Why Some Countries Want Companies to Think Inside the “Innovation Box”

IP-related tax breaks are meant to spur local investment and job creation. Do they?

January 16, 2024

| by Deborah Lynn Blumberg

A handful of countries provide a reduced tax rate for corporate income generated by the exploitation of intellectual property. | Cory Hall

To encourage innovation, some governments encourage companies to think inside the box. More exactly, they offer “innovation box” or “IP box” incentives that reduce taxes on innovation-related income.

“Countries really like innovative activity because it links so closely to economic growth,” says Rebecca Lester, an associate professor of accounting at Stanford Graduate School of Business and a senior fellow at the Stanford Institute for Economic Policy Research. “There’s a wide range of ways in which policy and policymakers can encourage this type of behavior, and innovation box tax incentives are one of them.”

Governments hope these tax breaks will spur businesses to make more investments locally, boosting domestic economic growth. Yet to what extent do companies follow through on this? Lester set out to investigate whether companies receiving innovation box incentives step up their investments in fixed assets such as buildings or equipment. She also wondered about the tax incentives’ impact on employment and wages.

Along with Shannon Chen of the University of Arizona, Michelle Hanlon of the Massachusetts Institute of Technology, and Lisa De Simone of the University of Texas at Austin, Lester found that multinational firms increase their on-the-ground investment only if innovation-related tax breaks are significant and require companies to have a physical presence or employees in-country to receive the benefit.

“In order for these regimes to really stimulate local activity, they have to be quite generous in the benefit that they give and they have to have really clear restrictions about a company’s presence in a country,” Lester says. The researchers also found that workers in innovation box countries are more highly compensated after their company receives the tax benefit.

Compete Globally, Invest Locally

In 2022, 21 countries had an innovation box policy that provided a reduced tax rate for corporate income generated by the exploitation of intellectual property. (Though the United States provides tax incentives for R&D, until the Tax Cuts and Jobs Act of 2017 it did not have a tax policy that resembled an innovation box.) Lester and her colleagues looked at seven countries (Belgium, France, Italy, The Netherlands, Portugal, Spain, and the United Kingdom) that had innovation box tax policies in place prior to 2017, comparing them with other European countries without similar policies.

Innovation box tax incentives are one of the few incentives countries can still use to retain and attract business activity across borders.
Rebecca Lester

Lester and her colleagues found that capital investment was 2.6 percentage points higher in innovation box countries compared to non–innovation box countries after companies took their tax incentives. Across all countries, companies likely claiming the tax break spent on average 3.6 million to 4.4 million euros more on capital expenditures over the following three-year period versus businesses that were ineligible for the tax break.

Countries that offered especially large reductions in their domestic tax rate (between 70% and 90%) saw even heftier investments. So did those with strict policies that required a real economic presence in the country as a condition of claiming the benefit. On the other hand, Lester says, “In countries that have a less strict policy, firms can claim the incentive, but a lot of them are not really investing as much.”

At the same time, Lester and her fellow researchers found that firms that got tax incentives from their innovations did not end up adding more jobs. They did, however, pass on some of the savings in the form of higher wages for current employees. The researchers found that in the three years following a firm taking an innovation tax incentive, an average individual employee’s compensation rose by around 45,000 euros.

Drawing Borders Around Innovation

These findings have implications for policymakers in countries considering implementing an innovation box tax policy, as well as those who want to tweak existing tax rules to encourage more investment and growth.

To truly spur investment with this type of incentive, Lester says, countries must be prepared to offer a large tax benefit and restrict their policy to companies that agree to operate and invest locally. However, she cautions that this can be an expensive tax policy and requires careful and thorough analysis on the part of both governments and companies.

The tax is one tool countries continue to have at their disposal to compete across borders. Recently, the 38 member countries of the Organization for Economic Cooperation and Development set a global minimum tax on large multinationals and passed other initiatives to reduce countries’ ability to compete on tax incentives. Currently, in Europe, countries that launch an innovation tax policy for the first time must require participating companies to have an in-country presence.

Lester says there are benefits and potential costs to stricter policies, such as a company choosing to move its investment across borders. Future research could look at how the stricter in-country presence requirements in Europe impact how much corporations choose to invest locally or fuel their decision to go elsewhere.

“Innovation box tax incentives are one of the few incentives countries can still use to retain and attract business activity across borders,” Lester says. “Our findings show policymakers some of the ways in which these types of policies can be more effective.”

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