LACSON, Ma. Lourdes C.

Econ 251 (Paper for Topic 2)

2015 – 40043 July 7, 2020

Title of the article to review: Do corporate taxes hinder innovation?

Authors: Abhiroop Mukherjee, Manpreet Singh, and Alminas Zaldokas
Year of Publication: 2017 (Journal of Financial Economics)

Abstract:
Policymakers and researchers are recognizing the significant role of corporate taxes on
innovation firms. The empirical results of Murkherjee et. al. (2017) confirm such role. Using a
variety of tests, their study shows that firms respond to tax increase by filing a lower number
of patents, investing less in R&D, and bringing fewer products into the market. However, their
paper only focuses on one mechanism by which corporate taxes affect innovation, known as
the financial constraint channel. This study aims to explore another channel that relates the
two variables: the tax avoidance channel. This second mechanism shows that a lower tax rate
releases resources that otherwise would be spent on tax avoidance. These cost savings by
firms could then be used to advance innovation. Econometric models that capture this channel
are presented in this study.
 I. Introduction
Most economists agree that innovation is a key driver of economic growth that benefits
consumers, businesses, and the economy as a whole (Solow (1956), Romer (1990)).1 In
economic terms, innovation relates “the development and application of ideas and
technologies that improve goods and services or make production more efficient” (European
Central Bank, 2020). In other words, innovation leads to higher productivity which accelerates
the production of goods and services in the economy which in turn translates to economic
progress. Empirical works confirm that countries that show more signs of innovation are
wealthier and grow faster.2
Due to this important role of innovation on economic growth, many researchers and
policymakers direct their attention in determining possible factors that could affect the level of
innovation in an economy. The literature identified the following as economic determinants of
innovation: size, corporate governance, incentive schemes and corporate intellectual property
rights system, competitive threat, culture, and financial development.3
In recent years, tax has also been recognized as one of the simplest and direct way to affect
innovation. Theoretically, taxes can have either have a positive or negative impact on firm
innovation. Lower taxes, for instance, can increase the after-tax profits or may reduce
resources allocated by firms on tax avoidance. On the other hand, lower taxes have a direct
impact on government revenue which in turn may reduce government spending on public
goods such as research, education, and infrastructure. Such investments of the government
have positive spillover effects on firms by reducing their costs and facilitating their own
investments. Despite of this ambiguity, empirical works found that taxes, overall, improve
innovation activities among firms.4
In particular, there are two main channels by which corporate taxes can affect innovation
namely, (1) financial constraint channel and (2) tax avoidance channel. The financial constraint
channel works through the after-tax profits of firms. For instance, lowering corporate taxes
means an increase in the after-tax profits of firms which in turn can be invested in new
technologies or products. The tax avoidance channel, on the other hand, is based on the idea
that lowering corporate taxes frees up resources that could otherwise be spent on tax
avoidance activities. These cost savings, in turn, can be used to spur innovation.

1 Solow (1956) added exogenous technological progress in the Solow growth model to explain the
phenomenon that high income countries have experienced sustained economic growth higher than their
population growth over the long run. He introduced technology that directly improves the input of labor,
which is referred to as labor augmenting. However, one fundamental limitation of his work is that
technology is introduced as an exogenous variable or that it is independent of economic forces.
Because of this, new growth theories emerged, one of which is that of Romer (1990); Romer’s
endogenous growth theory attempts to explain what determines the technological innovation in terms
of the technological production function: ∆𝐴 = 𝑓(𝐾𝐴 , 𝐻𝐴 , 𝐴) where ∆𝐴 is the technological progress, 𝐾𝐴
is the amount of capital invested in production of ideas and knowledge, 𝐻𝐴 is the amount of human
capital employed in research and development, and 𝐴 is the existing technology. Based on this
production function, technology increases substantially when more human capital, such as
improvements in education skills of the workforce, is employed for research and development. Likewise,
technology also increases by a considerable amount when firms invest more capital in research
laboratories and equipment in order to create new products and processes.
2 A case study by Cororaton (2001) found that after the Korean War in the 1960s, Japan and South

Korea were able to achieve rapid economic growth in a sustained manner due to the development of
their policies regarding technological innovation.
3
See Morck, Yeung, & Distinguished (2011), Bhattacharya & Bloch (2004), Foued, Hatem, & Karim
(2008)
4 See Cai, Chen, & Wang (2018), Attanasov & Liu (2014), and Attanasov & Liu (2015)

2
Most existing research focuses only on the first mechanism. This paper aims to shed more
light on the second channel by which corporate taxes affect innovation. In particular,
econometric models that capture this mechanism are presented in this work.
The organization of the rest of the paper is as follows: Section II discusses the financial
constraint channel by which the work of Mukherjee et. al. (2017) revolves. Section III details
the tax avoidance channel and presents new econometric equations. Section IV concludes.

