Tax Old Firms More?

It is widely believed that free markets tend to undersupply innovation, and that new firms tend to be more innovative. Here is yet another compatible academic analysis:

A subsidy to incumbent R&D equivalent to 5% of GDP reduces welfare by about 1.5% because it deters entry of new high-[quality] firms. On the contrary, substantial improvements (of the order of 5% improvement in welfare) are possible if the continued operation of incumbents is taxed while at the same time R&D by incumbents and new entrants is subsidized. This is because of a strong selection effect: R&D resources (skilled labor) are inefficiently used by low-[quality] incumbent firms. Subsidies to incumbents encourage the survival and expansion of these firms at the expense of potential high-[quality] entrants. (more)

Many have suggested that we subsidize firm research, though it still seems puzzling that we don’t do more of this. Yes it can be hard to measure research spending, but that probably isn’t the whole issue. However, one rarely hears serious proposals to tax old firms more relative to young firms. (Exception here.) And the age of a firm seems even easier to measure.

Why not tax old firms more, or young firms less? This doesn’t seem to be a left vs. right issue, or to favor any other side of a familiar political divide. Is this another example of our pretending to oppose dominance by big powers, but really accept it?

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  • Doug

    I’m not sure if this represents a genuine market failure, rather than just a preference by capital market investors (who at the end of the day are allocating R&D resources).

    New firms may have higher returns to R&D spending, but this isn’t surprising when you consider that new firms generally have higher returns on assets across the board. This doesn’t mean that investors irrationally over-allocate to old firms. Old firms may have lower expected returns, but they also have lower variance and risk, as well as co-variance to broader portfolios.

    Investors allocate capital to lower return older firms to maximize their expected future utility. This doesn’t represent a market failure, but a general preference for risk-aversion.

    Now you can say that R&D is different than many other types of investment since it has substantial public social benefits that aren’t fully internalized by private investors. And that’s a fair argument for a broad subsidy to R&D. But that’s not sufficient to argue for a higher subsidy for high-return new firm R&D over low-risk old firm R&D.

    In order to demonstrate that the latter is socially under-invested you would need to show either: A) High-return new firm R&D has a higher public benefit relative to its private benefit. B) The public social utility function is less risk-averse than private investors. Or C) The public returns to R&D carries less overall risk than the private returns, which would imply that optimal private risk under-supplies public risk.

    All of these positions are plausible, but none are trivial. In fact the opposite case could easily be made for every one. A) New firms tend to jealousy guard their innovations, whereas old firms tend to pursue more public-benefit oriented prestige projects. B) The public is probably more risk averse than private investors. Most private investors are wealthy, and the wealthy are less risk-averse than the median person. C) The public return to R&D may be overall more risky. Patents expire after a fixed period time frame, so the public’s benefit is more loaded on the usefulness of the innovation decades down the road (which is a lot riskier than whether the innovation will be useful or not in the next few years).

    • Peter McCluskey

      I invest mostly in old companies not due to risk-aversion, but due to the lower cost of useful data about the companies’ value. If I had perfect information, I’d invest more in younger companies. This tax offsets that problem a bit.

  • free_agent

    If there is anything that differentiates old firms from new firms, it is the possession of the sort of social capital that helps them lobby against changes that would make life easier for new entrants into their markets.

  • Sigivald

    Why not just not tax either of them, or subsidize either of them?

    • Sigivald

      (And to clarify: There’s no “dominance by big powers” in an “old firm” that is morally relevant, without the State’s imposed barriers to entry and competition (eg. regulatory hurdles that are trivial for a giant company and impassible for a small one).

      Clear it all out, as abetter solution than ‘fixing’ that State problem with more of the same in the form of a complex tax and subsidy regime.

      Without those barriers, the old, sclerotic firm – if it is so – gets out-competed by the new, agile, innovative one.)

      • Stephen Diamond

        There’s no “dominance by big powers” in an “old firm” that is morally relevant, without the State’s imposed barriers to entry and competition

        Mere assertion of discredited right-libertarian dogma.

      • Sigivald

        Talk is cheap.

        Show me the dominance and tell me why it’s morally relevant without State-imposed barriers.

        Otherwise I’ll just reply “Anti-libertarian propaganda” with equal validity.

      • IMASBA

        Try becoming a new player in public transportation or water distribution in a large city. Unless you have the funds to build a new transportation/distribution system you don’t stand a chance. The billions it would cost to build such a new system are a much larger hurdle than any permit in the known universe.

        In general large businesses in even the freest of markets destroy newcomers by temporarily undercutting their prices until the newcomers starting capital runs out, this subsequently discourages investors from investing in newcomers in that market.

        In theory a large enough megacorporation could achieve an eternal monopoly if it is larger than any other united group of investors.

