There has been a growing debate among politicians and policy makers, both at the state and federal levels, about the impact of taxes on investment, growth, and firm value. The focus has been predominantly on corporate income tax cuts because, as the Congressional Budget Office (2017) reports, the U.S. has the highest top statutory corporate income tax rate among the G20 nations. Without a systematic examination, however, especially one that focuses on the long-term, it is difficult to evaluate the importance of corporate income taxes.

In our article forthcoming in the Journal of Financial and Quantitative Analysis, we contribute to this debate by examining the impact of corporate income tax cuts on corporate innovation. The literature has shown that innovation is one of the most important drivers of long-term firm value and economic growth. While recent research in economics and finance has examined the impact of corporate income taxes on firm investment and business activity in the short-run, less is known about how tax cuts can affect long-term firm output and performance. By looking at innovation, we fill the gap in the literature by tracing a possible way that corporate income taxes can influence firm value and long-term growth.

We hypothesize that corporate income taxes distort the incentives of firms to innovate. Specifically, we demonstrate theoretically that in the presence of private benefits of control and differential effort, higher taxes make it more lucrative for managers and other employees to enjoy a “quiet life” or undertake routine projects rather than innovate. Consequently, projects that would not be undertaken when taxes are high will become profitable and will be undertaken if taxes are reduced, because they align with incentives. Even small changes in tax rates can lead to large changes in innovation if, on the margin, they provide enough incentives for managers to exert time and effort and switch from routine to innovative projects.

To establish causality, we use staggered changes in state corporate income tax rates that are largely exogenous to the decisions of the individual firm to innovate. This setup eliminates the impact of time-varying economy-wide shocks (such as changes in monetary policy and federal regulation) by comparing the change in innovation in a treatment group of firms that experienced a tax change with a control group of firms that did not do so over the same time period. To ensure consistency and relevance, we examine the impact of tax cuts on innovation using significant decreases of at least 100 basis points (e.g., 7 percent to 6 percent) in the top-bracket state corporate income tax rate from 1988 to 2006. While prior studies typically use company headquarters to define states, in many cases a firm’s corporate office is not where its major operations are located. To better identify the state with the most relevant tax rate, we use the most mentioned state in a firm’s 10-K reports. We use the number of patents and citations per patent to measure the quantity and quality of innovative output, respectively. We also control for many other economic, political, geographic, and regulatory factors at the state and firm level that could also affect innovation.

Using a sample of around 8,000 publicly traded U.S. firms and a differences-in-differences methodology, we find that tax cuts significantly increase both the quantity and quality of innovation, but the effect on quality of innovation is stronger. Firms operating in a state that implements a tax cut create 0.63 and 0.79 more patents three and four years later, respectively, relative to otherwise similar firms that do not receive a tax cut. In terms of innovation quality, firms receive 0.75 more citations per patent three and four years after a major tax decrease. We also find that tax increases have a negative and significant effect on innovation, documenting a symmetric effect.

Having illuminated our understanding of whether tax cuts affect innovation, our next step is to explore specifically how this relationship may occur. Our model demonstrates that the effect strongly depends on firms’ private benefits of control and assets at hand, such as internal funds, physical assets, patent stock, and other tangible and intangible assets that can be used in the innovative project. Consistent with these predictions, we document that tax cuts have a stronger impact on innovation for firms with weaker corporate governance, greater financial constraints, fewer tangible assets, and a smaller patent stock.

Furthermore, we hypothesize that taxes may also affect innovation by distorting firm behavior and resource allocation and encouraging firms to engage in tax shifting activities. There are two opposing predictions. On the one hand, firms that avoid taxes would be less affected by tax cuts because they have already shifted their tax burden. On the other hand, both tax avoidance and innovation require scarce resources such as managerial and employee creativity and effort. When the return on tax avoidance increases relative to the return on innovation, firms will shift more resources to tax avoidance. We examine the tax avoidance hypothesis and find that the impact of tax cuts on innovation is greater for firms that engage more in tax avoidance.

In sum, we provide strong causal evidence that corporate income tax cuts result in greater quality and quantity of corporate innovation. Our findings support the argument that tax cuts can stimulate long-term firm value and economic growth.

This post comes to us from professors Julian Atanassov at the University of Nebraska and Xiaoding Liu at Texas A&M University. It is based on their recent article, “Can Corporate Income Tax Cuts Stimulate Innovation?” available here.