Edward Conard

Top Ten New York Times Bestselling Author

  • “…a comprehensive explanation of the modern economy.” - Julian Robertson, Founder, Tiger Management
  • “…a must-read for serious students of economic policy.” - Glenn Hubbard, Dean, Columbia Business School, and former Chairman of the Council of Economic Advisers
  • “…serious thinking for serious thinkers. …a thought-provoking blueprint for growing middle- and working-class incomes.” - Mitt Romney, former Governor of Massachusetts
  • “Unintended Consequences provides a provocative interpretation of the causes of the global financial crisis and the policies needed to return to rapid growth. Whether you agree or not, this analysis is well worth reading.” - Nouriel Roubini, New York University; Chairman, Roubini Global Economics
  • “Unintended Consequences is full of substance, it is one of the must-read books of the year, and once I finish it I will be giving it a second read through right away.” - Tyler Cowen, Professor, George Mason University
  • “Unintended Consequences represents the most cogent and persuasive analysis of the Financial Crisis to date.” - Andrei Shleifer, 1999 John Bates Clark Medal Winner
  • “…a fresh argument for the productive value of inequality.” - David Autor, Professor of Economics, Massachusetts Institute of Technology
  • “…reminds us that inequality sends a signal of what society lacks most, in America’s case, entrepreneurship and risk taking.” - Lawrence Lindsey, CEO, The Lindsey Group, former Director of the National Economic Council
  • “…a very valuable contribution.” - Larry Summers, former Secretary of the Treasury and director of the National Economic Council, president emeritus, Harvard University
  • “…reminds us that inequality sends a signal of what society lacks most, in America’s case, entrepreneurship and risk taking.” - Lawrence Lindsey, CEO, The Lindsey Group, former Director of the National Economic Council
  • “…challenges misconceptions that distort our economic debates.” - Arthur Brooks, President of the American Enterprise Institute
  • “…challenges misconceptions that distort our economic debates.” - Arthur Brooks, President of the American Enterprise Institute
Upside of Inequality Oxford Unintended Consequences

Macro Roundup


Wednesday, January 5, 2022

AI Summary. A monthly rebalanced portfolio of the ten largest US stocks has doubled in value since 2020, versus a 50% gain for broader large-cap portfolios, reversing the prior decade when the top 10 underperformed more diversified portfolios. Since 1992 the top 10 averaged a 10% annual return against 9.5% for the top 500, with higher volatility.

Anuser Farooqui Policy Tensor
Date Posted:
Is Database:
Database

The recent outperformance of the top 10 US equities is a notable shift, doubling in value since 2020, compared to a 50% increase for broader large-cap portfolios.

Have the largest US stocks outperformed broader large-cap portfolios?

Core argument: A monthly rebalanced portfolio of the ten largest US stocks has doubled in value since 2020, versus a 50% gain for broader large-cap portfolios, a reversal from the prior decade when the top 10 underperformed more diversified portfolios.

The recent outperformance of the ten largest US equities is a notable shift, as a monthly rebalanced portfolio of these stocks has doubled in value since 2020, compared to a 50% increase for broader large-cap portfolios. This trend is attributed to structural changes post-Covid-19, marking a departure from the past decade where the top 10 underperformed more diversified portfolios. Over the past two years, the top 10 portfolio achieved a 39% annual return with a Sharpe ratio of 1.32, outperforming the top 500 portfolio's 24% return and 0.90 Sharpe ratio. Historically, since 1992, the top 10 averaged a 10% return, slightly above the top 500's 9.5%, but with higher volatility and lower risk-adjusted returns. This recent dominance of the largest firms is an unexpected development in equity markets.

Takeaways by Macro Roundup® AI

  1. A monthly rebalanced portfolio of the ten largest US stocks has doubled in value since 2020, versus a 50% gain for broader large-cap portfolios, a reversal from the prior decade when the top 10 underperformed more diversified portfolios.
  2. Over a recent two-year span, the top 10 portfolio returned 39% annually with a Sharpe ratio of 1.32, against 24% and 0.90 for the top 500 portfolio.
  3. Since 1992 the top 10 averaged a 10% annual return versus 9.5% for the top 500, but with higher volatility and lower risk-adjusted returns.

