Corporate taxes and creative destruction

There aren’t many good things that happen in a recession or a crisis, but Schumpeterian creative destruction is one of them. If weaker companies default, the stronger ones have more room to grow. Employees of the weaker companies lose their jobs, but hopefully, they can find a new job in the surviving firms, which typically have higher productivity than the failed firms.

Let’s ignore for a moment that it has by now been more than two decades since we let creative destruction happen on a large scale rather than asking the central bank or the government to bail them out in large numbers, and look at one factor that introduces creative destruction on a smaller scale.

Hang Nguyen analysed the relationship between the productivity of a company and changes in corporate income tax rates. If the government increases corporate income tax rates, it obviously reduces the margins of the affected companies. One way to deal with that is to save costs in other places by increasing the productivity of the firm. If you have less money to spend because the tax man takes more, you have to produce more with less.

Analysing almost 80,000 European businesses, Nguyen found that yes, if corporate tax rates increase, companies increase their productivity. But not all companies. The charts below show the change in total factor productivity in reaction to a tax increase, where companies are sorted by their productivity level before the tax hike. Companies with higher productivity are to the left of each chart; companies with lower productivity are to the right.

The left-hand chart shows that among domestic firms, more productive firms increase their productivity even more after a tax hike. Less productive firms, however, are unable to adapt and lose productivity because they have less money to spend internally. The net effect is that higher tax rates select in favour of productive companies and push the less productive ones towards creative destruction.

Note, however, that the right-hand chart below shows that this relationship does not exist for multinational enterprises (MNEs). When faced with higher taxes, they simply shift production to other countries without the need to increase productivity.

So, here is a provocative takeaway from this data. The next time you hear the boss of a company complain about higher taxes, tell them that they only have to fear them if they are less productive than their competitors. For the fitter companies, higher corporate taxes lead to higher productivity and more growth.

Change in productivity in reaction to higher corporate tax rates