II. Financial Constraint and Innovation

This section discusses the financial constraint channel. The main rationality of this channel is
that a decline in after-tax profits following tax increases leads firms and innovators to redirect
effort away from innovative activities.5 Moreover, a tax increase may raise attractiveness of
debt to firms, which is not the favored form of financing for innovation.6 Lastly, taxes might
also lower internal cash flows which have been shown to be a major source of financing for
innovation activities.7
In one section of their paper, Mukherjee, Singh, and Zaldokas (2017) explored this channel
explicitly by looking at the leverage and internal cash flows of US firms from 1990 to 2006.
The expectation is that firms respond to tax increases by increasing leverage and this high
level of leverage allows firms to reap greater tax benefits at the expense of lower future
innovation. They found that this is in fact true among US firms in their sample. There is a drop
in future patenting for firms that altered leverage in the predicted direction following a tax
increase.
Next, they looked at internal cash flows and test the hypothesis that, given internal cash flows
is considered to be a major source of financing for innovation, a tax-induced reduction in such
financing might reduce innovation. Such effect is also predicted to be more pronounced for
firms that are financially constrained. However, they did not find any supporting evidence for
this matter. One possible reason for this finding is that tax changes mostly affect the large,
profitable firms which are less likely to be financially constrained. That is, large profitable firms
are typically not restricted in their ability to find outside financing.
Overall, the results of the paper show that corporate taxes affect innovation in all stages.8 It
finds evidence that firms respond to tax increase by filing a lower number of patents, investing
less in R&D, and bringing fewer new products into the market, which, taken together, suggests
that higher corporate taxes are detrimental to innovation of firms.

5 A survey conducted by Cheng & Groysberg (2018) confirms that, overall, innovation does not rank
as a top strategic challenge for the majority of boards. In particular, it found that concerns about
innovation fall behind other issues for most directors. Innovation ranks fifth among the priorities of the
firm, the first ones are the more conventional concerns such as attracting and retaining top talent and
the regulatory environment. Moreover, when asked about the effectiveness of their board’s processes
for supporting innovation, only 42% rated their processes as above average or excellent.
6 One of the characteristic of R&D investment is that the capital created by it is “largely intangible and

firm-specific, limiting its resale market value”. Therefore, debt instruments that are secured by the
value of the capital assets are not likely to provide a valuable source of funding for R&D (Hall, 2009).
7 Due to information asymmetries, moral hazard, adverse selection, and lack of collateral, financial

markets, particularly banks, are reluctant to finance innovative activities of firms. This results to low
supply of loanable funds for innovation financing and as a consequence, innovative firms are often
forced to rely on internal funding sources (such as cash flow financing) to advance innovation within
their grounds (Spielkamp & Rammer, 2009).
8
The results are also found to not be driven by local economic conditions by which the firm operates.

3
 III. Tax Avoidance and Innovation
This section discusses the second mechanism by which corporate taxes affect innovation.
The tax avoidance channel shows that as tax rates go down, firms are able to deploy resources
that are previously used for tax avoidance towards more innovative projects. Among the costs
associated with tax avoidance are compensation of tax experts, possible penalties when
assessed by tax courts, and to some extent, reputational damage (Thomsen & Watrin, 2018).
As mentioned, there are few studies that explore this channel. One possible reason is the fact
that firms may avoid taxes through investment in research.9 However, research shows that tax
avoidance endeavors do not necessarily translate to economic value. For instance, in the
study of Gao et.al. (2015), despite finding that innovation is rewarded with less tax liability,
R&D success rate or the commercialization of R&D investments, which is defined as patent
output per R&D dollar (i.e. ratio of patent output summed value of R&D and capital
expenditures), is not significantly related to tax avoidance.
To accompany the work of Mukherjee et. al. (2017), this study proposes new econometric
models to capture this particular mechanism.10 Tax avoidance will be measured in terms of
long run cash effective tax rate, pioneered by Dyreng et. al. (2007). This is considered the
most popular metric of tax avoidance in literature. One advantage of this metric that it produces
an effective tax rate that more closely tracks the firm’s tax costs over the long-run.11 Moreover,
unlike traditional effective tax rates, cash effective tax rates are not affected by changes in
estimates such as the valuation allowance of tax cushion. This tax avoidance indicator is
calculated as follows:
∑𝑁
𝑡=1 𝑇𝑎𝑥𝑒𝑠 𝑝𝑎𝑖𝑑𝑖,𝑡
𝑪𝒂𝒔𝒉 𝒆𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝒕𝒂𝒙 𝒓𝒂𝒕𝒆 =
∑𝑁
𝑡=1(𝑃𝑟𝑒𝑡𝑎𝑥 𝐼𝑛𝑐𝑜𝑚𝑒𝑖,𝑡 − 𝑆𝑝𝑒𝑐𝑖𝑎𝑙 𝐼𝑡𝑒𝑚𝑠𝑖,𝑡 )

