Taxes, institutions, and innovation: Theory and international evidence

We develop an international model of the design of institutions for regulating innovative activities of private corporations. Informational limitations faced by the social planner preclude complete contracting with private firms. Corporate innovation creates positive and negative externalities. The social planner in each country takes into account the legal system in place, and designs an umbrella of institutions that include a menu of organizational forms, liability structures, corporate taxes, and subsidies. We show that limited liability may be accompanied by excessive innovation. However, when the nonmonetized benefits are very high, private firms may be too conservative in innovation policies. Firms choose their organizational form and level of innovation consistent with private optimality. With the optimal institutional design for each country, we demonstrate that private innovation choices are aligned with social optimality. In particular, we show that the optimally designed corporate tax rate in each country is a decreasing function of its legal effectiveness. Using data from 63 countries over 2003–2018, we document supporting evidence. MNCs can take advantage of differential liability and corporate tax structures across national boundaries to circumvent institutional design constraints. However, when MNCs generate positive externalities to host countries, their governments may provide subsidies and incentives.