        This is Econ 101 or 102 (depending on how honest your teacher is about real world businesses).

      • Sigivald

        So, that’s it? “Public utilities”?

        Good! At least we’ve given up on the idea that it’s mere “age of firm” or “Being big” that somehow anti-competes and requires a Special Extra Tax to “fix”.

        (Why not competitive bus companies? Is that somehow impossible? Would it really cost “billions”?)

        (I am intentionally disregarding the “undercut and destroy their capital” argument because can you show me even one time that ever happened?

        That must be an amazing level of capital, to fend off more efficient competitors forever; and of course eating your capital to undercut competition makes you comparatively unprofitable: capital is how you make profits!

        Which I thought was the entire alleged point of monopoly, to reap alleged extra profits?

        Likewise “eternal monopoly” – because the only way to approach that is to monopolize the entire economy, but if you get even close to that you’re undercut by the socialist calculation problem.

        “This is Econ 101″, to which I reply “Econ 101 needs to read the Austrians”, because “eternal monopoly because too much capital” doesn’t actually work.

        Never has. Not even once.)

      • IMASBA

        “So, that’s it? “Public utilities”?”

        Public utilities are an extreme example, certainyl not the only sector where this happens.

        “(Why not competitive bus companies? Is that somehow impossible? Would it really cost “billions”?)”

        It would definitely be very expensive to set this up (you’d probably need your own busstops and you’d get a complicated ticket system, people hate it when they have to wait for the bus from the “right” company before they can hop on). As always, if the owners of the existing company represent less than 50% of the world’s capital than you can in theory set up a second company but who would pour all his money into a project that might be slightly profitable 20 years from now? Why risk not breaking even within your lifetime when there are enormously profitable oligarchies to invest in?

        “(I am intentionally disregarding the “undercut and destroy their capital” argument becausecan you show me even one time that ever happened?”

        Walmart and the professional sports leagues in the US. The government of Ireland maintains ownership of the railways because research has shown the island is too small for even two profitable railway companies. The Chinese government has decided to employ this technique to break American and European solar companies. Many sectors in the world now only have 2 or 3 big players left (often from different countries), especially if you discount state owned companies, and they are routinely fined for price fixing (the EU catches a couple of them every year) and often the reason they haven’t merged yet is because national laws forbid it. Also, iamgine what happens when actual laws of physics protect the monopoly or oligarchy, for example in the domain of radio frequencies (if you own the whole range no one else can transmit radio, gsm, wi-fi, etc…) or if some company owns all 15 mines of some rare Earth metal (competitors would be forced to obtain the metal from the much more expensive process of recycling, this could last for centuries depending on how full the mines are).

        “That must be an amazing level of capital, to fend off more efficient competitors forever”

        Maybe not forever, but if it lasts 100 years the damage has been done, especially if the new player just ends up becoming a 100 year monopolist themselves. The trick is that these big players are more attractive to investors to begin with. Investors aren’t in it to for the good of humanity: if they can make things a lot better for themselves by making things a little worse for everyone else they’ll take that opportunity (similar to the tragedy of the commons). I know American libertarians like to think they’re smarter than the rest of the world combined but it’s getting annoying, I guess that’s backlash of decades of cold war era US propaganda against anything that even reeked of socialism (even though most of NATO was and is socialist by US right wing standards). Libertarian thinking about monopolies and oligarchies is not hindered by such practical details as people not willing to move to India for slightly cheaper groceries, and human lifespan being finite, that’s why it’s so out of touch with the real world.

      • Stephen Diamond

        Libertarians have their own jaundiced conception of “morality,” and that does all the work. Any argument that starts from “morality” is invalid. ( http://tinyurl.com/7dcbt7y )

      • Sigivald

        Mr. Diamond: That’s… nice? I mean, I agree, you can’t get an ought from an is, sure.

        But what does that have to do with libertarian “morality” (and how it’s allegedly jaundiced)?

        Did I even make a moral argument, rather than a practical one? (I mean, I could easily do so, but I was trying to stick to the practical “this isn’t actually a problem” one.)

  • http://www.facebook.com/yudkowsky Eliezer Yudkowsky

    In general, it seems to me like declaring new wealth to be tax-free for 15 years would be economically healthy, if there were some way to prevent old wealth from being disguised as new wealth, or if the disguise process itself were economically healthy.

    • Steve

      If 15 year old wealth were taxed at 100%, so that factories were simply abandoned after 15 years to build new ones, it seems like that’d be sub-optimal. It also seems like there’s a convex frontier between new-factory-incentivizing and enshrining old wealth forever.

      Not sure how to find the socially optimal point on that frontier.

      • IMASBA

        Why would new ones have to be built? The physical buildings are still there, they can just be taken over by a nother business.