Anuser Farooqui, "Superstar Stocks," Policy Tensor, December 21, 2021, https://policytensor.substack.com/p/superstar-stocks

Superstar Stocks

‘Only ten stocks really matter’, declared Robert Armstrong in a recent FT Unhedged newsletter. He showed that the returns on the 10 largest stocks have handily beaten the S&P 500 index over the past two years. Apple is closing in on a $3tn valuation. That’s larger than the GDP of India, France, the United Kingdom, Canada or Australia. Indeed, it is larger than the GDP of all but the four largest national economies in the world. At $2.5tn, Microsoft is not far behind. Following close on the heels, Amazon is at $1.8tn and Tesla at roughly $1tn (all market caps and returns are as of Dec 15, 2021). The top 10 stocks account for $12.5tn of market capitalization. That’s 30 percent of the market cap of the largest 500 companies, and 25 percent of the market cap of all publicly-traded American companies. The US stock market has never been this top heavy since at least 1992.

A portfolio that rebalances monthly to track the largest ten stocks has doubled in value since the beginning of 2020, even as broader portfolios that track large-cap stocks have increased by roughly 50 percent. The dramatic outperformance of the very largest companies is due to the structural changes that ensued in the economy after the arrival of Covid-19.

Superstar Stocks: Extended Excerpt Image 1


Indeed, zooming out reveals that this is a new development. For most of the past decade, the top 10 portfolio has underperformed more diversified portfolios of the largest US equities.

Following up on Robert Armstrong’s note on the outperformance of the ten largest US firms Anuser Farooqui reports that skewness in equity returns of those firms has increased in the aftermath of the pandemic. He looks at a monthly rebalanced portfolio of the 10, 100 and 500 largest US stocks and finds the outperformance of the top 10 is a recent phenomenon (see second chart 2012-2022), "... A portfolio that rebalances monthly to track the largest ten stocks has doubled in value since the beginning of 2020, even as broader portfolios that track large-cap stocks have increased by roughly 50 percent. The dramatic outperformance of the very largest companies is due to the structural changes that ensued in the economy after the arrival of Covid-19. Indeed, zooming out reveals that this is a new development. For most of the past decade, the top 10 portfolio has underperformed more diversified portfolios of the largest US equities. In fact, if we go back thirty years, we find that the top 10 portfolio usually lagged behind more diversified portfolios of large-cap equities. The size of companies has been one of the most commonly used investment factors since the 1990s when Fama and French documented the existence of a premium associated with this risk factor. But here’s the kicker: smaller stocks are supposed to sport a risk premium over larger stocks. So, the recent outperformance of the very largest companies is not only not to be expected, but the order of expected returns is upside-down. Just how much premium the largest companies have commanded is documented in what follows. Table 1 shows the mean annualized returns, volatility, Sharpe ratios, max drawdowns, tracking error and adjusted means for monthly-rebalanced portfolios of the largest US companies. The tracking error is the volatility of the difference between returns on the monthly-rebalanced portfolios and the market capitalization indices. Less diversified portfolios are harder to track, meaning that you may not, in practice, be able to match the returns on the index being tracked. The adjusted mean is the annualized mean return less the tracking error. You can think of it as a penalized expected return that accounts for the difficulty of tracking less diversified portfolios. Over the past two years, the top 10 portfolio has returned 39 percent per annum, compared to 24 percent per annum for the top 500 portfolio. It has outperformed the latter portfolio even in risk-adjusted terms, sporting a Sharpe ratio of 1.32 compared to 0.90 for the latter. Adjusted means also show a robust outperformance: 38 percent vs 23 percent. Over the past decade, the top 10 portfolio has returned 19 percent per annum, compared to 14 percent for the top 500 portfolio. The risk-adjusted performance is less dramatic: a Sharpe ratio of 1.0 vs 0.9. But over a longer period, the premium at the top vanishes. Since 1992, the top 10 portfolio has averaged a 10 percent return vs. 9.5 for the top 500 portfolio. The Sharpe ratio of the top 10 portfolio is actually lower over this horizon: 0.51 vs. 0.52. The max drawdown is also painfully larger: 70 percent instead of 57 percent. And the tracking error is much higher, 3.7 percent vs 1.9 percent, with the result that the adjusted mean return is much lower: 6.4 percent vs. 7.6 percent. So, there’s no outperformance of the top 10 since George H.W. Bush was last in the White House. What we have, in fact, is a brave new world dominated by the very largest corporations...."

Ed Comment:Suggests there is a long runway for the expansion of product offerings and insights in the info (surveillance!) sector.

In fact, if we go back thirty years, we find that the top 10 portfolio usually lagged behind more diversified portfolios of large-cap equities.

