In the web of taxes levied by governments, state corporate income taxes are relatively small, with substantial variation between states. These taxes account for only about 5.4 percent of state tax collections on average, but new data show they make a difference.
A recent study in the Journal of Financial Economics finds that corporate tax income increases dampen activity “across every step of the innovation process.” State-level corporate income taxes matter and state policymakers should avoid enacting tax increases that reduce patenting activity, research and development investment, and the rate of new product introductions.
Professor Manpreet Singh of the Scheller College of Business, writing with Professors Abhiroop Mukherjee and Alminas Žaldokas of the HKUST Business School in Hong Kong, analyze changes in state-level corporate tax rates from 1990 to 2006 to evaluate how these changes affected publicly-listed firms.
Their finding: patenting activity is affected by tax changes, but the magnitude of this effect is not symmetrical for increases and reductions. The response to a tax increase is substantially larger than a tax cut.
Patent Activity Response to Tax Change
Source: Mukherjee, Singh, and Žaldokas (2017).
The average firm affected by an increase in the state corporate income tax files one fewer patent, compared to a control firm. But the authors do not find any systematic response to reductions. In addition, the response to an increase is not confined to an immediate time period; the rate of patenting activity does not recover in later years, meaning the adverse effects of an increase persist.
One possible explanation for why responses to tax increases have a larger effect is that firms are able to cancel or scale back projects fairly quickly, while attempting to develop new projects in response to a rate reduction would plausibly take longer.
The authors find that in addition to the reduction in patenting activity, their most conservative estimate is that the ratio of R&D to sales declines by 4.3 percent in response to a tax increase.
They also develop a new method for analyzing whether these tax changes affect major new product launches, which are salient to consumers. Using a combination of textual analysis of relevant company press releases with event studies of stock market returns, they find that the number of major new product introductions by affected firms drops by 5.1 percent in the first year after a tax rise.
These tax increases also affect the type of investments firms are willing to make, as the authors “find a systemic decline in the riskiness of innovation products undertaken by firms.” In many cases riskier projects also carry outsized potential gains if the projects is ultimately successful, and a shift to more conservative project profile could preclude the development of new products that could be transformative.
Other underlying economic conditions could be influencing the results, so the authors include tests where they restrict their analysis to firms in contiguous counties straddling state borders. In some of scenarios they restrict it further to contiguous border-straddling counties that also have a similar political environment.
They also focused on tax changes that were not predictable in the year prior, based on macroeconomic conditions and a textual analysis, because a looming predictable tax increase could influence the intensity of firm patenting activity or investment in the time before the tax was enacted.
In most cases the authors obtain similar results, so other factors are not the real reason for these responses by firms rather than changes to state corporate income tax rates.
State-level corporate income tax hikes matter. Increases have a range of harmful effects, from limiting the riskiness of projects firms are willing to pursue to slowing the rate of new product introductions. Such tax increases have negative effects far larger in magnitude than the positive response to a tax reduction.
Perhaps in recognition of the harm that a series of increases have caused, some states have recently been implementing rate cuts, but these might still fail to reignite the dynamism that had already been lost. Going forward, states should avoid further increases in order to encourage innovation and minimize economic damage.
Charles Hughes is a policy analyst at the Manhattan Institute