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Taxes can spur and guide innovation

17 June 2010

[This text was written by Jeffrey Owens, director of OECD’s Centre for Tax Policy and Administration]

Innovation is fundamental to long-term prosperity – it drives growth and makes economies more nimble, dynamic and productive. The tax system can be a powerful policy instrument for spurring this. Tax measures can stimulate innovation; taxes on pollutants can guide innovation demand towards meeting environmental challenges.

Government funding of R&D as a percentage of GDP

underlying data (xls)

Anyone focusing on innovation realises its potential to transform economies. Innovation extends the bounds of our knowledge and our current capabilities, making firms more competitive and productive. These positive effects spill over to others in the economy.

Innovation goes well beyond scientists with goggles and Bunsen burners. It includes the development of new products, novel techniques of production, fresh approaches to marketing and original methods of organisation in firms and industries. Implementation is also key, since a good idea that is not picked up by others cannot have a significant impact.

If firms have incentives to innovate from the market, is there a role for governments? In particular, can taxation help? Yes – not least because the tax system can help overcome barriers to innovation by reducing the cost of undertaking innovative activities. Research and development (R&D) tax credits, which are in use in many OECD economies, provide tax benefits related to the costs of undertaking specific activities that aim to innovate. Canada, for example, offers a broad-based R&D tax credit of up to 35% for expenses towards experimental development, basic and applied research, and related supporting activities. Accelerated depreciation schemes for innovation-related capital and reduced labour taxes on scientists and researchers all provide incentives to innovation. These tools can be used broadly or targeted to specific sectors and outcomes, such as renewable energy.

One way to boost the supply of innovation can be to lower the corporate tax rate for innovation-related profits, such as from royalties or the sale of patents. The Netherlands does this through its Innovation Box programme where innovation-linked profits benefit from a tax rate of 5% in lieu of the general rate of up to 25.5%.

Tax measures specifically targeting innovation may increase innovation activities, particularly R&D activities, but there is a risk of merely shifting R&D from other jurisdictions and subsidising R&D activities that would have occurred anyway, without the tax credit. Governments should avoid this danger, and also be aware of the administrative burdens innovation policies create for both firms and authorities. Moreover, they potentially open avenues for tax planning, including transferring intellectual property to low-tax jurisdictions.

Nor are tax measures to spur innovation without costs to public finances. The value of R&D tax credits varies widely; it constitutes 0.1% of total tax revenue in the United Kingdom and Norway and over 0.9% in Canada. This means revenue foregone which, particularly in today’s budget-tight times, must generally be raised through other means, such as higher standard corporate tax rate or higher personal income tax rates. These in themselves could have adverse impacts on innovation activities by firms, not to mention economic activity more widely.

The issues affecting the supply of innovation also go beyond the existing corporate tax system. The relationship between the corporate tax system, the personal tax system and social security contributions can influence individuals’ decisions about whether to stay in dependent employment or seek out more entrepreneurial, innovative activities. Moreover, policymakers have to consider whether marginal personal tax rates are calibrated to account for highly-skilled workers who may more than proportionately drive innovation but who are mobile and can be sensitive to tax rates.

The environment is one area where innovation is critical, affecting everything from local water pollution to national energy systems and global climate change. Meeting environmental challenges with today’s technology would be quite costly.

But using the tax system merely to encourage the supply of innovation for the environment simply will not be sufficient. If there is no cost to polluting, why would a firm adopt environmental innovations, however technologically advanced or cheap, that helps it to pollute less? Some firms may benefit from undertaking “green” innovation for customer or investor relations purposes but, as a rule, environmental innovation is different from other types of innovation: stimulating environmental innovations will see little uptake by polluters, unless matched by measures to stimulate demand for those innovations.

This stimulus can come only by putting a price on environmentally harmful activities, akin to the prices of other goods and services in the economy. Without markets to do this naturally, there is a clear role for governments to step in and tax pollutants. Governments across the OECD are increasingly doing just this and not only to address climate change but to address wider environmental challenges. They levy taxes on smog-causing air pollutants, taxes on effluents to water sources and on waste to reduce load and boost recycling.

Taxes are generally considered the most effective environmental policy tool available to governments, alongside tradable permit systems, which have very similar properties. By placing a price on the pollutant, both approaches really can encourage firm-level action to reduce pollution and thereby stimulate innovation. Where well-designed environmental taxes have been levied, these taxes have been shown to be effective at inducing innovation. These taxes are generally levied directly on the harmful activity (or on the use of energy and other substances) at an appropriate rate with few exemptions but perhaps of most importance is that governments use taxes or tradable permits to maintain a high price for CO2 emissions and that it clearly forms part of a long-term policy.

In short, given the importance of innovation to sustainable growth and well-being, governments need to consider how to best optimise their approach. Skilfully harnessing the tax system offers a robust and indeed innovative way forward.

    – Jeffrey Owens

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