Superstar Stocks: Comments Image 1


The size of companies has been one of the most commonly used investment factors since the 1990s when Fama and French documented the existence of a premium associated with this risk factor. But here’s the kicker: smaller stocks are supposed to sport a risk premium over larger stocks. So, the recent outperformance of the very largest companies is not only not to be expected, but the order of expected returns is upside-down. Just how much premium the largest companies have commanded is documented in what follows.

Table 1 shows the mean annualized returns, volatility, Sharpe ratios, max drawdowns, tracking error and adjusted means for monthly-rebalanced portfolios of the largest US companies. The tracking error is the volatility of the difference between returns on the monthly-rebalanced portfolios and the market capitalization indices. Less diversified portfolios are harder to track, meaning that you may not, in practice, be able to match the returns on the index being tracked. The adjusted mean is the annualized mean return less the tracking error. You can think of it as a penalized expected return that accounts for the difficulty of tracking less diversified portfolios.

Superstar Stocks: Comments Image 2


Over the past two years, the top 10 portfolio has returned 39 percent per annum, compared to 24 percent per annum for the top 500 portfolio. It has outperformed the latter portfolio even in risk-adjusted terms, sporting a Sharpe ratio of 1.32 compared to 0.90 for the latter. Adjusted means also show a robust outperformance: 38 percent vs 23 percent.

Over the past decade, the top 10 portfolio has returned 19 percent per annum, compared to 14 percent for the top 500 portfolio. The risk-adjusted performance is less dramatic: a Sharpe ratio of 1.0 vs 0.9.

Superstar Stocks: Comments Image 3


But over a longer period, the premium at the top vanishes. Since 1992, the top 10 portfolio has averaged a 10 percent return vs. 9.5 for the top 500 portfolio. The Sharpe ratio of the top 10 portfolio is actually lower over this horizon: 0.51 vs. 0.52. The max drawdown is also painfully larger: 70 percent instead of 57 percent. And the tracking error is much higher, 3.7 percent vs 1.9 percent, with the result that the adjusted mean return is much lower: 6.4 percent vs. 7.6 percent. So, there’s no outperformance of the top 10 since George H.W. Bush was last in the White House.

Superstar Stocks: Comments Image 4


What we have, in fact, is a brave new world dominated by the very largest corporations. The top heavy structure of the stock market is a testament to the unprecedented concentration of economic power in the very largest institutions of organized greed.

How long can this world last? We should expect at least some of the economic transformations induced by the pandemic to reverse as the pandemic fizzles out. But we cannot be certain of the degree of such a reversal. Indeed, the top-heavy stock market may be with us for awhile longer.

Friday, January 7, 2022

AI Summary. The authors estimate that a U.S. corporate tax deduction for domestic production raised average earnings by 1.1% for each 1% cut in marginal tax rates, with the largest gains at the top of the earnings distribution. Small firms showed larger top-percentile wage responses and employment gains, while large firms increased capital investment and reduced employment.

Christine Dobridge, Paul Landefeld, and Jacob Mortenson Federal Reserve Board
Date Posted:
Is Database:
Database

The 2005 U.S. corporate tax cut, particularly the Domestic Production Activities Deduction (DPAD), significantly impacted wage distribution. A 1% cut in marginal tax rates increased average earnings by 1.1%, with small firms seeing higher gains at the top of the earnings distribution.

How do corporate tax cuts affect earnings across the wage distribution?

Core argument: A 1% reduction in marginal tax rates under the 2005 Domestic Production Activities Deduction raised average earnings by 1.1%, with the largest gains at the top of the within-firm earnings distribution.

The 2005 U.S. corporate tax cut, specifically the Domestic Production Activities Deduction (DPAD), significantly impacted wage distribution within firms, with notable effects on smaller firms. A 1% reduction in marginal tax rates led to a 1.1% increase in average earnings, with the most substantial gains at the top of the earnings distribution. For small firms, semi-elasticities at the 95th and 99th percentiles were 4.4 and 5.7, respectively, compared to 2.2 for large firms at the 99th percentile. This suggests that smaller firms experienced larger wage gains, likely due to less monopsony power and greater employee bargaining power. While overall employment remained unchanged, small firms saw an increase in employee numbers, contrasting with declines in large firms. The DPAD also spurred capital investment in large firms, indicating a shift towards capital-labor substitution. These findings highlight the tax cut's role in widening income disparities and its varied impact across firm sizes.

