How Taxing Short-Term Share Profits Can Foster Innovation

If short-termism shackles innovation, how do we break the chains? Our evidence suggests that increasing capital gains taxes for investors on short-term share appreciation is one possible solution.

Research shows that myopic focus on short-term earnings hurts investments in research and development (R&D), and one key driver of this corporate myopia is the pressure from shareholders with short horizons. The issue is that short-horizon investors are likely to devote their research efforts toward forecasting quarterly profits instead of trying to understand the long-term prospects of a firm’s R&D and investment portfolio. As a result, corporate managers worry that short-horizon investors might perceive the poor short-term profitability of R&D investments as a sign of incompetent management, sell their shares, and hurt the company’s stock price. Anticipating such an outcome, managers concerned about short-term stock-price decline forgo some long-term investments.

Can rewarding long-term share ownership by charging lower taxes on long-term capital gains relative to short-term capital gains mitigate such myopia? Some politicians and even corporate leaders have supported greater capital gains taxes on short-term investment profits to feed long-term innovation, but no one had examined whether it would actually work.

We collected data from 30 countries in the Organization for Economic Cooperation and Development, an intergovernmental economic association established in 1961. We looked at 21 occasions when countries made changes to capital gains tax rates, in particular, the difference between short-term and long-term capital gains tax rates over the 16 years between 1990 and 2006. We found that whenever countries increase the penalty for holding shares for short periods – in that they charge higher taxes for short-term capital gains over long term capital gains – companies invest more in long-term projects.

To measure investment in long-term projects, we studied the patents filed in the U.S. Patent & Trademark Office by countries supplying technology to U.S. markets. We looked at how the supply of those patents was affected by capital gains taxes in their home countries.

We found that about three years after a country increased taxes on short-term relative to long-term capital gains, their patent output increased by about 3 percent annually. That’s an economically significant effect.

We studied both increases and decreases in tax rate changes across several countries at different times. We were able to study the number of patents emerging from a country that changed capital gains taxation and compare that with the number of patents coming from a country where the tax policy did not change during the same time period. This helped us rule out the chance that the tax policy changes were coinciding with unrelated changes in demand in the U.S. that could have been driving patent filings.

We also studied other policy changes that countries made at the same time they changed their capital gains tax rates, so we could eliminate the possibility that the flow of patents was affected by a concurrent tax break for research and development, for example. Again, we found the number of patents coming from countries that increased short-term capital gains tax rates were much greater.

We also found other patterns that were consistent with the story we saw emerging. The effect we found is more profound in countries you would expect to be more vulnerable to this short-term focus – countries where the markets are dominated by public firms. It’s less of a problem in countries where private firms dominate, because share-ownership tends to be longer-term in private firms.

We also found variation in the kinds of patents that were being filed. In countries where taxes increased on short-term capital profits, we saw a larger bump in what we call explorative innovations, where firms were exploring new boundaries and innovating in areas they don’t know much about. That’s in contrast to the kinds of patents that are more incremental and build on what firms already know, which we call exploitative innovations.

There’s a very clear suggestion here that a policy of increasing capital gains taxes on short-term share profits has merit as a means of fostering long-term innovation. But any policy tool comes with costs and benefits, and this kind of policy would impose its own costs. It would give people less flexibility in what they do with their wealth, and it would distort their investment decisions.

The message to firms is that they must do whatever they can to encourage long-term share ownership so they too can invest in the long term. How they do that is the million-dollar question. It matters a lot that firms emphasize the long-term vision of the company. You need to have credibility to do this, it requires trust, but it’s something firms need to actively work toward if they want to innovate.

And if you are an investor and long-term innovation is something you care about — and there are good reasons why you should — then it’s important to understand that making an investment and sticking with it is the best way to play a part in fostering that.

This post comes to us from Eric He, a PhD candidate at Duke University’s Fuqua School of Business; Professor Martin Jacob at WHU – Otto Beisheim School of Management; Rahul Vashishtha at Duke University; and Professor Mohan Venkatachalam at Duke University’s Fuqua School of Business. It is based on their recent article, “The Effect of Capital Gains Tax Policy Changes on Long-Term Investments,” available here.