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Taxation and Innovation—A Sectorial Approach

A number of tax rules have been adopted or proposed to promote innovation. The primary justification for these rules is that they can be effective in reducing or eliminating chronic market failure in the innovation sector. This Article argues that special tax rules for innovation generally are inappropriate. The basic circumstance giving rise to market failure in the innovation sector is the positive externality associated with information production. Special tax rules do not correct the externality; they merely compensate for it through other mechanisms that themselves create deadweight loss. In place of special tax rules that promote innovation, policy-makers should adopt rules that counteract tax-induced distortions in the innovation sector that are disproportionately large. Among these distortions is excess risk-taking, a phenomenon attributable to the interaction between the lognormal nature of returns to risk-bearing and incomplete loss offsets. The absence of full loss offsets can be expected to induce some investors to take on excess risk, thereby increasing deadweight loss and creating negative externalities.

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