Takeaways by Macro Roundup® AI

  1. A 1% reduction in marginal tax rates under the 2005 Domestic Production Activities Deduction raised average earnings by 1.1%, with the largest gains at the top of the within-firm earnings distribution.
  2. Semi-elasticities for small firms reached 4.4 at the 95th percentile and 5.7 at the 99th, versus 2.2 for large firms at the 99th percentile, a gap attributed to less monopsony power and greater employee bargaining power at small firms.
  3. Overall employment was unchanged under the Domestic Production Activities Deduction, with small firms adding employees while large firms saw declines and increased capital investment, suggesting a shift toward capital-labor substitution.

"...This paper investigates how corporate tax changes affect workers’ earnings. We use a dataset of U.S. worker-level W-2 filings matched with corporate tax returns and study the implementation of the Domestic Production Activities Deduction (DPAD). We find the DPAD tax rate reduction has a substantial effect on the distribution of annual wage earnings within a firm. Earnings of workers at the top of their firm’s earnings distribution rise relative to those at the bottom of the distribution. We estimate a semi-elasticity of average earnings of 1.1 with respect to the DPAD marginal tax rate reduction, while the semi-elasticity of median earnings is notably smaller—0.5. Furthermore, we estimate a semi-elasticity of 1.3 at the 95th percentile of workers’ earnings and 2.7 at the 99th percentile. This trend of larger semi-elasticities at the top of the earnings distribution is especially pronounced for small firms. Looking at overall employment effects, we see no change overall, but the number of employees rises at small firms and declines at large firms. In contrast, we find that capital investment rises for large firms, suggesting that the DPAD also resulted in domestic capital labor substitution for large corporations. Our paper has significant implications for assessing the progressivity of the U.S. tax code and for analyzing the effect of corporate tax policy changes on the U.S. income distribution....We find the DPAD tax reduction resulted in a substantial increase in mean earnings at the firm level and that earnings gains were particularly concentrated at the top of the earnings distribution within firms. Our results suggest that a one percentage point reduction in marginal tax rates due to the DPAD led to a 1.1 percent increase in average earnings at the firm level. We find a much smaller impact, however, on median earnings within a firm, with an estimated semi-elasticity that is less than half the size of the average effect. Looking more broadly across the within-firm earnings distribution, we find semi-elasticities of earnings that are statistically indistinguishable from 0 at the very bottom of the earnings distribution—the 1st percentile through the 10th percentile. At the 25th percentile, we observe a statistically significant semi-elasticity of 0.4, which rises slightly at the median and the 75th percentiles, to 0.5 and 0.6, respectively. Earnings at the top of the distribution are notably more responsive: we find a semi-elasticity of 0.9 at the 90th percentile and of 1.3 at the 95th percentile. Earnings are the most responsive at the very top of the distribution; at the 99th percentile, we observe a semi-elasticity of 2.7—more than double that of mean earnings. As a result of rising earnings at the top of the distribution, we find the tax reduction leads to a widening of the within-firm earnings distribution overall. A one percentage point tax rate reduction due to the DPAD leads to a 1.1 percent increase in the ratio of earnings paid to the 95th percentile of workers compared to the 5th percentile. The change is even more pronounced at the higher end. A one percentage point rate reduction leads to a 2.8 percent increase in the 99th-to-1st percentile earnings ratio....We also examine the DPAD’s effect on overall firm employment and investment. We find no effect of the DPAD tax reduction on firm employment but find that the number of employees rises at small firms and declines at large firms. Our estimates of investment responses are consistent with capital-labor substitution for large firms, with investment increasing substantially in the highest two quintiles of firm size. But we find no investment effect of the tax cut for small firms...."

The core evidence"... We find the DPAD tax reduction resulted in a substantial increase in mean earnings at the firm level and that earnings gains were particularly concentrated at the top of the earnings distribution within firms. Our results suggest that a one percentage point reduction in marginal tax rates due to the DPAD led to a 1.1 percent increase in average earnings at the firm level. We find a much smaller impact, however, on median earnings within a firm, with an estimated semi-elasticity that is less than half the size of the average effect. Looking more broadly across the within-firm earnings distribution, we find semi-elasticities of earnings that are statistically indistinguishable from 0 at the very bottom of the earnings distribution—the 1st percentile through the 10th percentile. At the 25th percentile, we observe a statistically significant semi-elasticity of 0.4, which rises slightly at the median and the 75th percentiles, to 0.5 and 0.6, respectively. Earnings at the top of the distribution are notably more responsive: we find a semi-elasticity of 0.9 at the 90th percentile and of 1.3 at the 95thpercentile. Earnings are the most responsive at the very top of the distribution; at the 99thpercentile, we observe a semi-elasticity of 2.7—more than double that of mean earnings. As a result of rising earnings at the top of the distribution, we find the tax reduction leads to a widening of the within-firm earnings distribution overall. A one percentage point tax rate reduction due to the DPAD leads to a 1.1 percent increase in the ratio of earnings paid to the 95th percentile of workers compared to the 5th percentile. The change is even more pronounced at the higher end. A one percentage point rate reduction leads to a 2.8 percent increase in the 99th-to-1st percentile earnings ratio….”

