Profit Taxation, R&D Spending, and Innovation

By Andreas Lichter, Max Löffler, Ingo E. Isphording, Thu-Van Nguyen, Felix Poege, Sebastian Siegloch

Advances in pharmaceuticals and vaccines, robotics and artificial intelligence dominate newspaper headlines. These innovations are often the product of huge investments and risky research, which firms might be reluctant to undertake without government support. At the same time, firms are important sources of tax revenue for public goods. How do we effectively encourage investments in innovation while also balancing other policy priorities? To answer this, we need to understand how firms react to tax policy.

A new discussion paper, coauthored by TPRI postdoctoral associate Felix Poege, estimates the impact of profit taxation on the levels of R&D spending and filed patents. Using data from the near-universe of active R&D firms in Germany, the authors examine how nearly 7,300 local tax changes impacted plants in that locality. The local tax changes effectively serve as natural experiments, allowing a comparison of plants impacted by a tax change to plants in localities with no tax change. Do firms decrease or shift their R&D expenditures in response to increased taxes? Does this decreased R&D spending lead to fewer patent filings?

The results suggest that when confronted by higher profit taxes, plants lower their R&D spending, and likely as a consequence of that lower spending, file fewer patents. However, the authors caution that this result does not suggest the policy response should necessarily be decreased taxes on profit, but rather targeted tax incentives for R&D.

Innovation is not just beneficial to the broader society that reaps the direct benefits of a new product, but particularly the local economy. The authors provide suggestive evidence that the impacts stemming from innovation are long lasting in the local economy. Local business taxes on profit also are associated with a decrease in local GDP. Taking these points together, the author’s calculate that about 8% of the decline in local growth stemming from profit taxation can be attributed to reductions in innovation.

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