Enhanced tax credit policy could boost California’s innovation based economy

Enhanced tax credit policy could boost California’s innovation based economy

California’s innovation economy is considered to have the recipe for success. It has the technology industry base, talent, universities, entrepreneurs, and risk capital necessary to fuel economic growth. But what is the exact role of innovation in driving a successful economy, and can California continue to rest on its laurels to maintain its dominant position?

This is the subject of a recent study “California’s Innovation-Based Economy: Policies to Maintain and Enhance It,” which conducts one of the most thorough analyses of the landscape of research and development (R&D) spending in California. It also demonstrates the key role of R&D in the state’s economy, and proposes ideas for spurring businesses to continue and intensify their research activity.

California’s economy is advancing at a faster rate than the rest of the USA. Much of this stems from its dominant position in the social networking and applications industries; the recovery in the global information and communications technology sector, where the state maintains a unique concentration of clusters; and the depth of California’s economic collapse during the recent financial crisis and the inevitable resurgence.

Santa Clara County has the highest level of private-sector R&D spending compared with other California counties, despite its small size. Santa Clara is a technology hub (the heart of Silicon Valley), and the high levels of R&D in the county emphasize its importance to businesses that want to remain competitive in their fast-moving industry. The San Francisco Bay Area has a plethora of tech talent, the Los Angeles area has both entertainment and technology, and San Diego has an emphasis in biotechnology. There are pockets of innovative activity in the Central Valley and in Riverside-San Bernardino as well.

Providing private risk capital to California’s stellar group of entrepreneurs is a crucial source of strength for the state’s economy. At $28.1 billion in 2014, California had the largest amount of venture capital placement in the USA. Another area of strength for California’s innovation economy is the depth and breadth of its science, technology, engineering, and mathematics (STEM) talent. California has nine fields where its intensity ranks among the top seven states. It has regional innovation advantages as well. It has six metropolitan areas that rank among the top 20 technology centers in the U.S. and Canada.

Innovation capacity declining

California’s economy is the seventh-largest in the world. However, from a longer-term perspective, although the state retains many competitive advantages, the study says some indicators suggest its innovative capacity is declining, or will unless preventive steps are taken. For example, California ranked 17th in the human capital component of the Milken Institute’s 2014 State Technology and Science Index and ranked slightly above average in its success at receiving National Science Foundation research funding.

The study describes the critical role innovation plays in economic growth around the world. It traces the evolutionary nature of innovation in California and demonstrates the extent to which research and development drives the economic performance of the state. It also highlights several metrics that are crucial to understanding California’s future position in the innovation-driven economy.

Tax credits as a tool to spur innovation

At a global level, especially within technology industries, clusters of innovation activity are today largely determining the economic prowess of nations, and innovation in turn is largely the result of cumulative R&D investments, or the capital stock of knowledge. A key challenge with relying solely on market forces to stimulate industry-funded R&D is that the private rate of return for an innovating firm is less than for the larger economy, since other firms expropriate value, resulting in less investment than is socially optimal. The use of tax credits can reduce the cost of R&D and induce more investment, and extensive research has demonstrated a strong relationship between R&D tax credits and R&D activities.

Silicon Valley is a stand-out example of the huge economic value of knowledge sharing, but it is far from California’s only innovation cluster: it has six metropolitan areas that rank among the top 20 technology centers in the U.S. and Canada. California is the leading state for industry R&D spending, with $76.9 billion in 2013, and leads the nation in patents issued per capita.

California Innovation economy

Illustration: R&D spending intensity in California metropolitan statistical areas
Source: Milken Institute

Yet the state cannot rest on its laurels. “California’s innovation economy is one of the strongest among states, but the state scores poorly in other measures of business climate,” says Ross DeVol, chief research officer and co-author of the study at the Milken Institute.

California’s research credit, currently at 15 percent of qualifying supplemental research activity conducted within the state, in combination with the federal credit, is a crucial part of the tax environment that businesses evaluate in choosing whether to site new research activity in California or in another innovation hub. Since the research credit is one of the most direct policy levers available to affect the level of R&D conducted in the state, the study suggests four R&D policy options:

  • Introduce tradable credits
  • Refund credits for small businesses
  • Increase the R&D tax credit for qualifying institutions funding university research
  • Double the R&D tax credit for firms

To give a sense of the economic effects that a major change in policy might have, the researchers modeled the impact of a doubling of the California research credit to 30 percent from 15 percent over five years. The model suggests that ten years after such a change, $700 million in additional research credits would stimulate between $4.5 billion to $6.8 billion in additional research and development activity in California. This would translate into $3.2 billion to $3.8 billion in economic ripple effects from the additional spending, as well as a range of 60,000 to 84,000 new jobs in California.

The study concludes that California should take bold steps to maintain and enhance its capacity for innovation and the conversion of it into commercial applications, thereby allowing firms to create high-quality jobs in the state and benefiting from the large multiplier effect associated with them. While it’s true that California has long been a high-tax, high-cost place to do business, the imperative for innovation in the state can’t be overstated.

The legislature must consider additional policies that will provide fertile ground for existing and prospective businesses and universities to conduct research. Some might consider policies such as doubling the R&D tax credit as an unfair tax giveaway. The study says that such an inducement is well worth the cost. The additional research and high-paying jobs that firms and entrepreneurs create would boost economic performance in. In the bigger picture, this policy suggestion could benefit not just to California, but many other placed around the world that depend on an innovation economy.

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California’s innovation economy is considered to have the recipe for success. It has the technology industry base, talent, universities, entrepreneurs, and risk capital necessary to fuel economic growth. But what is the exact role of innovation in driving a successful economy, and can California continue to rest on its laurels to maintain its dominant position?…
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