Turning Corporate Taxes into an Innovation Spur

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. In particular, innovation economics holds that market forces alone often do not produce optimal outcomes and that public policy, including tax policy, that corrects these mismatches can enhance societal welfare.

As such, a corporate tax code based on innovation economics would seek to explicitly promote the international competitiveness of American businesses and encourage innovation by lowering the effective rate, but doing it in ways that also provide strong innovation incentives. There are three things Congress should do:

First, Congress needs to spur R&D spending by altering the tax code. Lawmakers should expand the R&D tax credit by increasing the Alternative Simplified Credit rate from 14% to between 20% and 40%, depending on how much investments are increased. In addition, it’s time to broaden the definition of qualified R&D from beyond that involved in inventing a product to that involved in developing a production process. Congress should also broaden the current flat credit for collaborative energy-related research to any area of research and expand the rate to 40% from 20%. Taking these steps would make the U.S. R&D tax credit among the five most generous in the world.

ENCOURAGING EMPLOYEE TRAINING

Second, investment in new capital equipment—machinery, computers, and software—is needed because it is through such purchases that innovation spreads. One way to do this would be to let firms write off investments in capital equipment in their first year instead of having to depreciate investments over a number of years.

Third, for business to get the full benefits from new equipment, they need higher-skilled workers. Providing a carrot for on-the-job education, Congress should allow employee-training expenditures to be counted as qualified expenditures for the Alternative Simplified R&D Credit.

Even if conventional economists can be persuaded that these activities are subject to market failures that tax code can help correct, many may still resist, arguing that the nation can't afford new incentives and that more innovation would be spurred if we instead paid down the national debt. The short answer is that it’s more effective to target these kinds of innovation-enhancing activities than to simply reduce the debt in the hope that interest rates fall.

U.S. IS AT RISK

But it is possible to have more innovation tax breaks and lower deficits. Congress could repeal the portion of the 2003 Jobs and Growth Tax Reform & Reconciliation Act which reduced the top individual tax rates on dividend income to 15% for investors in the top four tax brackets and 5% for investors in the bottom two tax brackets. In addition, Congress could raise top marginal rates back to the Clinton era rates or even slightly higher.

One way not to pay for these is to limit deferral of foreign source income, as the Obama Administration has proposed. Such a move would raise less revenue than expected, and by raising corporate taxes, move us in exactly the opposite direction we should go in.

In short, the U.S. is at risk of losing its global competitive advantage and with it faster per-capita income growth. To effectively respond will require the nation to take concerted and strategic actions in a host of areas, including reform of the corporate tax code to transform it into an energetic tool to support private sector efforts to innovate and be more productive.

Originally posted on BusinessWeek.com.