Milton Friedman's theory of monopolies disproved

By Carl Stoll

In Capitalism and Freedom, p. 130, M Friedman claims that government causes monopolies. His reasoning: Capital income is taxed twice: first when earned by corporation and later when corporation pays it out as dividends to stockholder. Consequently the corporation has an incentive to retain some earnings to avoid additional taxation. What does it do with these additional earnings? It invests them. So corporations get bigger and bigger, thus turning into monopolies.

Friedman likewise claims that retaining profits in a corporation is a less productive investment than would be reinvesting the profits in other, perhaps more productive firms. Thus the double taxation system renders capital less productive overall. In other words, the double taxation is inefficient.

 In this note I propose to subject Friedman's claims to two empirical tests. From each of his claims I will derive a prediction and then compare the prediction with empirical observation.

Hypothesis 1: If capital earnings tax rises (falls), the corporation will retain a greater (smaller) proportion of its earnings.

Data for USA:

From 1953 to 2003 tax on capital earnings fell from 47% to 28% (see Table 1).

Did the proportion of retained earnings fall? No, it did not (see Figure 14.3).

Consequently there is no prima facie reason to believe Friedman’s first hypothesis.

Source: Jane Gravelle: Historical Effective Marginal Tax Rates on Capital Income, Congressional Research Service. Report for Congress, January 12, (presumably 2006), cited in V.V. Chari and Patrick Kehoe: Modern Macroeconomics in Practice: How Theory Is Shaping Policy, Journal of Economic Perspectives, Volume 20, no. 4, Fall 2006, pages 3-28, p. 20

Composition of financing sources for gross investment (as % of total):

United States, non-financial companies

Legend: Gross retained profit (dashes),  stock issue net of stock repurchase (hyphens), and change in net indebtedness (solid line)

Source: Gérard Duménil, Dominique Lévy: Crise et sortie de crise : Ordre et désordres néolibéraux, Presses Universitaires de France, 2000, p. 160. (published in English as Capital Resurgent)

Hypothesis 2: If for whatever reason additional profits are paid out as dividends, they will be reinvested in more profitable firms belonging to the non-financial sector.

According to Gérard Duménil and Dominique Lévy, referring to France, op.cit., p. 99 [my translation] “…the growth rate of fixed capital [of the aggregate of French non-financial firms] developed exactly like the profit rate after taxes, interest and dividends. These results suggest that profits collected by finance do not return to non-financial firms.”

On p 101 is a graph illustrating this phenomenon:

 Figure 9.6  Rate of retained profit (solid line) and accumulation rate (hyphens) %: France, non-financial firms

Source: Gérard Duménil, Dominique Lévy: Crise et sortie de crise : Ordre et désordres néolibéraux, Presses Universitaires de France, 2000, p. 101. (published in English as Capital Resurgent)

France too has a system of double taxation of corporate profits.

In other words, what was paid out as dividends was not reinvested in non-financial firms, either in more productive ones or in less productive ones. 

I think it reasonable to assume that the results for France are directly transferable to the USA.  

Consequently the second hypothesis derived from M. Friedman’s claims is likewise falsified.