How Do Taxes Affect Entrepreneurship, Innovation, and Productivity?

Discussions about tax policy usually focus on how taxes affect hard work and wealth creation. But this narrow focus on investment and labor supply does not account for the crucial role of innovation in economic growth. This Research in Focus examines how income tax policy in particular shapes incentives for innovation and entrepreneurship in the United States.

Author Aaron Hedlund begins by reviewing existing research, which shows that both tax rates and the tax structure as a whole have a large impact on innovation. In particular, high-income tax rates and inefficient tax structures can discourage innovation and encourage entrepreneurs to move to areas with lower tax rates. Specifically, income tax rates are shown to affect:

• The quality of innovative ideas
• The number of startup businesses and patent applications
• Where entrepreneurs decide to locate

Hedlund then discusses two policy implications of these studies. First, policymakers seeking to foster innovation should craft a tax code that treats personal and corporate income taxes consistently. Second, broad-based tax systems featuring low rates are more likely to encourage innovation than tax regimes with high rates and loopholes that shrink the tax base.

Taken together, these findings suggest that tax policies that reduce the financial gains to innovation risk hurting a country’s economic growth. By considering how both the level and design of the tax code affect innovation, policymakers can take steps to improve economic growth and produce rising living standards for decades to come.