How Taxing Short-Term Share Profits Can Foster Innovation

Professors study effects of tax changes on patent filings

July 24, 2019
Accounting, Taxes & Trade
How Taxing Short-Term Share Profits Can Foster Innovation

Rahul Vashishtha studies the causes and effects of corporate myopia – the short-sightedness that harms firms by driving them to prioritize immediate results over long term profitability. 

The associate professor of accounting at Duke University’s Fuqua School of Business has shown in the past this corporate myopia exists, that it makes corporate managers wary of long-term projects, and that it’s caused in part by shareholders with short horizons. 

Vashishtha has now turned his attention to what – in addition to requiring less frequent reports – policymakers can do to address this short-term mindset. In his latest working paper, Vashishtha found that increasing capital gains taxes for investors on short-term share appreciation can lead to more long-term innovation at companies. 

The research was conducted with Fuqua colleague Mohan Venkatachalam, Martin Jacob of the WHU Otto Beisheim School of Management in Germany, and Fuqua PhD student Eric He.  

Vashishtha discusses the findings in this Fuqua Q&A. 

How did you determine capital gains taxes on short-term profits can feed long-term innovation? 

Some politicians and even corporate leaders have supported this idea, but no one had examined whether it would actually work. We collected international data from 30 countries in the Organization for Economic Co-operation and Development, an intergovernmental economic association established in 1961. We looked at 21 occasions when countries experienced changes in capital tax rates over the 16 years between 1990 and 2006. We found that whenever countries increase the penalty for holding shares for short periods – in that they charge higher taxes for short-term capital gains over long-term capital gains – companies invest more in long-term projects. 

To measure investment in long-term projects, we studied the patents filed in the U.S. Patent & Trademark Office by overseas countries supplying to the technology to U.S. markets. We looked at how the supply of those patents was affected by capital gains taxes in their home countries. 

We found that about three years after a country increased taxes on short term capital gains, their patent output increased by about 3 percent annually. That’s an economically significant effect. 

How do we know the innovation increases you found weren’t caused by something else? 

We studied 21 different tax system shocks in various countries at different times. We were able to study the number of patents emerging from a country that changed its tax rate and compare that to the number coming from a country where the tax policy didn’t change during the same time period. This helped us rule out the chance the tax policy changes were coinciding with unrelated changes in demand in the U.S. that could have been driving patent filings. 

We also studied other policy changes that countries made at the same time they changed their tax rate, so we could eliminate the possibility that the flow of patents was affected by a concurrent tax break for research and development, for example. Again, we found the number of patents coming from countries that made that increased short term capital gains tax rates were much greater. 

We also found other patterns that were consistent with the story we saw emerging. The effect we found is more profound in countries you would expect to be more vulnerable to this short-term focus – countries where the markets are dominated by public firms. It’s less of a problem in countries where private firms dominate because share ownership tends to be longer-term in private firms. 

We also found variation in the kinds of patents that were being filed. In countries where taxes increased on short-term profits, we saw a larger bump in what we call explorative innovations, where firms were exploring new boundaries and innovating areas they don’t know much about. That’s in contrast to the kinds of patents that are more incremental and build on what firms already know, which we call exploitative innovations. 

What can policymakers, firms and shareholders learn from this research? 

There’s a very clear suggestion that a policy of increasing capital gains taxes on short-term share profits has merit as a means of fostering long-term innovation. But any policy tool comes with costs and benefits, and this kind of policy would impose its own costs. It would give people less flexibility in what they do with their wealth, and it would distort their investment decisions.  

The message to firms is that they must do whatever they can to encourage long-term share ownership so they too can invest in the long term. How they do that is the million-dollar question. It matters a lot that firms emphasize the long-term vision of the company. You need to have credibility to do this, it requires trust, but it’s something firms need to actively work toward if they want to innovate. 

And if you are an investor and long-term innovation is something you care about – and there are good reasons why you should – then it’s important to understand that making an investment and sticking with it is the best way to play a part in fostering that. 

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