Tax Analysts Blog

Tax Policy in a Knowledge-Based Economy

Posted on Oct 21, 2013

We need a new economics.

Until the tech revolution of the 1990s, economists' conceptualization of production portrayed reality reasonably well. Businesses hired labor and purchased capital to make the things that improved consumers’ well-being. To promote employment, productivity, and economic growth, it was necessary to increase capital formation. Intellectual property was relegated to a supporting role. It gave firms a competitive edge. And for the economy as a whole it generated residual growth that could not be explained by capital and labor. Spending more on research and advertising was the way to increase intellectual property.

With sweeping advances in technology over the last two decade business has become increasingly globalized and knowledge-based. Buildings, equipment, and workers are no longer the central drivers of growth. Now innovation, advanced organization, design (think Steve Jobs and Apple), and communication are the keys to economic prominence. To develop the intellectual property that translates into profits, businesses need to spend on more than laboratory research and ad campaigns. The skeptical accounting profession rarely allows worker training, brand-building, software, and business restructuring to be capitalized, but in so doing it is unwittingly keeping the most important sources of value out of view of managers and stockholders. The economics profession, mired in old concepts and ever less relevant data, can only offer increasingly clumsy policy responses to 21st century problems.

A new 362-page OECD report “Supporting Investment in Knowledge Capital, Growth and Innovation” provides a fascinating and useful overview of the new face of the world economy. It also is full of (admittedly preliminary) policy ideas to promote growth in a knowledge-based economy. Needless to say, many of them are very different than what would have been needed during the Reagan administration.

The rising prominence of intellectual property in the modern economy significantly affects two areas of tax policy: international tax rules for the allocation of multinational profits among nations and the design of incentives to promote research. It is now routine for multinationals to assign legal rights to valuable intellectual property to holding companies in tax havens.

Chapter 2 of the report points out that the tax treatment of profits from research may be more important than tax subsidies for the costs. Governments devote a great deal of attention to tax credits for research spending, but in many cases they are providing much larger incentives for research when they allow profits from intellectual property to be shifted to tax havens. These unintended incentives, the report argues, are not cost-effective because they encourage foreign use of intellectual property. That denies the country where the research is performed the tax revenue, employment, and knowledge spillovers that accompany successful research. It also puts smaller businesses that are often highly innovative at a competitive disadvantage to their multinational counterparts.

The report acknowledges that more research is needed on what type of intellectual property is most conducive to economic growth and what type of spending (not just traditional R&D) creates intellectual property. In the meantime, it advocates leveling the playing field between multinationals and domestic-only firms by targeting research credits to businesses that are not part of a multinational group and by curtailing profit shifting by multinationals. This last conclusion fits hand in glove with the thrust of the OECD’s project on base erosion and profit shifting. It will be fought hard by multinational business. But as much as they want their economies to stay competitive, cash-strapped governments are likely to become increasingly receptive to these cost-saving ideas.

Read Comments (1)

emsig beobachterOct 27, 2013

Marty, good write up in the Business Section of the Sunday edition of the
Washington Post. However, no offense intended, but you didn't discover how the
tax avoidance schemes were made -- the large law firms and accounting firms did
that -- you helped uncover these schemes and quantified the level of avoidance.

One of the things that strikes me about the level of profits booked offshore
and the clamor by many of these firms that they want to repatriate a
significant portion of these funds but won't because of the tax consequences is
that they really don't have many great ideas to use the funds productively
overseas. No great plans for plant expansion, research and development
projects, etc. Perhaps they have become too big and sclerotic. Perhaps they
could repatriate a portion o those funds booked overseas at a 20% rate if those
funds are passed through to the shareholders in the form of dividends. Perhaps
the shareholders would put these funds to good use.

Your avid reader,

Emsig Beobachter

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