Turning Corporate Taxes into an Innovation Spur

Countries compete for mobile, high-value-added jobs, and increasingly they use their tax code as a key tool

By Rob Atkinson

As Michael Mandel has written in BusinessWeek, the current U.S. recession is due in part to a shortfall in innovation and competitiveness. Those lags, in turn, can be traced to the U.S. corporate tax code. U.S. statutory and effective corporate tax rates are high compared to those of other nations. Moreover, the code provides only minimal incentives for companies to invest in the building blocks of innovation: research, new capital equipment, and labor skills. It is time to redesign the tax code to help turbocharge the U.S. innovation engine. Doing so will improve U.S. competitiveness, not only by reducing international tax differentials, but by also spurring more domestic investment in research and development, productivity-enchancing capital expenditures, and worker training.

Unfortunately, many Washington economists—principally neoclassical economists—oppose using the tax code to explicitly spur innovation and do not believe that the U.S. is in competition with other nations.

At a Washington tax economist forum, I recently presented the recommendations of a new report from the Information Technology & Innovation Foundation, which I founded and run, calling for making the U.S. corporate tax code more internationally competitive. One prominent congressional tax economist countered that "economists agree that while companies may compete, nations do not." In other words, there is no need to make the tax code more competitive since the long-term welfare of the U.S. economy is unrelated to what other nations do.

Cuts Aren't Enough

The reality is that countries do compete for mobile, high-value-added jobs, and increasingly they use their tax code as a key tool. Average corporate tax rates among the 30 OECD nations have declined by at least 15 percentage points over the last 30 years, to under 35%. In 2007, economists Michael Deveraux, Ben Lockwood, and Michela Redoano found that the desire for nations to be internationally competitive has been the principle driver of these declines.

Even if neoclassical economists were to acknowledge that our tax code needs to be more competitive, most would counsel cutting the marginal rate, not adding or expanding particular incentives to cut the effective rate. William Gale, director of the economic studies programs at the Brookings Institution, sums up this view in a debate on a National Journal blog: "The sine qua non of meaningful tax reform is to clean out and rationalize the exclusions, exemptions, deductions, and credits in the tax system." Translation: Get rid of incentives for innovation and just give everyone the same low tax rate.

While appealing in its simplicity, this conventional view is based on a faith that markets work efficiently and that taxes only distort activity, leading to less innovation. But a position on taxes should be based on empirical evidence, not faith. In fact, there is compelling scholarly evidence that businesses do not capture all of the benefits of their investments in R&D, workforce training, and new machinery and equipment, particularly IT. As a result, without specific encouragement, companies will invest less in these areas than is optimal. This gap between the level of spending supported by the market alone and the social optimum justifies a role for government.

Promoting Global Competitiveness

In contrast to the faith-based neoclassical economics view that dominates Washington's economic thinking, "innovation economics" is based on a view that economies differ by time and place and the only way to make effective policy is to pragmatically analyze each situation.

Business Exchange

Track and share business topics across the Web.