Moreover, to account for industry and size effects, industry and size adjusted ETR is to be
calculated. The calculation of this adjusted ETR is based from the work of Balakrishnan et. al.
(2012) wherein they subtracted the same year’s ETR for the portfolio of firms in the quintile of
total assets and the same Fama-French 48 industry from the firm’s calculated ETR. That is,
every year firms will be sorted out in terciles (i.e. any two points that divide an ordered
distribution into three parts) based on their industry and size adjusted ETRs. Thus, the main
variable that measures tax avoidance, Tax avoid, is equal to 1 if the firm is in the bottom tercile,
and zero otherwise.

9
The federal R&D tax credit, also known as the Research and Experimentation (R&E), is a general
business tax credit under Internal Revenue Code (IRC) section 41. The R&D tax credit may apply to
any taxpayer that incurs expenses for performing Qualified Research Activities (QRA) on U.S soil.
The following types of QRA are: (i) Wages paid to employees for qualified services (including amounts
considered to be wages for federal income tax withholding purposes); (ii) Supplies (defined as any
tangible property other than land or improvements to land, and property subject to depreciation) used
and consumed in the R&D process; (iii) Contract research expenses paid to a third party for
performing QRAs on behalf of the taxpayer, regardless of the success of the research, allowed at
65% of the actual cost incurred; (iv) Basic research payments made to qualified educational
institutions and various scientific research organizations, allowed at 75% of the actual cost incurred.
On December 18, 2015, President Obama signed into law the Protecting Americans from Tax Hikes
(PATH) Act which extended the R&D tax credit and expanded its provision (Holtzman, 2017).
10
Similar to the work of Dyreng et. al. (2007), tax avoidance in this study is broadly defined as
anything that reduces firm’s cash effective tax rate over a long time period, in this case is three years.
11
According to Dyreng et. al. (2007), this makes the metric superior than the simple averaging of
single-year effective tax rates. The latter tends to overweigh the effects of years with unusually large
or small (even negative) effective tax rates.

4
To test the tax avoidance hypothesis, an interaction between the main explanatory variables,
𝑇𝑎𝑥 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡 and 𝑇𝑎𝑥 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡 , and Tax Avoidance indicator is introduced in the original
equations found in the work of Mukherjee et. al (2017). This method is adopted from the work
of Attanasov and Liu (2015). Table 1 summarizes the new econometric models.

Table 1. Econometric models to account for tax avoidance channel

Innovation Measure Econometric model

Patents ∆𝐿𝑛(1 + #𝑃𝑎𝑡𝑒𝑛𝑡𝑠)𝑖,𝑠,𝑡+𝑘
= 𝛽𝐷 𝑇𝑎𝑥 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡 + 𝛽𝐷𝐸𝐶 𝑇𝑎𝑥 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡
∗ 𝑇𝑎𝑥𝐴𝑣𝑜𝑖𝑑 + 𝛽𝐼 𝑇𝑎𝑥 𝑖𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡
+ 𝛽𝐼𝑁𝐶 𝑇𝑎𝑥 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡 ∗ 𝑇𝑎𝑥𝐴𝑣𝑜𝑖𝑑 + 𝛿∆𝑋𝑖𝑡
+ 𝛼𝑡 + 𝜖𝑖,𝑠,𝑡+𝑘
R & D spending ∆𝐿𝑛(1 + 𝑅&𝐷)𝑖,𝑠,𝑡+𝑘
= 𝛽𝐷 𝑇𝑎𝑥 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡 + 𝛽𝐷𝐸𝐶 𝑇𝑎𝑥 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡
∗ 𝑇𝑎𝑥𝐴𝑣𝑜𝑖𝑑 + 𝛽𝐼 𝑇𝑎𝑥 𝑖𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡
+ 𝛽𝐼𝑁𝐶 𝑇𝑎𝑥 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡 ∗ 𝑇𝑎𝑥𝐴𝑣𝑜𝑖𝑑 + 𝛿∆𝑋𝑖𝑡
+ 𝛼𝑡 + 𝜖𝑖,𝑠,𝑡+𝑘
New product announcements ∆𝐿𝑛(1 + 𝑀𝑎𝑗𝑜𝑟 𝑛𝑒𝑤 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑠)𝑖,𝑠,𝑡+𝑘
= 𝛽𝐷 𝑇𝑎𝑥 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡 + 𝛽𝐷𝐸𝐶 𝑇𝑎𝑥 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡
∗ 𝑇𝑎𝑥𝐴𝑣𝑜𝑖𝑑 + 𝛽𝐼 𝑇𝑎𝑥 𝑖𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡
+ 𝛽𝐼𝑁𝐶 𝑇𝑎𝑥 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡 ∗ 𝑇𝑎𝑥𝐴𝑣𝑜𝑖𝑑 + 𝛿∆𝑋𝑖𝑡
+ 𝛼𝑡 + 𝜖𝑖,𝑠,𝑡+𝑘
where 𝑖, 𝑠, 𝑡 + 𝑘 index firms, states, years with 𝑘 = 1 to 3. 𝑇𝑎𝑥 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡 and
𝑇𝑎𝑥 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠𝑡 are indicators equaling to one if state s decreased or increased its corporate
tax rate in year t, and zero otherwise.

