Innovation Tax Breaks Could Be Economic Tailwind for US Economy

The most recent Global Innovation Index puts the US at No. 2, again, behind Switzerland, which has led the ranking for 12 years. Beyond the question of what Switzerland is doing right in terms of encouraging innovation, there’s mounting concern that other European countries will soon surpass the US in intellectual property metrics.

IP is strongly correlated with productivity, but how do countries entice corporations to invest, and how do these enticements translate to a country’s general economic growth?

My colleagues and I recently found that a specific type of corporate tax incentive—the “innovation box” or “patent box”—is associated with countries’ economic growth, significantly increasing capital investment and the number of high-paying jobs.

Boosting Innovation Through Tax

Policymakers generally have two types of corporate tax incentives in their toolbox: input-based and output-based. The idea behind an input-based incentive is to reduce what it costs a company to produce IP. Examples include credits, immediate expensing, or super-deductions for research and development expenses.

Output-based incentives, meanwhile, reward innovation on the back end, offering companies a reduced tax rate for income that results from IP. One example is the innovation box, named after the box on corporate tax returns where companies list IP-related earnings.

The innovation box has caught on. As of 2022, 21 countries had reduced rates for income resulting from IP, such as patents, copyrights, and trademarks. The popularity of the innovation box springs from the current global tax environment of multilateral cooperation.

In this environment, new rules aimed at curbing harmful tax competition have dramatically slowed the “race to the bottom,” in which countries compete for corporate investment by lowering their tax rates on all income. Now, innovation boxes remain as one of the few measures available to governments to attract corporate investment, highly skilled employment, and increased income.

Effects of Innovation Boxes

Prior research seemed to show that innovation boxes do boost innovation. The number of patent applications and grants increased after an innovation box incentive was put into place. However, there were nagging questions about how economically important such patenting activity really is.

For example, some companies acquired patents from outside the country or outside the company to be able to claim the tax benefits introduced by innovation boxes. Further, there is mixed evidence that the increased patent activity represents high-quality patents.

My own research, co-written with Shannon Chen of the University of Arizona, Michelle Hanlon of the Massachusetts Institute of Technology, and Rebecca Lester of Stanford University, reveals several tangible—and positive—results of innovation box regimes.

We examined seven European countries for which relatively complete data was available and found that those with an innovation box saw 2.6% higher levels of capital expenditures—investments in assets such as factories and machinery—compared with similar countries offering no tax incentive.

Although we observed no bump in hiring or overall compensation from innovation box policies, we did find increased average pay for employees. These findings suggest a change in the mix of employees, probably from lower-skilled technical workers to higher-skilled research and development workers. Employees in countries that implemented an innovation box earned at least 46,844 euros more (or around $50,000) after the tax policy change relative to workers in countries without such a policy in place.

As expected, these effects grew with the size of the tax benefit provided by the innovation box policy. The policies also appear more effective at attracting investment and employment when they require some amount of the innovative work to be done by the company, rather than allowing companies to acquire the intangible property that qualifies for the tax benefit. This is important information for US policymakers as they consider implementing these types of regulations.

Implications for the US

Although the US didn’t have an innovation box during the period we studied, Congress tried a similar strategy in the Tax Cuts and Jobs Act of 2017. This well-intentioned policy provides a foreign-derived intangible income provision, offering US companies a deduction for sales of products related to IP exported to foreign countries.

In this way, it acts similarly to an innovation box regime in that it permits a lower tax on certain types of income to motivate US multinationals to retain or relocate IP onshore.

The general idea was a good one: Offer benefits similar to an innovation box to increase investment and jobs in the US. But the implementation falls short. The policy calculates income that qualifies for the deduction as the amount above a 10% return on US assets. As such, one easy way to get more qualifying income is to reduce investment in the US, which is the opposite the policy’s goal.

If the US were to enact a true innovation box comparable with the ones studied in Europe, it could increase investment and jobs for highly skilled workers here.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Lisa De Simone is an associate professor of accounting at the University of Texas at Austin’s McCombs School of Business, a Public Voices fellow of the OpEd Project, and co-host of the podcast “Taxes for the Masses.”

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