Sound Tax Policy Can Withstand Creative Destruction

This year’s Nobel Prize in Economics was awarded to economists Joel Mokyr, Philippe Aghion, and Peter Howitt for their work on how creative destruction improves lives and drives human progress. Creative destruction—coined by famed economist Joseph Schumpeter—is the idea that new innovations disrupt and “destroy” existing economic structures as they create better and more efficient products and processes.

This cycle can hurt established firms and industries, creating short-term job losses, but ultimately leads to greater productivity and better products and services for the economy. The automobile destroyed the horse and buggy; the refrigerator and freezer destroyed ice production and delivery; streaming replaced video rentals; and the world is a better place to live today because of these and millions of other instances of creative destruction.

While the Nobel-awarded work focused on detailed historical examples of creative destruction—and the timing appears to be no coincidence as artificial intelligence and big data open the door for the next round of economic transformation—a question for policymakers is how taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. policy (and collections) will be affected by creative destruction. Fortunately, the answer is straightforward.

Creative destruction exposes poorly designed tax policy, as it may rely on specific taxes on industries or activities displaced by innovation. But sound tax policy is resilient; simple, broad-based, neutral taxes will yield stable revenues as economies transform.

If someone creates a Thneed that suddenly everyone needs, broad-based tax policy has us covered. A broad-based consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or income taxes where all savings are tax-deductible., like a sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding.  or value-added tax, will generate revenues from sales; income taxes will be collected from workers; corporate profit taxes will be generated from the Thneed company; and any physical production facilities will face property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. levies.

If governments levy principled taxes, creative destruction won’t necessitate tax policy changes. Tax revenues will continue to be captured as industries, production, and consumption change. This is great news because economies are constantly changing. We may remember dramatic market changes—the mass production of automobiles, the personal computer, the iPhone—but smaller changes occur every day. Sound, stable tax policy means that legislators don’t need to revamp the tax code every year just to keep up.

Targeted taxes with narrow bases, like excise taxes, don’t have the same protection from creative destruction. Because excise taxes target specific goods and services, when innovations encourage shifts in consumption, tax revenues from increasingly obsolete products will shrink. We see this in several products today.

Alternative tobacco products like vapes, heated tobacco, and oral nicotine pouches have accelerated a switch away from combustible cigarettes. Cigarette tax collections decline as fewer Americans smoke each year, despite continued tax rate increases. Over the past 15 years, state cigarette tax revenues have declined by roughly a quarter, and federal collections have nearly halved.

Increasing fuel efficiency and electric vehicles have made gasoline taxes less effective at funding roads. Federal revenue per vehicle miles traveled decreased by more than 50 percent from 1977 to 2022.

Gasoline taxes and tobacco taxes are levied on specific products, so as consumption changes over time, these tax revenue sources get left behind. Income, broad-based consumption, and corporate taxes, on the other hand, automatically capture revenue as economies change. Most US and OECD countries collect the bulk of their tax revenue from these sources.

Creative destruction may create tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. jealousy, however. As the creative destruction process plays out, there is no guarantee that the new jobs and industries will be located where the destroyed jobs and industries were previously. Digital services are a great example of this. Several of the world’s largest companies that specialize in digital services call Silicon Valley home. Even if these companies are reasonably taxed, those tax revenues are concentrated in California and the US.

Some countries have proposed digital service taxes (DSTs) in response. The US government has voiced bipartisan opposition to DSTs, most recently regarding the Canadian DST. Several countries implement DSTs in Europe, though DSTs were largely considered to be interim measures until an agreement could be reached at the OECD level. However, discussions of an EU-wide DST have resurfaced following President Trump’s opposition to the OECD global tax deal. 

Creative destruction is a powerful force that drives innovation, improves lives, and reshapes economies. As industries evolve and consumer preferences shift, the economic landscape will continue to transform—sometimes dramatically, sometimes subtly. But amid this constant change, one thing can and should remain stable: tax policy. Broad-based, neutral taxes are resilient to the churn of creative destruction, ensuring governments can continue to fund public services without needing to reinvent the tax code every time a new innovation emerges.

The key to future-proofing tax revenue isn’t chasing trends or taxing the latest invention. It’s building a tax system that’s flexible enough to capture value wherever and however it’s created. In a world where the next “Thneed” could be just around the corner, sound tax policy ensures governments are ready—not reactive.

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