For this study, the three measures of innovation proposed by Mukherjee et. al. (2017) are
employed. According to their study, patents can be thought as an intermediate product in the
innovation process while R&D investment being the input and new products being one of the
outputs. Moreover, the equations above also control for a set of firm-level factors that affect
innovation, ∆𝑋𝑖𝑡 . These include logarithm of firm sales and capital-labor ratio, change in
profitability, asset tangibility, presence of debt rating on the firm (to account for availability and
ease of financing), R&D-to-sales ratio, Herfindahl-Hirschman Index (HHI) based on the
distribution of revenues of firms in a particular three-digit SIC industry (as well as its square
term, to account for nonlinearities). Moreover, the models control for aggregate trends by
including year fixed effects. In addition, state-level economic indicators are also incorporated,
namely, change in Gross State Product (GSP), change in total revenues of the state as a
proportion of GSP, change in the state’s population (in logs), and change in the state’s
unemployment rate.
The null hypothesis (𝐻0 ) for these econometric models is that tax changes will have a smaller
and negligible impact on firms that avoid taxes more because they are more likely to adjust
their effective tax rate, and hence minimize tax burden. Given this, the expectation is that the
interaction term between tax decrease and tax avoidance indicator will be negative while the
opposite is true for tax increase and tax avoidance indicator.
The alternative hypothesis (𝐻1 ), on the other hand, is that firms that participate more in
avoiding taxes are more vulnerable to tax changes. As mentioned above, when tax rates
decline, these firms will have more resources at their disposal giving them incentive to shift

5
these cost savings from tax avoidance activities to more innovative projects. From this
argument, it follows that higher taxes produce the opposite scenario. That is, higher taxes are
more harmful on innovation of firms that engage more in tax avoidance. Thus, the prediction
for the interaction between corporate income tax decreases and Tax avoid indicator is positive
while it is negative for corporate income increases and Tax avoid indicator.
The work of Attanasov and Liu (2015) supports the alternative hypothesis wherein firms that
avoid taxes more are more impacted by tax decreases than those who do not try to minimize
their taxes. In terms of economic magnitude, the positive impact of tax decreases on the
number of patents is 150% and 157% greater for firms that avoid taxes more, 3 and 4 years
into the future respectively. Likewise, the positive impact of tax decreases on the number of
citations per patent is 89% and 117% greater 3 and 4 years into the future respectively.
This study improves from the work of Attanasov and Liu (2015) in a way that it provides
measures of innovation across the innovation spectrum. Moreover, the analysis in this study
is not limited to tax decreases alone. It interacts the tax avoidance indicator for both tax
increases and tax decreases to comprehend fully the effect of changing the level of taxes on
the innovation of firms.

IV. Conclusion
Innovation is considered to be one of the engines of long-run economic growth. For this
reason, literature that determines possible factors that affect innovation are also increasing.
One factor that is considered to have a direct effect on innovation is corporate taxes. Recent
works that relate taxes and innovation suggest that higher taxes are detrimental on the
innovation activities of firms. This effect could be explained in two channels: the financial
constraint channel and the tax avoidance channel. This work focuses on the later channel
since there has been deficiency in studies that look at this mechanism. An extension of the
work of Mukherjee et. al. (2017) is introduced through econometric models that capture this
second channel. Empirical works that have done the same method have rejected the null
hypothesis that tax changes have a negligible impact on firms that avoid more taxes. Instead,
tax changes have seen to have a significant impact on innovation under this channel similar
to what is found when the financial constraint channel is considered.
Future research could use the econometric models presented in this paper and see whether
results conform to existing research findings. Likewise, policymakers could consider the
workings of the tax avoidance channel in crafting policies that aim to encourage innovation in
the economy.

6
 V. References
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%20as%20the%20Research,in%20the%20current%20tax%20year.

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