In the most recent Global Innovation Index, the USA is again in second place, behind Switzerland, which has led the ranking for 12 years. Aside from questions about what Switzerland is doing right when it comes to fostering innovation, there is a growing concern that other European countries will soon overtake the US in terms of intellectual property.
Intellectual property is highly correlated with productivity, but how do countries attract companies to invest and how do these incentives affect a country’s overall economic growth?
My colleagues and I recently found that a specific type of corporate tax incentive – the “innovation box” or “patent box” – is related to a country’s economic growth, leading to a significant increase in capital investment and the number of well-paying jobs.
Encourage innovation through taxes
Policymakers generally have two types of corporate tax incentives: input-based and output-based incentives. The idea behind an input-based incentive is to reduce the costs a company incurs to produce intellectual property. Examples of this are credit notes, immediate settlements or special deductions for research and development costs.
Output-based incentives, on the other hand, reward behind-the-scenes innovation and offer companies a reduced tax rate on intellectual property income. An example is the innovation box, named after the box on corporate income tax returns where companies list IP-related income.
The innovation box has prevailed. In 2022, 21 countries had reduced tax rates on income from intellectual property such as patents, copyrights and trademarks. The popularity of the Innovation Box stems from the current global tax environment of multilateral cooperation.
In this environment, new rules designed to curb harmful tax competition have drastically slowed the “race to the bottom,” in which countries compete for business investment by lowering their tax rates on all income. Today, innovation boxes remain one of the few measures available to governments to attract business investment, high-skilled jobs and higher incomes.
Effects of innovation boxes
Previous research seemed to show that innovation boxes actually encourage innovation. The number of patent applications and grants increased after an innovation box incentive was introduced. However, the question arose as to how economical such patenting activity actually is.
For example, some companies acquired patents abroad or outside the company in order to be able to take advantage of the tax advantages of the innovation boxes. Additionally, there is mixed evidence that increased patent activity represents high-quality patents.
My own research, co-authored with University of Arizona’s Shannon Chen, Massachusetts Institute of Technology’s Michelle Hanlon, and Stanford University’s Rebecca Lester, shows several tangible — and positive — outcomes of innovation box systems.
We examined seven European countries for which relatively complete data were available and found that those with an innovation box had 2.6% higher capital expenditures – investments in assets such as factories and machinery – compared to similar countries that do not offer tax incentives .
Although we did not see an increase in hiring or total compensation due to Innovation Box policies, we did see an increase in average employee salaries. These results indicate a change in the composition of the workforce, probably from low-skilled technical professionals to more highly-skilled research and development workers. Workers in countries that introduced an innovation box earned at least €46,844 (or around $50,000) more than workers in countries without such a rule after the tax policy change.
As expected, these effects increased with the size of the tax benefit granted by the innovation box policy. Measures also appear to be more effective in attracting investment and jobs when they require companies to do some of the innovative work, rather than allowing companies to acquire intangible assets that qualify for the tax benefit. This is important information for US policymakers who are considering implementing these types of regulations.
Impact on the US
Although there was no innovation box in the US during the period studied, Congress attempted a similar strategy with the Tax Cuts and Jobs Act of 2017. This well-intentioned policy provides a provision for intangible foreign income and gives US companies a deduction for the sale of intellectual property-related products that are exported abroad.
In this way, it resembles an innovation box regime by allowing a lower tax on certain types of income to incentivize US multinationals to keep or relocate intellectual property on land.
The basic idea was good: offer benefits similar to an innovation box to increase investment and jobs in the US. But the implementation is flawed. The policy calculates the amount in excess of a 10% return on US assets as deductible income. Therefore, an easy way to get more qualified income is to reduce investment in the US, which is the opposite of the policy’s goal.
If the US introduced a true innovation box comparable to those being studied in Europe, it could increase investment and jobs for a highly skilled workforce here.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Information about the author
Lisa De Simone is an Associate Professor of Accounting at the University of Texas at the McCombs School of Business in Austin, a Public Voices Fellow on the OpEd Project, and co-host of the podcast Taxes for the Masses.
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