Monopolies are unhealthy, but high taxes make the disease worse

Taxes are necessary to fund worthy government activities, but taxes come with side effects. The side effects can be especially harmful in an economy where businesses enjoy monopoly power.

People and businesses individually attempt to reduce their tax burden by doing less of the activities taxed at high rates and more of the activities tax at low rates or by doing activities that aren’t taxed at all.

{mosads}If the primary activities hit with high rates were unpleasant — pollution is an example — then thankfully taxes would not only bring revenue to the treasury but also induce people to pollute less.

However, most of the objects of taxation are labor and capital, which are not intrinsically undesirable the way pollution is. The reduction in labor and capital, and ultimately national income, by taxes is a regrettable side effect. 

The size of government is ultimately a choice of the tradeoff between reducing side effects and obtaining tax revenue. 

Former Obama-administration economists, and New York Times economist Paul Krugman, have recently decided to treat corporate income as a kind of pollution that is supposedly a source of tax revenue without adverse consequences. They are confused about how monopolies work. 

We all agree that a real problem with monopolies is that they may charge too much, owing to the fact that by definition they have little concern that a competitor will outbid them. But charging high prices is equivalent to producing too little, because customers’ natural reaction to high prices is to buy less.

So the problem with monopolized industries is that they produce too little, and with their lower production levels, they ultimately have less need to hire labor and capital. Taxing monopolies only worsens their low usage of labor and capital. In this way, monopolies are the opposite of pollution.

A second feature of monopolies is that everybody wants to own one! The result is a competition for the ability to have a monopoly. Sometimes this feature of competition for monopoly rights only adds to the problem, as when businesses compete to convince government officials to grant them monopoly power.

Other times, businesses and individuals compete to invent a new product that they can successfully monopolize. Yes, it’s too bad for the consumer that the new product costs so much — that’s the first feature of monopoly noted above — but that’s better than having no product at all. Taxing the profits of innovators discourages innovation.

An important aspect of taxing monopoly profits is therefore to understand how the monopoly rights are attained and who benefits from the competition for rights. Certainly, the headline “monopolists” of today, like Facebook, Google, Apple, etc., got their monopoly rights from socially valuable innovation and not government favors.

Are we sure that we want to discourage the next generation of innovators?

None of this is to say that monopoly is a sign of a healthy economic system. It’s just that taxes probably make the disease worse. A time of rising monopoly is the time for tax cuts, not increases.

Casey Mulligan is a professor of economics at the University of Chicago. His recent research has focused on non-pecuniary incentives to save and work and how the economy affects policy. His two recent books are, “The Redistribution Recession: How Labor Market Distortions Contracted the Economy,” and “Side Effects: The Economic Consequences of the Health Reform.”