Technological Innovation, International Competition, and the Challenges of International Income Taxation

TECHNOLOGICAL INNOVATION, INTERNATIONAL COMPETITION, AND THE CHALLENGES OF INTERNATIONAL INCOME TAXATION Michael J. Graetz* & Rachael Doud** Because of the importance of technological innovation to economic growth, nations strive to stimulate and attract the research and development (“R&D”) that leads to that innovation and to make themselves hospitable environments for the holding of intellectual property (“IP”). Tax policies have taken center stage in their efforts to accomplish these goals and to capture a share of the income from technological innovations. Designing cost-effective methods of supporting technological innovations has, however, become substantially more difficult as the world economy has become more interconnected. Where R&D is performed and where income is earned change in response to the nature and level of government support. The capacity of multinational enterprises (“MNEs”) to shift their IP production, IP ownership, and IP income across national borders, along with their ability to establish new corpora- tions in tax-favorable jurisdictions, makes designing cost-effective incentives exceptionally difficult. Devising appropriate tax rules for develop- ing IP and for taxing IP income has become the central challenge for international income taxation. This Article examines the three primary tax policies supporting innovation: (1) incentives for R&D, (2) “patent boxes,” and (3) tax benefits for “advanced manufacturing.” It then briefly describes common techniques MNEs use to lower their taxes on IP income. The Article then assesses the various incentives and offers recommendations about how the United States might respond to challenges it now faces in promoting technological innovation. Based on extensive examination of the economic evidence, the Article concludes that, at most, only R&D incentives are justified. This Article also summarizes the current proposals for limiting op- portunities for U.S. MNEs to shift IP income to low- or zero-tax jurisdictions. In that connection, it offers proposals for change that would more closely align U.S. taxes with U.S. sales. * Columbia Alumni and Wilbur H. Friedman Professor of Tax Law, Columbia Law School; Justus S. Hotchkiss Professor Emeritus, Yale Law School. ** J.D. 2012, Yale Law School. 347 348 COLUMBIA LAW REVIEW [Vol. 113:347 INTRODUCTION ......................................................................................... 348 I. U.S. AND EUROPEAN TAX INCENTIVES FOR R&D .................................... 352 A. Tax Incentives for R&D ............................................................... 352 B. How Well Do R&D Tax Incentives Work? ................................... 355 II. PATENT BOXES IN EUROPE .................................................................... 362 A. Tax Benefits for IP Income .......................................................... 363 B. A Proposed Patent Box for the United States ............................. 369 C. How Well Do Patent Boxes Work? .............................................. 372 D. Summary of the Evidence on R&D and Patent Boxes ............... 374 III. INCENTIVES FOR “ADVANCED MANUFACTURING” ................................. 375 A. U.S. Manufacturing Incentives .................................................... 376 B. European Manufacturing Incentives ........................................... 379 C. The Justifications for Manufacturing Incentives ........................ 380 1. The Link Between R&D and Manufacturing ....................... 382 2. Other Justifications for Manufacturing Incentives .............. 387 IV. TAX-MINIMIZING GAMES MULTINATIONALS PLAY ................................ 392 V. RESOLVING THE TAX POLICY CHALLENGES ........................................... 404 A. Evaluating the Incentives ............................................................. 404 B. Efforts to Limit IP Income-Shifting ............................................. 413 CONCLUSION ............................................................................................. 434 INTRODUCTION Two things are clear and essentially uncontested among economists. First is the importance of technological innovations to economic growth. In a 1957 paper, Robert Solow advanced an economic growth model (for which he won a Nobel Prize in 1987) demonstrating that a large majority of economic growth per hour of labor in the United States between 1909 and 1949 could be attributed to technological advances.1 The importance of technological development to economic growth has been accepted ever since.2 1. Robert M. Solow, Technical Change and the Aggregate Production Function, 39 Rev. Econ. & Stat. 312, 320 (1957). Solow’s original estimate was 87.5%, but that was later corrected to 81%. Interview with Robert Solow, in Arnold Kling & Nick Schulz, From Poverty to Prosperity 66 (2009). 