The relationship between a nation’s tax policy and its standard of living  has been a longstanding topic of debate. While many economists and  policy analysts argue that higher taxes discourage real economic growth,  others reject the argument or claim that taxes are a relatively unimportant  influence on standards of living compared to other determinants such as  physical infrastructure.

Empirical studies document the critical role that technological  change plays in improving the productivity of labour and capital, while  improved productivity underlies increases in the real incomes of domestic  factors of production. Technological change is broadly equivalent to innovation, where the latter can be thought of as the creation, introduction,  and widespread commercial use of new knowledge that takes the form of  new products, new production and distribution techniques, and new ways  of organizing production and distribution activities.

Innovation is the main underlying contributor to improved total factor productivity (TFP) and, therefore, to higher standards of living. Hence,  the influence of tax policy on the quantity and quality of innovation activity is an important public policy issue.

Tax policy encompasses the economic activities and payments to  factors of production that are subject to taxation, the tax rates that are  applied, particularly the progressivity of the relevant tax schedule, and the  exemptions, deductions, and credits that are applicable to specific activities or sources of income.

Innovation activities are inherently risky and will be undertaken by  private sector organizations only if the expected risk-adjusted returns from  the relevant investments exceed the costs of capital for those organizations. 

Likewise, individuals involved in the innovation process, such as scientists  and engineers, will invest in education and other training needed to participate effectively in innovation activities only if the expected returns to the  necessary investments in human capital exceed the associated costs.