How Corporate Taxes Benefit the Greater Good

When the world needed a vaccine for COVID-19, corporations around the globe raced to develop one. Governments poured billions of dollars into drug companies to subsidize a speedy introduction of a safe and effective vaccine. And it worked. Less than 10 months later, people around the world started receiving the first shots.

The vaccine development is a prime example of how companies can have huge social benefits with their innovations, pushed forward by government policies, while also standing to make hefty profits. That idea is the central theme of new research from the University of Maryland’s Robert H. Smith School of Business, which lays out an international model for how governments should design corporate taxes and subsidies to spur companies to innovate in ways to have the greatest social impact.

The research, published in the 50th-anniversary issue of the Journal of International Business Studies, was spearheaded by Lemma W. Senbet, the William E. Mayer Chair Professor Finance and founding director of Smith’s Center for Financial Policy. He worked with Amar Gande of the Cox School of Business at Southern Methodist University, Kose John of the Stern School of Business at New York University, and Vinay B. Nair of the Wharton School at the University of Pennsylvania. They looked at data from multinational corporations in 63 countries from 2003 to 2018.

“We focus on corporate innovative decisions,” says Senbet. “We argue that these innovations have social benefits and costs. In the case of corporate benefits, obviously, there are cash flows – corporate profits. But then, if innovations could have a spillover effect on the rest of society.”

The researchers say private companies need more incentive not to do things that hurt society. They point to examples of the financial crisis, oil spills, nuclear power plant disasters and climate change as evidence for why better mechanisms are needed to align corporate and social interests. The tax system, and the legal system that enforces it, are the ways to do that, says Senbet.

It’s all about striking the right balance, he says. But why do we have this misalignment in the first place? Senbet says it’s thanks to corporate limited liability, which allows companies to take excessive risks with too much innovation and capture all the financial benefits on the upside, but walk away without much penalty if things go downhill. And if they don’t see an obvious financial upside to an innovation, they might not pursue it, even if it could have societal benefits.

“That creates a wedge between optimal innovation and private innovations and this wedge is mitigated by the design of corporate taxation and subsidies,” says Senbet. These instruments can align corporate profit incentives to encourage the kinds of innovations that benefit the greater good and dissuade the innovations that hurt it.

The researchers offer an optimal solution at the theoretical level and conduct an empirical study based on international data to test the predictions. To get companies to innovate at the optimal level for the greatest societal benefit, countries need to have the right level of corporate taxation and a strong legal system that enforces the tax system, says Senbet. “If the legal system is strong and holds companies to the taxes they owe, the tax rate doesn’t have to be as penalizing. That’s the relationship that we need.”

Senbet says this paper answers the long-debated question: Why do we tax corporations?

“Corporate taxes can have a social benefit. This paper is positioned in the burgeoning thinking around the globe of how do we incentivize private decision-makers to what is socially important and what impacts society.”

But it’s not just about taxes, says Senbet. Sometimes – like in the case of the COVID-19 vaccine development – it’s also about subsidies.

“It’s not just one-size-fits-all,” he says. “Corporations vary depending on the damage and the benefits they confer to the rest of society. You can minimize the damage through corporate taxation and strengthening the rules, and you can provide subsidies to boost benefits.”

Read the full research, “Taxes, Institutions, and Innovation: Theory and International Evidence,” in the Journal of International Business Studies.