Christine Dobridge, Paul Landefeld, and Jacob Mortenson, "Corporate Taxes and the Earnings Distribution: Effects of the Domestic Production Activities Deduction," Federal Reserve Board, December 2021, https://www.federalreserve.gov/econres/feds/corporate-taxes-and-the-earnings-distribution-effects-of-the-domestic-production-activities-deduction.htm

Size of firms, "... Generally, these results suggest that the DPAD had larger effects on the widening of the earnings distribution for the smallest firms by employment size than for the largest firms. Small firms exhibit positive and significant semi-elasticity estimates, and the estimates are strongest at the upper end of the earnings distribution. The semi-elasticities for small firms are statistically discernible from zero at the 25th, 50th, 75th, 90th, 95th, and 99th percentiles, with magnitudes that increase substantially at the very top of the distribution. The semi-elasticities in the upper portion of the distribution are also notably larger for small firms than for larger firms. The point estimate for the median percentile of small firms is a semi-elasticity of 1.8, for example, which rises to 4.4 and 5.7 percent, respectively, for the 95th and 99th percentiles. In contrast, for the largest firms, semi-elasticity estimates are considerably smaller overall. The point estimate for the semielasticity of the earnings for the median worker is 0.03, for example, and not statistically different from zero. Estimates increase the most at the very top of the earnings distribution for the largest firms, with a 2.2 semi-elasticity of earnings estimate for workers in the 99th percentile (though still less than half the magnitude of the 5.7 estimate at the 99th percentile for the smallest firms). Interestingly, for the largest firms, we observe statistically significant earnings increases at the very bottom of the earnings distribution—the 1st, 5th, and 10th percentiles—in addition to the top of the distribution, and the magnitude of the effect is similar to that for workers in higher earnings percentiles of these large firms. For workers in the 5th and 10th percentiles of the largest firms, for example, the semi-elasticity point estimates are 0.9, similar to the point estimates of 0.7 and 0.9 for the 90th and 95th percentile. The largest firms are the only firms for which we observe earnings increases due to the DPAD at the very bottom of the distribution. For firms in the middle of the employment distribution (the 2nd through 4th quintiles), we observe a statistically significant increase in earnings only at the 99th percentile for the third and fourth employment quintiles, and also at the 75th percentile for the third employment quintile.20 Finding larger effects for small firms is consistent with employees having more bargaining power at those firms but is also consistent with small firms having less monopsony power than large firms to set earnings. We further investigate the bargaining power and monopsony theories by studying effects of the DPAD on earnings for publicly traded firms and multinational firms in our sample. Large, public firms and multinational firms operating in global markets may also be expected to have greater local wage-setting power and workers in these firms may have less bargaining power as well. Semi-elasticities specific to publicly held firms for select earnings percentiles are presented in Table VI, column (3) and shown in Figure IV.B. Multinational firm results are in Table VI, column (4). Semi-elasticities for the full earnings distribution for public and multinational firms are given in Appendix Table A3. For publicly held firms, we find little effect of the DPAD on workers’ earnings. The largestpoint estimate is for the 99th percentile of the within-firm earnings distribution and implies a semielasticity of about 2.2. This result lends some support for Ohrn’s (2021) finding that top executives of publicly traded firms capture a substantial fraction of the DPAD and bonus depreciation tax reductions, but that there are no effects elsewhere in the earnings distribution for public firms. Widening of the within-firm earnings distribution, therefore, only occurs when comparing the very top of the distribution to the very bottom; the ratio of the 99th percentile earnings to the 1st percentile earnings rises by 2.2 percent as a result of the DPAD (Table VI)...."

