Another Nail in the Coffin of Tax Reform
Perhaps without realizing it, the Obama administration sent Congress another signal that it is not serious about passing corporate tax reform this year, even a narrow bill limited to the international aspect of corporate taxation. Speaking at a conference devoted to the corporate taxation of intellectual property in a global economy, the chairman of the President’s Council of Economic Advisers, Jason Furman, listed several reasons why an "innovation box" (sometimes known as a "patent box") would be bad policy. The problem is that an innovation box is one of the few serious components of corporate tax reform that has drawn interest from leaders in both parties in Congress. By preemptively ruling it out without proposing a serious alternative, the administration left little room for finding common ground with Congress.
There is widespread agreement that the U.S. corporate tax system is broken. In addition to imposing a significantly higher rate than most of its international competitors, the law taxes U.S. companies on all of their income earned abroad, but only when the income is brought back to the United States. This gives companies a strong incentive to keep foreign profits overseas. Recent estimates suggest that the amount of unrepatriated profits is now $2.4 trillion. But eliminating the deferral of taxation would damage the ability of U.S. companies to compete in overseas markets and increase existing incentives for them to move abroad. Dr. Furman himself has referred to current tax law as our “stupid territorial tax system.”
Spurred by the rapid growth in unrepatriated profits and a growing number of U.S. companies moving their corporate headquarters abroad, congressional leaders in both parties have spent the last two years trying to forge a bipartisan consensus on corporate tax reform, especially the international component of it. One of the few bright spots in this long effort has been the growing interest in an innovation box. So named because it can take the form of a check box on a corporate tax form, this would tax income derived from certain productive activities, such as patenting, research and development (R&D), or manufacturing, at a lower corporate rate. The idea is to reduce taxes on those sources of income that are viewed as being most beneficial to economic growth and most able to move overseas in return for a lower tax rate.
An innovation box have received support within both parties in Congress. Last summer a bipartisan report by the Senate Finance Committee stated agreement on the wisdom of including an innovation box in any reform effort. Representatives Charles Boustany (R-LA) and Richard Neal (D-MA) have jointly introduced a bill for discussion. Speaker of the House Paul Ryan (R-WI), who was then chairman of the House Committee on Ways and Means, commented favorably on it.
Innovation boxes of one type or another have been enacted by an increasing number of Organization for Economic Cooperation and Development (OECD) countries. In the past, these provisions were content merely to attract the profits associated with productive activity. However, under recent agreements stemming from the OECD’s Base Erosion and Profit Shifting project, countries must also require that a nexus of other activities also occur in the country in order to qualify for the lower rate. The risk is that, in order to keep the lower rate, companies will move their R&D and production overseas. Once abroad, they may never come back, even if tax reform eventually eliminates the tax disadvantage that U.S. companies face.
In his remarks, Dr. Furman listed six reasons why expansion of the current research and experimentation (R&E) tax credit would be a more effective way of encouraging additional research activity and why adopting an innovation box “would move tax policy in the wrong direction, increasing complexity and cost without a commensurate boost to innovation.” All of these objections have some legitimacy and were raised by other speakers at the event. However, they all go to concerns about the design of an innovation box, not its existence. Like every other tax provision, an innovation box will add complexity to the tax code and will need to be designed carefully in order to maximize its social benefits and minimize its costs.
First, he argued that the “R&E credit is a better tool to promote innovation.” But the economic evidence suggests that R&D incentives should be much higher than they are in the United States, where the tax code provides about a 6-percent subsidy. To equalize the private and social benefits, the effective credit should be about 50 percent. Yet, the most the Obama administration has proposed is going to an 8-percent effective subsidy (going from 14 to 17 percent on the Alternative Simplified Credit). So if they the administration wants to defend the research credit, they should be proposing a much bigger credit.
Second, Furman also said that the “social benefit from investment in research may not, however, be proportional to its anticipated commercial potential.” But this is also true with the research credit. Moreover, at least with an innovation box, society is rewarding innovations that meet the test of the market and have a real impact on society.
Third, Furman also argued that “the R&E credit focuses its entire subsidy on new research, while shifting to an innovation box would, depending on how it is structured, confer a windfall subsidy on research that has already been undertaken.” But in fact, it would not. At least after a few years of the innovation box being enacted, firms would factor this into their decisions to conduct R&D, knowing that the after-tax return would be higher with an innovation box.
Fourth, he complained that “the cost of an innovation box is highly uncertain, [and] potentially large.” But the cost is only related to how generous Congress wants it to be. Also, as ITIF has shown, the U.S. effective corporate rate is high and needs to be much lower.
Fifth, Furman went on to complain that, “In the United Kingdom, the introduction of a low-tax patent box reduced corporate tax revenues.” But so does the R&E tax credit, at least using static, not dynamic scoring. But that’s the whole point of corporate tax incentives to allow business to pay lower taxes in exchange for some other activity (e.g. investing in R&D).
Finally, he argued that “moving to an innovation box would entail joining in a race to the bottom.” But why is the administration’s proposal to increase the R&E credit from 14 to 17 percent not joining a “race to bottom?” Enacting an innovation box is not a race to bottom, it is a race to innovation. Moreover, America is already in a race for global innovation and to pretend that we can continue to levy high taxes on globally traded firms and not pay a price is to pretend we are living in the 20th century.
Of course, no tax policy is perfect, even the best have to reconcile important but conflicting goals. But evidence presented at the same event showed that well-designed boxes in other countries are having a positive effect. Two different papers have found that companies increase their patenting activity within a country by 3.5 to 3.8 percent for every one percentage point reduction in the tax rate on patent income. Another paper focused only on the effect of innovation boxes found a response of 3.0 percent. The higher activity seems to come from greater domestic patenting rather than the movement of patent ownership across borders.
Innovation boxes accomplish other goals as well. One is that they reward research and development. The administration’s support for an increase in the existing R&E tax credit does not reduce the merits of an innovation box, which concentrates tax benefits on innovation that has proved itself in the market. Combined with a requirement that companies have some nexus to the nation where their profits are taxed, an innovation box gives companies a reason to locate productive activity as well as profits in the United States. Finally, in the absence of broader corporate tax reform, an innovation box responds to the growing international competition for a greater slice of corporate profits.
That may be where the administration response is most disappointing. Faced with this competition, the White House has done little to make the United States a more attractive place for international corporations or to protect them from growing threats to link taxation to sales or other economic activity within a company rather than profits. The traditional practice for taxing the income of international corporations is facing serious threats due to the mobility of corporate profits and the increased demands for revenue from national governments. If the administration wants to affect the outcome in a positive way, it needs to do more than state a position and wait for others to fall in line. It needs to engage with both Congress and other nations in a way that recognizes the scope of possible agreements.
Summarily dismissing innovation boxes, one of the major pieces of bipartisan agreement in Congress and a component of corporate tax that other nations are increasingly adopting, does the opposite.
