underlying economic conditions. But in the United States, we allow companies to deduct interest expenses from their taxes but not dividends on their stocks. This makes it far cheaper for companies to raise money by borrowing than by selling shares.
One reason this debt bias is a problem is that it leads companies to take on large amounts of debt, which raises the risk that they will go bankrupt. Yet there is another problem: It is much easier for some companies to borrow than for others. Specifically, well-established firms ‑ for example, large incumbents with pricing power that have been around for years ‑ find it much easier to borrow than new, unproven firms with high-growth potential, which have little choice but to rely on selling shares to finance investment. And so the tax-deductibility of interest expenses and not dividends gives the entrenched corporate Goliaths that have the option to borrow a big boost, while doing nothing for the would-be corporate Davids eager to take them on.
With this in mind, Robert Pozen of the Brookings Institution and Harvard Business School and his research associate, Lucas Goodman, have devised an ingenious plan to level the playing field. First, they call for cutting the corporate tax rate from 35 percent to 25 percent. This lower statutory rate will make the U.S. a much more attractive destination for profitable investment projects, particularly since our current corporate tax rate of 35 percent is the highest in the industrialized world. To finance this substantial cut, Pozen and Goodman propose a modest 60 percent to 85 percent cap on the amount of interest companies can deduct from their tax bills, sharply reducing debt bias and keeping the proposal revenue-neutral. Firms that rely heavily on debt would cry foul, and for some the process of reducing debt levels would be painful. Yet start-ups that don’t have the option of raising money by taking on enormous amounts of debt would find themselves at far less of a disadvantage. The end result could be an entrepreneurial renaissance, as lumbering corporate dinosaurs that had used cheap credit to scare off competitors are forced to reckon with innovative new rivals.
And if reducing the debt bias really does encourage start-up activity, the implications for employment levels could be significant. As the economists John Haltiwanger, Ron Jarmin, and Javier Miranda have observed, start-ups and young firms make a substantial direct contribution to creating jobs. Yet they can also make an indirect contribution to job creation by forcing incumbent firms out of their defensive crouch and into a fight to retain and gain market share. Consumers will also stand to benefit from this kick of the invisible foot as competition forces down prices and gives rise to entirely new products and services.
There is obviously no guarantee that reducing the tax code’s debt bias will be a silver bullet for economic growth. But Pozen and Goodman’s plan has enormous upside potential and, if designed with care, wouldn’t add a dime to the deficit. It would be foolish not to give it a try.
PHOTO: Footprints mark a snow-covered field in Warngau January 26, 2012. REUTERS/Michael Dalder