The effects of taxation on entrepreneurship and innovation

Innovation and entrepreneurship play a pivotal role in sustained U.S. economic growth and improved standards of living through lower prices, higher wages, and advances in healthcare. There are many factors involved in bringing an idea to the market, but we know surprisingly little about the role of government, and taxation specifically, in attracting foreign entrepreneurs and spurring or repressing U.S. innovation. Stefanie Stantcheva, an Equitable Growth grantee and Junior Fellow at the Harvard Society of Fellows (and future assistant professor at Harvard’s Department of Economics), together with co-authors Ufuk Akcigit an Assistant Professor at the University of Pennsylvania and Salome Baslandze, a Graduate Student at the University of Pennsylvania, seeks to understand how tax systems affect international mobility and the activity of innovators and entrepreneurs.

To do so, Stantcheva will combine international data on inventors and their patents, and tax policies across developed economies in order to understand how income taxes, a country’s immigration policies, and companies influences the activity and mobility of inventors as well as the quality of innovative activity. The focus is on “superstar’’ inventors, those inventors with the most valuable patents, who play a key role in economic growth. She will use the results to build a more complete taxation model, which takes entrepreneurship and innovation into account.

Stantcheva posits that a progressive tax code can reduce the profits from any given innovation, thus encouraging inventors and entrepreneurs to move to a lower-tax country. Her preliminary results find that, broadly speaking, this prediction holds true. Yet she also finds these results can be mitigated by a country’s investment in a strong basic research infrastructure, allowing for an active community of innovators whose contributions to growth are shared equally instead of just among the top earners.

Stantcheva suggests that progressive tax systems may also safeguard against the high possibility of failure inherent to any start up, allowing smart individuals without an abundance of wealth to act on their good ideas. Her hypothesis is supported by some emerging literature, which contends that some government social insurance programs can actually spur entrepreneurship by encouraging people to take risks.

Her final results, due out later this year, will be timely for U.S. policymakers, many of whom are under pressure to cut U.S. research & development funding. To the untrained eye, spending millions of dollars on, for example, fruit fly research may seem wasteful. In fact, this research not only serves as the basis for understanding the entire human genome and many genetic diseases but also produced massive economic returns relative to the original public investment. Despite such evidence, R&D spending by the federal government as a percent of GDP has dropped from 1.7 percent in the 1970s, to 0.7 percent in the 2000s, a phenomenon that may, in the long run, reduce the long-term growth of our economy.

Furthermore, with foreigners comprising 40 percent of all science and engineering Ph.D. graduates in the United States—many of whom are not permitted to stay because of our current immigration laws—there is ample reason to consider reforms to these laws in order to attract and retain more of the talent that creates jobs and drives our economic prosperity. Congress is beginning to take notice, with the recent introduction of the bipartisan Startup Act, which would create a new “entrepreneur” visa category for foreign students who graduate in STEM fields.

Too little is known about how taxes interact with innovation and entrepreneurship, despite invention being a cornerstone of growth. Many immediately conclude that a progressive tax system reduces the returns to innovation, and thus discourages entrepreneurship, which intuitively makes sense. Stantcheva’s research, however, allows us to consider whether this assumption is just one of many considerations we must take into account when designing optimal tax systems and policies to boost innovation and spur economic growth.