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Book Chapter

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Many governments encourage the development and use of new technologies within the borders of their countries. It is not difficult to understand why they do so. It is widely believed that the positive correlation between local economic affluence and the presence of technologically advanced industries implies that the use of new technologies enhances overall productivity. More direct evidence generally supports the conclusion that the economic benefits of research and development (R&D) activity extend to local firms other than those undertaking the R&D. Since there are reasons to expect that externality-generating R&D activities may be underprovided by markets in which developers of new technologies do not capture all of the economic benefits that the technologies provide, various governments offer R&D-related tax subsidies. Governments that do not offer R&D tax subsidies are often concerned that perhaps they should. There are, however, many open questions about the impact of tax policy on the level of R&D. Tax systems influence the level and content of R&D activity through a variety of channels. This paper focuses on R&D by multinational firms, and on the impact of one particular set of taxes: withholding taxes on cross-border royalty payments. Finns that develop new technologies in their home countries and use the technologies in foreign locations are required to pay royalties from foreign affiliates to domestic parent companies. Governments tax these royalty payments. High tax rates make royalties, and the technology imports that they accompany, more expensive for the foreign affiliates that pay the taxes. In theory, higher costs of imported technology might encourage or discourage local R&D by affiliates of multinational corporations. If local R&D is complementary with imported technology, then high royalty tax rates should discourage local R&D, while if local R&D is a substitute for imported technology, then high royalty tax rates should encourage local R&D.