Corporate Taxes and the Earnings Distribution: Effects of the Domestic Production Activities Deduction: Extended Excerpt Image 1


Who gains, "...To investigate whether earnings increases are flowing to firm owners, we examine a sample of firms (half of whom are in our main sample) who reveal their owners in Schedule G of their corporate tax return.23 These data are available starting in 2011. We match these firm owners to W-2s issued by the company and determine where in the firm earnings distribution these owners lie for firms with employee counts in the first quintile of our main sample (about 50 employees or less). The location of owners in the within-firm earnings distribution is shown in Figure V. This figure demonstrates that owners comprise more than 50 percent of the workers above the 99th percentile at these firms and around 25 percent of the workers between the 95th and 99th percentiles (i.e., more than 75 percent of workers in this sample of firms are in the top 5 percent of their withinfirm distributions). This result provides suggestive evidence that earnings gains among these small firms are accruing to firm owners and that some of the corporate tax cut benefits are accruing to capital and not labor...."

Corporate Taxes and the Earnings Distribution: Effects of the Domestic Production Activities Deduction: Extended Excerpt Image 2


Employment, Net Investment, and Total Earnings Effects

"...We report results for employment in column (1) of Table VII, Panel A, and we find an aggregate firm employment effect that is indistinguishable from zero. Column (2) presents the results for net investment as a share of installed capital and finds a point estimate of 0.008, implying that a one
percentage point reduction in the tax rate leads to 0.8 percentage point increase in net investment as a share of installed capital.26 Because the calculation of net investment requires an extra year of data and therefore the sample of firms is smaller, column (3) reproduces the estimates from column (1) with the smaller, common sample as well. We see that the employment effect remains statistically insignificant if a somewhat larger magnitude in the common sample...."
"...Figure VI.B shows the response of net investment as a share of installed capital to the DPAD rate cut. We find that the investment response is generally concentrated among the largest firms, with an increase in net investment as a share of capital of about 0.8 and 1.4 for every 1 percentage point decline in the tax rate due to the DPAD, for firms in the 4th and 5th quintiles by employment size, respectively.28 Of note, the combination of results in Figures VI.A and VI.B are consistent with evidence from Lester (2018), who uses a sample of large, publicly traded firms and finds that total employment declined among firms using the DPAD while investment increased. Lester suggests that this is consistent with capital-labor substitution among these firms...."

Corporate Taxes and the Earnings Distribution: Effects of the Domestic Production Activities Deduction: Extended Excerpt Image 3


"..Similarly to the largest firms in our sample, we also observe some decline in terms of total employment for publicly traded firms and for firms that payout to shareholders (our proxy for firms less likely to be financially constrained)—declines of 1.6 percent and 1.2 percent, respectively (Table VII). In contrast, we do not observe a statistically significant responses in terms of total employment among multinationals or firms that do not payout to shareholders. But we find that all of these subsets of companies have statistically significant and sizeable investment responses (1.6 percent, 1.1 percent, 0.7 percent, 1.0 percent for publicly traded, multinational, no payout and payout firms, respectively). Of note, the results for payout and non-payout firms taken together do not provide consistent evidence of financial constraints driving firm investment or employment responses to the tax cut; if looser financial constraints due to the DPAD were the primary mechanism driving our results, we would expect to see an investment increase in the “no payout” firms only...."

Ed Comment: "Not clear what time frame they used. My guess is a short one. Very profitable firms have sustainable competitive advantages. That’s why they are more profitable. If we lower the tax rate, they and their leaders will capture some of the value in the short run. But the prospect of excess returns is the very thing the incents innovation. Without excess returns, competitors are highly incented to wait until their competitors take the risks and suffer the failures needed to create innovation. So the correct time frame for tax analysis has to be very long, much longer than anyone’s Ceteris paribus data. And the link between tax rates and R&D, which we saw recently, and here capex and tax rates, both harbingers of the future, are not encouraging that we can enjoy a free lunch in the long run. The notion of a progressive corporate tax rate that looks at returns above the cost of capital is intriguing in theory but hard to imagine how it would work in practice. This harkens back to my debate with Jan Eeckout. We can’t look at the one lucky success and tax their excess returns, if we want innovation to pay. If we want a logical tax system, we have to look at the returns of the one lucky firm divided by the cost of the entire pool of failure, or said differently, we have to discount a successful firm’s profits by its ex-ante probability of success. Good luck with that! Otherwise we are taxing the very thing we would like to avoid taxing—excess returns to innovations that are large enough to make a difference to our growth. Moreover, those are the very firms that expose our most productive workers to the technological frontier, which is critical increase the probability of producing successful innovation. And we have to treat international competitors differently, if they can’t pass their higher tax rates on to customers when competitors have lower rates in other countries."

Steve Comment: Time Frame Is 2005-2017 (Repealed By TCJA)