2. See, e.g., Joseph F. Brodley, The Economic Goals of Antitrust: Efficiency, Consumer Welfare, and Technological Progress, 62 N.Y.U. L. Rev. 1020, 1026 (1987) (as- serting innovation “is the single most important factor in the growth of real output in . the industrialized world”); Herbert Hovenkamp, Restraints on Innovation, 29 Cardozo L. Rev. 247, 253 (2007) (“[T]oday no one doubts . that innovation and technological progress very likely contribute much more to economic growth than [other factors].”); Susan Hockfield, President, Mass. Inst. of Tech., Keynote Address at the National Governors Association Annual Meeting: Restarting America’s Job Creation Engine (July 15, 2011), available at http://web.mit.edu/newsoffice/2011/nga-conference-hockfield-0715.html 2013] TECHNOLOGICAL INNOVATION AND TAX POLICY 349 Second, research and development (“R&D”), which is crucial to on- going technological advances, is underproduced in the absence of government support.3 In the absence of government intervention, firms underinvest in R&D, despite its benefits, because R&D produces positive externalities—knowledge that “spills over” to others, preventing investors from reaping the full benefits of their R&D through profits.4 In addition to spurring innovation, R&D also creates good jobs and raises standards of living.5 But when investors cannot reap the full benefits of their R&D, they may not invest in projects that would produce substantial benefits to society. Economic studies have estimated that the public returns from R&D can be two to five times greater than the private returns.6 So while (on file with the Columbia Law Review) (“Innovations that drive lasting economic growth emerge from the most advanced science, mathematics and technology.”). 3. See, e.g., Charles I. Jones & John C. Williams, Measuring the Social Return to R&D, 113 Q.J. Econ. 1119, 1133 (1998) (finding actual R&D investment in United States was only quarter to half of optimal amount); see also, e.g., OECD, Tax Incentives for Research and Development: Trends and Issues 6 (2002), available at http://www.metutech.metu.edu.tr/download/tax incentives for R&D.pdf (on file with the Columbia Law Review) (“Both economic theory and empirical analysis underline the key role of research and development (R&D) in economic growth.”); Office of Tax Policy, U.S. Dep’t of the Treasury, Investing in U.S. Competitiveness: The Benefits of Enhancing the Research and Experimentation (R&E) Tax Credit 1 (2011), available at http://www.treasury.gov/resource-center/tax-policy/Documents/Research and Experim entation report FINAL.PDF (on file with the Columbia Law Review) (“Investments in research and experimentation produce technological advancements that drive productivity growth and improvements in U.S. living standards.”). 4. See, e.g., Chiara Criscuolo, The Effect of R&D Tax Incentives on Location of R&D Investment, in Expert Grp. on Impacts of R&D Tax Incentives, Design and Evaluation of Tax Incentives for Business Research and Development: Good Practice and Future Developments 32, 32 (Nov. 15, 2009) [hereinafter E.C. Report], available at http://ec.europa.eu/invest-in-research/pdf/download_en/tax_expert_group_final_ report_2009.pdf (on file with the Columbia Law Review) (“[T]he returns to investment in knowledge and innovation cannot be fully appropriated by innovating firms as knowledge is a public good that can ‘spill over’ to others.”); Dep’t of Fin. Can. & Revenue Can., The Federal System of Income Tax Incentives for Scientific Research and Experimental Development: Evaluation Report, at vi–vii (1997), available at http:// publications.gc.ca/collections/Collection/F32-1-1997E.pdf (on file with the Columbia Law Review) (noting “spillover benefits” of R&D “mean that, in the absence of government support, firms would perform less research and development than is desirable from the economy’s point of view”). 5. See, e.g., Nat’l Sci. Bd., Nat’l Sci. Found., Research and Development: Essential Foundation for U.S. Competitiveness in a Global Economy 1 (2008), available at http://www.nsf.gov/statistics/nsb0803/nsb0803.pdf (on file with the Columbia Law Review) (“The scientific and technological advances that have led to our Nation’s remarkable ability to create new industries and jobs, improve the standard of living for people, and pro- vide sophisticated technology that ensures our national security can be traced back to the outcomes of basic research.”). 6. Ammon Salter et al., Sci. & Tech. Policy Research, Univ. of Sussex, Talent, Not Technology: Publicly Funded Research and Innovation in the UK 20 (2000), available at http://www.sussex.ac.uk/Units/spru/nprnet/documents/talentshort.pdf

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