    • IMASBA

      Yeah, businesses would just change names every couple of years which is why it’s better to tax businesses based on size. It’s the big businesses that hinder innovation, exert levels of power rivaling that of elected governments, create the “too big too fail/jail” problem, undermine tax systems and shield people from criminal charges (the business just gets a pitiful fine)

      All that is if you want to tax businesses at all, personally I prefer this tax to be abolished and the dividend/capital gains taxes to be increased to the level of the income tax (globally of course, tax havens should be dealt with as if they were sponsoring Al-Qaeda).

  • http://profiles.google.com/johnthacker John Thacker

    “And the age of a firm seems even easier to measure.”

    Easy to measure until you start building in significant incentives for firms to make it difficult to measure and seem younger than it is.

    • http://www.gwern.net/ gwern

      But no doubt the state of Delaware would be thrilled by such new taxes.

  • cournot

    But to make this a proper analysis don’t you have to figure out everything that differentiates old and new firms that contribute to welfare? There might be costs that new firms impose on the economy that incumbency does not. I have no idea whether this is true or not but absent a better study I’m not willing to support compensatory taxes/subsidies without a better idea of costs vs. benefits. All you’ve done is shown that on one important margin new firms are more productive. What about survivorship issues? Shouldn’t we also count all the new firms that don’t make it but cost something?

  • Tomasz Wegrzanowski

    There’s plenty of tax relief and subsidies for new small businesses and extra taxes for old larger businesses.

  • IMASBA

    “Why not tax old firms more, or young firms less?”

    Wouldn’t firm size be a better criterium?

    • Sigivald

      So, penalize size?

      Incentive to not hire more people? Check.

      Incentive against any possible economies of scale? Check.

      Incentive to prevent larger capital investments [on the reasonable assumption that capital investment possibilities are roughly correlated to size]? Check.

      I can’t imagine how anything could go wrong with that. (See Spain.)

      • IMASBA

        It’s better than penalizing age. The precise rates would determine how heavy economies of scale would be affected and it employment has nothing to do with: large corporations aren’t the only ones that can hire people. If there is a demand for a certain product or service smaller businesses will meet that demand and hire people to do it.

  • stevesailer

    Young firms (e.g., Facebook) pay far less in health insurance premiums than old firms (G.M.).

    • http://www.gwern.net/ gwern

      I don’t think that’s related to the kind of youth Hanson means.

  • aluchko

    To me the main question is are the old firms less efficient in their R&D spending because the organizations are culturally inefficient (ie researchers just not motivated as much), or because they’re more risk adverse in their spending. If it’s due to inefficiencies a tax change may be in order, but if it’s being risk adverse than penalizing old firms might make the market more volatile.

  • IMASBA

    “Many have suggested that we subsidize firm research, though it still seems puzzling that we don’t do more of this. Yes it can be hard to measure research spending, but that probably isn’t the whole issue.”

    If it’s not then it’s at least a very big part of the problem: businesses are creative enough to label Malaysian children painting shoes with a new type of paint as “design R&D” or the CEO’s bonus as an “essential R&D-related expense”.

    In the real world most innovation is done by universities, often paid for by a contract with a business, but still, it’s the universitiy researchers who do most of the work (and get the smallest financial reward), so why should a government not just cut the middleman out of the picture?

    • IMASBA

      P.S. corporations should be neutered. They are given too many rights and too few duties in most countries, in *some* countries they literally buy politics.

      If a corporation dumps chemicals or kills kids the CEO should go to jail, if a corporation fails and is saved by the state the shareholders should be forced to pitch in, if a corporation owns a daughter corporation it should not be able to legally distantiate itself from the actions of that daughter, a corporation should not be allowed to give “donate” to politicians or political parties, a corporation should not have the power to decide over the private lives of employees, corporations should not be allowed to transfer profit and loss to other countries, corporations should not be allowed to negotiate their tax rates, corporations that avoid billions in taxes should and/or bribe politicians should be treated as the threat to national security that they are (intelligence and security agencies should be allowed to infiltrate them).

  • Stephen Diamond

    Is this another example of our pretending to oppose dominance by big powers, but really accept it?

    Framing it as a tax on longevity seems “unfair.” But if you said “tax breaks for new firms”—well, don’t they exist already?

    [I think some commenters miss the point when they point out that old firms already are taxed more (on average)--say, by higher taxes based on other express criteria. The point, as I take it, is that longevity-related tax breaks aren't express.]

  • http://profiles.google.com/prakash.chandrashekar Prakash Chandrashekar

    Or wait for a deflationary currency like bitcoin to take over the world. Corporations would exist only until the initial arbitrage that required the creation of the firm is still valid, like the earliest corporations created for sea voyages. Voyage over, corporation disbands.