Tax Policy and the Financing of Innovations

Luis Bryce, Roberto Bonfatti and Luigi Pisano

The private and social gains from technological research diverge in the presence of externalities in the production and dissemination of innovation. The policy prescription of the endogenous growth literature is simple: subsidize innovation activity sufficiently to eliminate that wedge. However, there is substantial evidence that firms face constraints in financing of innovations. In the presence of asymmetric information, providing incentives to innovators does not necessarily lead to more innovation activity; the government must also take into account the response of financial markets, and prevent the adverse selection problem from constraining innovators.

In his Nottingham School of Economics working paper, published in the Journal of Public Economics, Roberto Bonfatti and co-authors build a model in which some entrepreneurs are more talented than others, but their talent is private information. Even if the market can separate the two types, the investment decisions of the high types may be biased downwards by their need to avoid being confused with the low types. Credit constraints on the high types are more severe, the lower is the high types' investable net worth. What is the impact of fiscal policy in this environment? The authors show that increasing the after-tax labor income of entrepreneurs is often necessary to increase technological research. The reason is that investable net-worth equals after-tax labor income. Thus, boosting net-worth provides a rationale for taxing profits in order to subsidize labor income. Moreover, taxing profits may lead to an overall increase in research, because it may make it easier for high-talent entrepreneurs to differentiate themselves from the low-talent ones. This starkly contrasts the benchmark Schumpeterian growth model, and provides an entirely different explanation for the inverted-U relationship between competition and innovation that is well known to the empirical literature.

Substituting labor income and profit taxes for consumption taxes, ie. fundamental tax reform, more decidedly boosts technological research. Consumption taxes do not hurt the incentive to innovate, as profit taxes do, nor do they constrain the entrepreneur's effort choice, as labor income taxes do. In fact, when the government can freely tax consumption, it is able to implement the first best level of technological research. Surprisingly, if the government is unable to tax consumption sufficiently the second best equilibrium exhibits adverse selection. This happens because implementing a separating equilibrium requires a low tax on labor income, which given a low tax on consumption requires an excessively high tax on profits to balance the government's budget.

Journal of Public Economics, "Tax Policy and the Financing of Innovations", by Luis Bryce, Roberto Bonfatti and Luigi Pisano.

http://dx.doi.org/10.1016/j.jpubeco.2015.12.010

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