The Effect of Market-Based Sourcing on Firm Innovation

Abstract

Historically, states have taxed intangible income in the state where a firm’s intangibles are located. However, over the past two decades, states have begun adopting market-based sourcing (MBS), which causes the intangible income to be sourced to the state where the customer is located. Using a generalized difference-in-differences design, I examine the effect of MBS laws on both state corporate tax revenue and firm innovation, as MBS directly effects both where innovation is taxed as well as the tax rate for innovation. My tests indicate that the adoption of MBS is associated with both an increase in state corporate tax revenues as well as a decrease in the quantity and quality of firm innovation. Additionally, I document that affected firms locate a greater proportion of patents in states with MBS. Together, these findings suggest that MBS laws lead to changes in state tax rates that impede corporate innovation.