Federal government doesn’t need a new agency to spur innovation—it should simply lower taxes

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Appeared in the Hub, March 2, 2023
Federal government doesn’t need a new agency to spur innovation—it should simply lower taxes

After decades of trying to promote innovation with government programs with disappointing results, the federal government continues to pursue “top-down” innovation strategies including the new Canadian Innovation and Investment Agency introduced last year.

While details about how the agency will operate remain unclear, it represents yet another effort by government to channel public money to innovation-related activities rather than relying more on private capital markets. Innovation Minister François-Philippe Champagne has acknowledged that innovation policy has been a problem for decades, but he assured Canadians this time the government is on the right track.

But in reality, Ottawa doesn’t need a new agency to spur more innovation in the Canadian economy. Rather it could simply implement some time-tested reforms. For example, reduce general corporate and personal income tax rates, particularly the highest marginal tax rates. A new study published by the Fraser Institute reviews numerous empirical studies of the relationship between taxes and innovation. The studies generally conclude that lower tax rates promote innovation (typically measured by the number and quality of patents filed, and number and quality of new products introduced into the market).

Innovation is a financially risky activity. The corporate and personal income tax structure is asymmetrical, inasmuch as allowable tax deductions for expenses and financial losses related to innovation activities (ex. starting a new business) are typically lower than the relevant tax liabilities would be on profits earned by a successful new business startup. Consequently, reductions in general tax rates increase the expected net income from entrepreneurial innovation and thereby encourage more innovation.

Lower personal income tax rates, especially the highest marginal rate, should also promote innovation by attracting more star scientists to Canada and by retaining those already working in Canada. These high-income earners are geographically mobile and often relocate to jurisdictions with relatively low marginal tax rates. Not only would an inflow of star scientists bring advanced human capital to Canada, it would also help prompt technology-intensive enterprises to locate innovation activities in Canada.

Of course, some argue that government grants and tax credits for domestic technology startups are a more targeted and effective way to encourage innovation as opposed to general tax rate reductions. Indeed, many advocates and policymakers want Ottawa to intensify its grant and tax credit initiatives and focus them on domestic startup enterprises. But this type of targeted government spending inevitably politicizes the process. Would-be innovative enterprises spend time and money lobbying government bureaucrats for financial support when they could be innovating. Furthermore, there’s no evidence that government bureaucrats can reliably identify companies that will be successful at innovating and growing their businesses in a sustained manner.

According to the Global Innovation Index, in 2014 Canada ranked 10th out of 15 high-income countries for overall innovation performance. By 2022, Canada had dropped to 12th. This assessment aligns with the rankings of the Tax Foundation, which gives Canada relatively low marks for the competitiveness of its corporate and personal income tax regimes. Specifically, Canada’s overall corporate tax structure ranked 8th out of the 15 innovating countries in 2014, then dropped to 12th in 2022. For personal income taxes alone, Canada dropped from 11th in 2014 to 13th in 2022.

Meanwhile, the United States improved its corporate and personal income tax rankings between 2014 and 2022, and the U.S. personal income tax system is particularly competitive compared to Canada’s. Given the prominence of cross-border corporate investment between Canada and the U.S., and the relative ease of migration of star scientists between the two countries, the more competitive U.S. tax regime should be a major concern to Canadian policymakers.

Clearly, as the federal government considers how to spur more innovation in Canada, it should look closely at our relatively uncompetitive tax system.

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