Tax rates and tax structure have a significant impact on innovation. It influences the quality of innovative ideas and the number of businesses, startups and patent applications in a region. An inefficient tax structure or high-income tax rates can not only discourage innovation but also lead to entrepreneurs moving to low-tax rate regions.
The article "How Do Taxes Affect Entrepreneurship, Innovation, and Productivity?" by Aaron Hedlund explores the relationship between tax rates and innovation. With the help of this article, we will try to understand how high tax rates and tax policies not only hinder economic growth but also affects every stage that it takes for an idea to become a product.
The article mentioned the work of two Nobel laureate economists Robert Solow and Paul Romer who made significant contributions in the context of economic growth. Solow provided insights into capital accumulation, including machines and equipment, which enabled countries to move beyond subsistence living and contributed to the economic growth of regions during the Industrial Revolution. He also noted how adding more capital leads to smaller or temporary incremental gains over time, followed by a return to the previous trend. In contrast, sustained economic growth comes from being able to produce more with fewer resources, leading to continuous growth over the long term.
Romer highlighted the concept of non-rivalrous ideas, innovations or improved management practices as a key driving factor in driving productivity and growth. This provides limitless opportunities as the use of the non-rivalrous idea is not restricted to one person and lead to the building of new ideas on each other. This dissemination of ideas leads to a compounding effect on long-term economic growth.
Patents are an important asset in the modern economy where knowledge is highly valued. A study found that income tax hikes at either the personal or corporate level have negative effects on state-level innovation and the individual behaviour of inventors.
Multiple research indicates that higher tax rates discourage one from becoming an innovator. A 40% increase in income tax led to a reduction of up to 48% in patent filings. Moreover, income tax hikes, whether at personal or corporate levels, negatively affect state-level innovation, causing a 6% to 10% decrease in patents and citations for each percentage point increase in the average personal tax rate.
Innovators tend to move to locations with lower taxes. A 1% increase in state taxes is associated with a 1.8% higher net outflow of innovators. Finally, income taxes also impact the quality of new ideas, as higher taxes reduce inventors' incentive to create high-impact inventions. A 40% increase in income taxes could lead to a 9.4% to 12.5% reduction in innovation quality, as measured by citations.
It is crucial to differentiate between temporary and permanent growth. To achieve sustained economic growth focus should be on rising productivity resulting from the creation and dissemination of ideas and not on policies that focus only on incentivizing work or investment.
Global Innovation Index and a Look at G20 Countries
India's rank improved to 40 in 2022. India has leapfrogged 41 places in 7 years as India was at 81st position in 2015 and at 46 in Global Innovation Index, in 2021. India's strength includes ICT service exports, Domestic market scale, Finance for startups and scaleups. Other countries like UK, USA and China have performed well in QS university rankings, Patents by origin, Environmental performance etc. China's rank improved to 11 in 2022 from 35 in 2013.
USA in Market sophistication, South Korea in Human capital and Research are at the top. India ranks 19 in Market Sophistication. But when it comes to Infrastructure, it ranks 78 and has been performing poorly over the years. All other countries included in the visualization performed well in Infrastructure as compared to India.
The relationship between an investment friendly tax-regime, and innovation is abundantly clear. However, the relationship between IP, and productivity is still a matter of greater investigation and needs to be seen from the prism of human capital, and not just technological leapfrogging. There is evidence as we have seen above that streamlining taxation brings with it a positive impact on innovation, but it also needs to create a secondary environment.
