9.5 Well-being and tax incentives for innovation

In chapter 5 and as the first of three case studies, the framework for assessing tax measures undertaken by states in their aim for well-being through taxation, as established in chapter 4, is applied to tax incentives for innovation, whereby innovation concerns the implementation of a new or significantly improved product (good or service), or process, a new marketing method, or a new organisational method in business practices, workplace organisation, or external relations.

This assessment framework application to tax incentives for innovation generates observations, issues, and recommendations, a number of which are briefly outlined here.

The answers to the first four general questions suggest that there are good arguments for state intervention in innovation in the case of clear market failures. A more proactive approach by states, and the choice how to intervene, requires careful consideration of the different options available, and of the potential drawbacks pertaining to those options. The two-way connections between innovation and well-being also suggest well-being as a factor to consider in the assessment of tax incentives for innovation. In practice, though, it seems uncommon for taxation to focus on the combination of innovation and well-being. References to well-being in tax incentives for innovation are not made, or are not thoroughly explained. Innovation is more often associated with other matters (such as economic growth and development, employment, productivity, international competitiveness and fairness, and meeting global challenges in domains of, for instance, sustainability, resource efficiency, the environment, and health), and it seems difficult to convincingly establish a dominant importance of well-being. States that do aim for well-being through tax incentives for innovation should pay attention to, and properly explain, well-being scoping (for instance in the form of territorial targeting of innovation, or via the incorporation in tax incentives for innovation of novelty requirements such as new to the world, new to the country, or new to the firm), measurement, distributive preferences, and the particular well-being aims pursued. That it is uncommon for tax incentives for innovation to be expressly related, in their wording or goal setting, to well-being, may also have to do with difficulties of specificity, measurability, and achievability in these matters. These issues make it difficult to set realistic and time-bound well-being aims for tax incentives for innovation. Also, various alternatives to tax incentives for innovation exist for states that pursue well-being aims, with many of those alternatives providing for a more fundamental intervention. Direct state intervention in innovation can prove to be a better option than tax incentives for pursuing well-being aims, if states can get the targeting right. If proper targeting is difficult, tax incentives for innovation allow for a more general, or nondirective, approach. Possibilities for (tax) competition or lobbying may also influence the choice between different forms of state intervention, although such considerations come with well-being and other concerns. An important potential drawback of indirect state intervention, in the form of tax incentives for innovation, is that companies are not primarily concerned with picking the projects that generate the highest social returns.

Consequential reasoning, addressed in the answers to questions 5 and 6, requires that, in considering the net impact on well-being of government spending and taxing in relation to tax incentives for innovation, (well-being) opportunity costs and distortive effects of such tax incentives are considered within a broader frame involving for instance other taxes, state revenues, and government spending. Positive spillover effects (such as know-how diffusion) need to be sufficiently substantive to outweigh related inefficiencies, in order to make the application of tax incentives for innovation desirable if the aim is to increase well-being. Tracing the (well-being and other) effects of tax incentives for innovation is challenging. Part or all of the effects of such tax incentives may translate into matters other than innovation (such as increases in R&D related wages, or increases in R&D related asset prices), or may ultimately be offset by indirect responses, and measurement is difficult. Substantiation of the overall net well-being effects, the contribution of the tax measure thereto, and the incidence of tax incentives for innovation, is no easy task. A number of issues and recommendations that concern the effectiveness and efficiency of tax incentives for innovation are identified in chapter 5. While assessing the effectiveness and efficiency of tax incentives for innovation is not without data and methodological challenges, it is important that such assessment does take place, and not only focuses on bang-for-the-buck (for instance in the form of increase in R&D spending compared to decrease in tax revenues), but also on the resulting innovation and broader societal impact. Tax incentives for innovation should be subject to systematic, rigorous evaluations, with high-quality data collected according to international standards. States furthermore need to deal with ineffectiveness and inefficiency in tax incentives for innovation in a proper way, which does not always mean that immediate alteration or abolition is desired, as certain innovation effects involve, or require, longer time horizons. Stability and predictability are conductive framework conditions for both innovation and well-being.

Viewed from a deontological perspective and in answer to questions 7 and 8, there are various international, supranational, and national bodies of rules or laws that may impose restrictions on tax incentives for innovation, such as the European fundamental freedoms and State aid rules, for instance with regard to territorial or sectoral restrictions included in such incentives. States need to verify and substantiate whether their tax incentives for innovation are in conformity with such applicable laws and regulations. Tax incentives for innovation can furthermore create conflicts with equality, certainty, and neutrality, or with other principles that underlie tax systems. In case principles are weighed in view of conflicting well-being considerations, states should provide insight into the consideration made. Tax incentives for innovation may also pose risks to political processes. Notably, using tax to incentivise innovation, with a view to well-being, can create room for lobbying by special interest groups. Proper substantiation, increased transparency, and pre-determined checks and balances, or review procedures, are all examples of initiatives that can be undertaken to manage political process risks associated with tax incentives for innovation.

Finally, from a virtue ethics perspective, as follows from the answering of questions 9 and 10, tax incentives for innovation can stimulate many character traits that are typically positively viewed upon, such as creativity (or innovativeness), entrepreneurship, leadership, cooperation, diversity, and discipline. At the same time, such incentives can also stimulate character traits that carry negative connotations, such as harmful competitiveness, carelessness (risk-taking), striving for more, calculating behaviour, or free-riding. It is therefore important that states indicate which character traits are stimulated by their tax incentives for innovation, to enable a discussion on the desirability or virtuousness thereof. Public support for tax incentives for innovation may reduce in case of, for instance, non-transparent incentives, or where such incentives result in harmful tax competition. Where this is the case, governments need to carefully consider their course of action, and the behavioural impact thereof. The drafting and scoping of tax incentives for innovation determine whether such incentives encourage competition for existing well-being (e.g. in the case of more lenient novelty requirements such as new to the firm or new to the country, or in the case of incentives targeted towards mobile IP income), or bring about additional well-being.