The Unintended Effect of Tax Avoidance Crackdown on Corporate Innovation

Abstract

To constrain the use of intangible assets in tax-motivated income shifting and thus crackdown on corporate tax avoidance, many U.S. state governments adopted addback statutes. Addback statutes require firms to add back intangible-related expenses paid to related parties in other states to the taxable income reported in the state taxable income. The addback reduces the benefits that firms and managers can gain from creating intangible assets such as patents. In this study, we examine the potential unintended effect of addback statutes on corporate innovation. First, we find that the adoption of addback statutes significantly reduces a firm’s innovation, measured by the number of patents or patent citations. Second, the “disappeared patents” resulting from tax avoidance crackdown do not seem to be of lower quality than other patents. Third, after a state adopts an addback statute, a firm with material subsidiaries in that state assigns fewer patents to subsidiaries in Delaware, where income generated by intangible assets is free of state income tax. Finally, affected firms do not have lower innovation prior to the adoption of addback statues. Overall, these findings suggest that the adoption of addback statutes impedes corporate innovation. Our study has important implications for policy makers who are interested in understanding the consequences of policies that constrain tax-motivated income shifting using intangibles and prevent income base erosion.