Among its myriad flaws, the US tax code does a poor job of incentivizing domestic research and investment, crucial ingredients to future US economic growth. It is not clear that any of the tax reform proposals currently on the table will do much to remedy this deficiency.
There are provisions currently in the code intended to encourage domestic research and investment: for instance, the United States was the first country to implement a tax credit to incentivize research and experimentation, and it also allows corporations to immediately deduct 30 percent of any new investment. However, most economists believe that neither provision has been terribly effective at boosting investment: the on-again, off-again nature of the investment deduction means that it has done more to affect the timing of investment than the amount of it, and the research and experimentation credit is so complicated, poorly designed, and parsimonious that most corporations have little idea as to which of their activities will actually qualify for the credit. Most companies that claim the credit hire an accounting firm to identify where they can take the credit after they have already made their research and investment decisions. A substantive reform is well overdue.
Advocates of corporate tax reform have suggested that these provisions be sacrificed to help pay for a lower corporate tax rate. Since these regulations are not effective at achieving their ostensible goal, getting rid of them may seem like a small price to pay to achieve a 25 percent corporate tax rate. However, a tax code that does even less to encourage these salutary activities than the current one is hardly an improvement, regardless of the lower tax rate, which would still leave our rate above the mean for the OECD countries.
An innovation box would make it much more likely that companies would return their IP to the US, and less likely that they would shift future IP abroad.
One sensible way to remedy this flaw in the tax code would be to embrace a reform that includes an “innovation box.” An innovation box (sometimes called a patent box) imposes sharply lower tax rates on income that accrues to patents, copyrights, unique production processes, and other innovations that result from research and investment.
The advantage of an innovation box is that it would not only encourage more investment and research, but would also incentivize companies to keep the fruits of that research in the United States — along with the related production jobs that invariably go with research and experimentation. Doing research in one country and production in another is not optimal for most industries, and the tax code is a main reason why these activities have increasingly been done in different countries.
I recently completed a study with Michelle Hanlon of MIT in which we surveyed the chief tax officers of large biotech and pharmaceutical companies and asked them how an innovation box regime in the United States might affect where they locate their intellectual property, their research and development, and their manufacturing processes.
The data suggested that an innovation box would make it much more likely that companies would return their IP to the US, and less likely that they would shift future IP abroad. The main reason for shifting it abroad, of course, is to avoid having to pay the high US corporate tax rate on their profits. As one COO told us, no one in his industry moves their production to Switzerland for cheap labor costs.
Over the last decade, numerous European countries have adopted an innovation box of some sort, as has China. In fact, innovation boxes have become so prevalent that the OECD is currently working with its member countries to develop some rules governing their implementation, which will likely lead to many other developed countries going the route of an innovation box.
The current tax code essentially incentivizes US companies to invest in other countries. The high US corporate tax rate and the deferral tax treatment of foreign-sourced income deters US companies from repatriating foreign-sourced profits, making it more profitable for US multinationals to use this capital to invest in building new plants and production facilities overseas rather than at home.
If all the political process can manage is a modest cut in the corporate tax rate, we should seek to include an innovation box and give US companies a reason to invest domestically.
Ike Brannon, a former Treasury official, is president of Capital Policy Analytics, a consulting firm in Washington, DC.
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