A High Tax Rate on Star Inventors Lowers Total Innovation

Federal Tax

A recent paper by economists Alexander Bell, Raj Chetty, Xavier Jaravel, Neviana Petkova, and John Van Reenen uses new data to examine how tax policy affects innovation. The authors show that while tax policy is not the only determining factor influencing innovative activity, taxes have a greater impact on effective tax rates as earnings rise. Going further, other barriers such as the complexity and structure of the tax code may impact the level of innovation as well.

The authors use data on 1.2 million inventors by linking their patent records with their federal income tax returns. This provides details on the decision making, productivity, and success of inventors over time. The authors find that punitive taxes have a negative effect on innovation. For example, an increase in the tax rate from 0 percent to 30 percent on an inventor’s earnings reduces forecasted total innovation by about 5 percentage points, while a tax hike from 30 percent to 60 percent reduces it by roughly another 15 percentage points. The total number of inventors also falls as the tax rate on inventor earnings rises. High tax rates may not eliminate innovation, but they do reduce innovative activity at the margin.

Engaging in innovative activity entails risk, which means that inventors engage in it partly for the non-monetary benefits. This makes “star” inventors who produce much of the innovation less sensitive to changes in their expected financial return. By contrast, the authors find that doubling the exposure to innovative activity for underrepresented groups, such as children from low-income families, doubles the number of individuals who become inventors.

This paper builds on previous work looking at how taxes affect where inventors choose to locate. Two studies found that taxes at the state and international levels affect where innovators decide to live. Even if the total output of innovation is only modestly affected, taxes may determine where much of the innovation takes place. Policymakers should consider inventor mobility when setting tax rates.

The findings suggest that while a policy agenda to revive innovation must include an assortment of changes – including greater access to mentorship – tax policy matters too.

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