Taxes And Innovation

Milton Ezrati

Chief Economist

When a country – or a state or a city — taxes more, it gets less of whatever it taxes. Sales taxes discourage consumption. Income taxes discourage money making, which in most cases is work. Capital gains taxes discourage investment. All statistical research supports this conclusion, at least to a degree. Disputes arise only over the extent of the adverse impact. Since taxes are a necessity of life in an organized society, the object is to find ways that minimize these ill effects and place them in areas least important to society.

Innovation is an area of particular concern. It is the lifeblood of this country’s high-tech economy and a key element in America’s ability to compete with lower-wage labor in most of the rest of the world. Until recently, little of the statistical work on tax effects focused on innovation. New insight has, however, emerged in a recent joint study by a combination of scholars at the University of Chicago, the Harvard Business School, and Harvard University. Their work makes clear that taxes on income especially have an adverse impact on innovation, how much occurs overall and where it occurs within the country, though it is far from the only factor. Though most of the analysis draws on historical data, the new tax law’s cap on the amount of state tax available for a deduction on federal tax liabilities will tend to exaggerate the already stark distributional findings of this impressive research effort.

For a long time, economists and statisticians had difficultly gauging the particular impact on innovation. Three new data sets and the considerable resources of these collaborators have, however, overcome past difficulties and allowed the researchers more definite conclusions than in the past. The first of these new data sets is the digitalization of historical patent and research citation data going back to 1920. The second includes more complete information on research and development (R&D) efforts, specifically the numbers of research laboratories and the number of people employed in them. These, combined with data on both federal and state taxes, provide insight into the overall effects of taxation on innovation. A third new data set on state level corporate and individual income taxes allowed the analysis to take yet another step and examine the impact of taxation on where innovation takes place within this country.

What these researchers discovered is that the tax impact on innovation nationally is less significant than how state taxes determine where innovation locates. Evidently, the hurdle to leave the country is higher than the hurdle to move from one region within the nation to another. Even then, the analysis shows less impact from taxes where innovators cluster. If a region contains a significant concentration of firms and individuals in the same technological field, it will continue to show high levels of innovation almost regardless of taxes. The continued productivity in Silicon Valley in high-tax California stands as an example, as does the continued impressive activity around route 128 outside Boston in almost as high-tax Massachusetts. But even considering the impact of concentration, the work of this impressive team found a clear inverse relationship between taxes and innovation.

It seems that especially those the researchers categorized as “superstars” are sensitive to tax. Evidently, those who generate an inordinate number of patents and receive a lot of research citations, whether individual innovators or corporate efforts have confidence that others will follow if they move. Without the risk of isolation, these sorts can afford to respond more readily to tax considerations. The researchers discovered what they refer to as negative “elasticities” of between 2 and 3.4 to hikes in personal income taxes and 2.5 and 3.5 to hikes in corporate taxes. The term elasticity has a strict technical meaning, but for these purposes, it might be viewed as a percent effect for each percentage point of additional tax.

When the analysis breaks out the impact on individual inventors, the elasticities tend to shrink, though they still find an adverse impact of tax on innovation. When personal state income taxes rise, patents fall by the elasticity of between 0.6 and 0.7, while the elasticity on citations falls between 0.8 and 0.9. State taxes also determine the flow of individual innovators from elsewhere. The adverse elasticity is lowest when the inventor is originally from the state in question. It comes in at only 0.11. Evidently, family and personal connections have an independent positive impact. For innovators with origins in another state, this adverse elasticity of state income taxes rises to 1.23.

The policy implications are clear enough. States that want to attract innovation would do well to contain both personal and corporate taxes. This is true especially of states that from a historical accident do not already enjoy a cluster of innovation that can attract others and hold those already in place despite tax considerations. These conclusions are clear even in the historical period of analysis when a federal law was more generous to high-tax states than now. If anything, the new, less generous federal law will increase these adverse “elasticities,” though it will take years before research will have the ability to put a number on the extent.

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