A Quick Note on Taxation and Innovation

Posted on June 3, 2012

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Libertarians frequently cite innovation as a key reason to cut taxes, simplify regulations and reduce the size of government. A good example of this argument can be found in Sun Microsystems founder Scott McNealy’s essay on Mitt Romney’s campaign website:

Sun Microsystems, which I co-founded way back in 1982, began with only four employees. Four “people,” that is. It eventually grew into a workforce of more than 40,000, based primarily in the United States. That’s a lot of jobs. It is a safe bet that the number would have been even higher if every year Sun had not been taking a significant fraction of its profits and turning it over to the Internal Revenue Service.

That money could have been reinvested in the company so that we could produce new and better computers, or it could have been sent directly to shareholders in the form of dividends, producing a better return on their investments and thereby attracting even more investment capital. The new employees receiving the money as salary to work on the new products, and the shareholders receiving the money as dividends in return for their investment, would still have paid taxes on it. But more economic activity would have occurred.

This argument is commonly made by people with only a speculative and anecdotal understanding of the link between government spending and technological innovation. The fact that there is an entire field of study devoted to empirically studying such issues is normally overlooked. Since I am studying to be part of that field, I feel a bit put off by this, and feel I should set the record straight.

A useful resource on the subject is this paper on the factors affecting national innovative capacity. Its authors, who are authorities on the subject, have come up with an innovation index they use to rank countries. Unsurprisingly, the United States is in first place despite its 35% tax rate. Recognized high-tax countries such as Finland, Sweden, and The Netherlands are all in the top 10, despite the supposedly detrimental effect that taxation has on innovation. So what’s going on?

It turns out that the empirical evidence suggests three factors that influence a country’s capacity to create and market new technologies: the conditions in innovative clusters such as firms or economic sectors, the strength of the common (public) innovation infrastructure, and the linkages between the two. In other words, while conditions in the private sector are indeed important, successful private sector innovators still owe a great deal to universities, research institutes, and other publicly funded institutions that provide useful research. Furthermore, there must be well-established transfer mechanisms so that this research can find its way into the private sector-something that also frequently requires government funding.

The reason for this is fairly simple. Some forms of research do not immediately appear to have commercial potential, meaning that business owners will be hesitant to risk their capital on them. Sometimes, however, research that did not seem promising at first can pay out massive unexpected commercial dividends. The public sectors is best positioned to pursue this research. This phenomenon can be seen clearly in innovation powerhouses like Silicon Valley, where a strong private sector benefits from the human and knowledge capital generated at a nearby university.

These findings are corroborated by Innovation Canada and the OECD FactBlog. The bottom line is that while tax cuts might be part of a strategic innovation policy, they are not the only useful policy lever and a successful innovation strategy requires substantial government spending in the public research and development sector. Innovation policy should be shaped by these facts, rather than anti-tax and anti-government ideology.

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