Innovation drives economic growth, but it is a fragile engine that can either be driven by tax incentives or made less efficient by heavy tax responsibilities. Tomorrow’s tax leaders will need to thoroughly understand the relationship between taxation and innovation to develop policies that benefit individuals and corporations.
Why is innovation important to the economy?
In today’s complex economy, innovation can take many forms. In the technology field, innovation can refer to the creation of new solutions to business challenges. To an executive, innovation means the ability to achieve goals more efficiently. From a production standpoint, innovation can mean the development of new inventions and methodologies.
Each of these perspectives is tied to the others. The inventor working in his or her garage may produce a new technology that leads to further innovations in a particular industry. Within organizations, innovation in the IT department can strengthen the company’s ability to meet customer expectations.
The economy is the petri dish in which innovation grows and manifests into tangible benefits. Economic policy at the national and state levels directly impacts how individuals and organizations address their business challenges. Taxes therefore have a significant effect on innovation.
In a widely cited 2018 paper titled “Taxation and Innovation in the 20th Century,” Chicago University associate professor of economics Ufuk Akcigit and members of the Harvard Business School faculty set out to scientifically understand how taxes have inhibited or encouraged innovation in the U.S. between 1900 and 2000. The researchers found a direct correlation between innovation and economic growth as well as between innovation and intergenerational social mobility.
Tax professionals who work in the corporate world may be able to help their organizations to compete better by strategically addressing tax issues. Corporate tax experts can help their companies navigate this complex landscape since they are equipped with a comprehensive understanding of their individual business, industry, and laws. By creatively limiting tax liability and taking advantage of tax incentives, businesses can use their budgets to drive innovation and ultimately benefit the economy at large.
How are taxes and innovation interconnected?
One way to look at the relationship between innovation and taxation is to view taxes as an economic tool with costs rather than as a pure driver of government revenue. For instance, taxes—especially on income and wealth—are typically levied to raise funds for government projects. But in addition to generating income for the state, they also introduce a cost at the individual or corporate level—i.e. less innovation. Lower innovation levels today could result in lower economic growth in the future. Let’s abstract this concept using a simple example.
Say an individual has generated enough wealth to no longer need to go to work every day. In his free time he tinkers with equipment in his garage and eventually makes a discovery or creates an invention that makes a common process more efficient. In the long term, his invention not only generates additional wealth for himself, but also gives other people more free time to think, work, and invent. As a result, his local economy grows and his local government gains new revenue.
What would have happened if our inventor was subject to heavy taxation before he could experiment in his garage? He might not have been able to afford that free time and therefore never have invented his revolutionary solution. The state got more revenue from this individual in the short term, but lost out on the wider benefits of his never-to-exist invention.
This is a hypothetical and overly simplified example, but it demonstrates the potential impact taxation can have on innovation. In their paper, Akcigit and his team examined state and federal level tax policies and events from the last century in relation to patent production. They found that corporate and personal income taxation negatively affects the quantity, quality, and location of innovation at the individual, organizational, and state level.
The research team also found that high taxation in 20th-century Europe may have caused a “brain drain” into the U.S., inadvertently sending innovative individuals to American corporations. Additionally, the team determined that the 1986 tax reform directly and positively impacted the number of top-performing inventors in the U.S., suggesting that top-tier tax rates have significant influence on corporations and the individuals they hire to fill out their research and development departments. Researchers suspect that foreign-born skilled-workers were drawn to the U.S. by companies with bigger R&D budgets.
Essentially, some tax policies will drive innovation down, while others will encourage its growth. Tax professionals who shape policy at the organizational and state levels may be able to nurture innovative thinking. Designed properly, Akcigit’s team believes tax systems can “foster innovation by better aligning the incentives of private agents with the social value of innovation.”
What should tax professionals know about innovation?
In 2017, Congress passed the most sweeping tax reform since 1986. Will these new laws boost innovation or stymie the creative spirit of skilled innovators? Only time will tell what far-reaching consequences the law will have on innovation, but some industry experts are not optimistic. In his analysis of Akcigit’s work, economist and Forbes contributor Milton Ezrati noted that the new policy’s less generous approach to individual taxation could lead to less innovation overall, especially in regions of the country that do not already possess centers of innovation, such as states in the deep south.
Considering the average individual tax refund has shrunk by 16% since the 2017 reforms, it stands to reason that burgeoning inventors will have fewer resources to contribute toward innovation. And when the individual tax cuts expire, the situation is likely to skew even further toward the negative. At the same time, tax breaks for corporations could lead to increased innovation, if the tax savings are passed on to research and development departments.
Tax professionals who want to help their organizations cultivate innovation need to understand how policies impact technological progress. In the fully online Master of Science in Taxation program from the D’Amore-McKim School of Business at Northeastern University, students can gain an in-depth perspective on corporate and individual taxes in courses such as:
- State and Local Taxation: Addresses the most common taxes imposed by state and local governments with an emphasis on the underlying principles governing each one.
- Federal Tax Issues and Analysis: Broadly examines tax authority as it guides action on tax issues such as personal and business decisions.
- Tax Accounting for Income Taxes: Takes a deep approach to the investigation of tax reporting, especially for uncertain positions.
To discover how an online MST program can help you advance your career, learn more about the program today.