Cato Online Forum

Tax Cuts for Innovators Are a Good Economic Investment

By Enrico Moretti
November 2014

Economists on the right of the political spectrum tend to favor tax cuts, while economists on the left tend to oppose them. But there is a type of tax cut that all economists should support, irrespective of their political inclinations. It is an incentive designed to increase investment in R&D and innovation by American companies. It will foster economic growth and job growth in the years to come. It will not cost the Treasury a penny — in fact it will ultimately pay for itself.

Innovation and research are the engines that sustain the American economy and its workforce. The problem is that the United States is not investing enough in innovation and research. As a consequence, our economy and our salaries are not growing at the rate they used to. This is not to say that American companies invest too little relative to other countries (although this is sometimes true) but rather that they invest too little compared to what would be optimal for the country. This is caused by a serious failure in the market for knowledge. The market failure stems from the fact that the creators of new ideas are not always fully compensated for their efforts, as some of the benefit of their research inevitably accrues to others in the same industry.

Consider, for example, the introduction of the iPad. Because the product was completely new, nobody really knew its market potential. Apple carried substantial risks, because it had invested significant resources in the iPad’s development. Indeed, when Steve Jobs unveiled the device in front of a select group of journalists and opinion leaders, in San Francisco in 2010, many industry analysts were skeptical, arguing that the iPad was just an expensive gadget and therefore destined to remain a niche product. Some ridiculed it as an outsized iPhone without the phone and predicted that it would generate little interest. After the launch, however, it became clear that the iPad was going to be an international sensation, and many competitors — including Samsung and Microsoft — immediately started developing their own versions. Essentially, those competitors benefited from Apple’s risk-taking.

The magnitude of these knowledge spillovers is substantial. In two of the most rigorous studies to date, economists Nick Bloom of Stanford and John Van Reenen of the London School of Economics followed thousands of firms and found that the spillovers were so large that R&D investment of one firm raised not only the stock price of that firm but also the stock price of other firms in the same industry. Part of the spillover is global in scope. For example, an increase in R&D investment by U.S. firms in the 1990s translated into significant productivity increases for UK firms in similar industries, with the majority of the spillover accruing to firms with an American presence. But a significant part of the spillover is local, because it occurs between firms that are geographically close. So new knowledge generated by American companies benefits other American companies.

In essence, private investment in innovation has a private return for the firm that makes that investment, but it also supplies an external return that benefits other firms. This means that the market provides less investment in innovation than is optimal, because the return on such investments cannot be fully captured by those who pay for it. To correct for this market failure, and compensate those who invest in R&D for the external benefits that they generate, the United States government subsidizes R&D through tax breaks.

The problem is that the difference between private and social return on innovation is much larger than the current subsidies. Bloom and Van Reenen estimate that the social rate of return on R&D is about 38 percent, almost twice as large as the private return. The implication is jarring. The United States is not just underinvesting in R&D; our current level of R&D investment is barely a fraction of the optimal level. This is not just an American problem, but it is more salient for the United States than for other countries because of the role that innovation will play in our future growth.

Although patents in theory protect intellectual property, in practice innovative companies that invest in research appropriate just some of the benefits of their efforts. This is an unavoidable feature of the way innovation is created today and the speed at which new ideas and new knowledge spread in the high tech industry.  Last year, a federal jury in San Jose, CA did find Samsung guilty of making phones and tablet computers that copy key features of the iPhone and iPad, thus infringing on Apple’s patents. But it is hard to stop the flow of knowledge through lawsuits. When high tech companies need to hire lawyers to protect their products instead of engineers, creativity and innovation inevitably take a toll.

The lessons for Congress are clear: the current U.S. tax credit for corporate spending on R&D is far smaller than it should be. We need to increase it to reflect the real benefits of innovation to the US economy.  We also need to make the R&D tax credit permanent, to give innovators more certainty about the future. It is important for legislators to realize that this is not about fairness — it is purely about economic efficiency. The government should not subsidize innovators because it has a moral obligation to do so. It should subsidize innovators because it is in the interest of the American economy to do so. It will create well-paying jobs in the short run, and even more in the long run. Irrespective of our political inclinations, this is a tax break we can all support.

Knowledge spillovers are also pervasive in basic research. Academia has traditionally provided the basic science upon which the private sector builds new commercial applications. This is a big reason that the federal government subsidizes academic research through institutions like the National Science Foundation and the National Institutes of Health. The problem is that this funding has not kept up with the increased value of knowledge. Globalization and technological change have resulted in increased returns on the economic value of new discoveries in basic science. If the return on an investment increases, the rational reaction is to invest more. And yet the resources that the federal government devotes to supporting basic research in science and technology have actually declined.

As a society, we are much too focused on the present at the expense of the future. Our culture glorifies instant gratification and quick results, and it shuns long-term commitment. Most of the energy and attention in our policymaking is concerned with short-run issues, such as how to stimulate the economy over the next six months or how to deal with this week’s employment numbers. While short-term issues can be pressing, their importance pales relative to that of long-term ones, because the latter are the ones that really affect our standard of living in profound and permanent ways. The magic of compound growth means that even tiny differences in growth rates can have enormous consequences for our future jobs and incomes. Thus, policies that can increase growth even marginally are vastly more important than any short-term fix to the economy. Most economists, both on the left and the right, agree that innovation and R&D are key sources of firm productivity growth, and ultimately of economic growth. Lowering taxes on innovative companies and supporting basic research in science and technology are investments that make economic sense.

The opinions expressed here are solely those of the author and do not necessarily reflect the views of the Cato Institute. This essay was prepared as part of a special Cato online forum on reviving economic growth.

Enrico Moretti is a professor of economics at the University of California – Berkeley and the author of The New Geography of Jobs (2012).