In this study we explore effects of two distinct tax policies on innovation in a pure knowledge economy: an ‘IP box’ incentive and a (hypothetical) tax incentive on compensation earned by agents from profit sharing schemes (PSS). In contrast to the conventional assumption that firms decide on whether to innovate or not, we focus on a bottom-up innovation process (sometimes also called ‘bootleg innovation’), where firms set incentives to fulfill different tasks, but the final decision on whether to make the more innovative task is taken by an employee. We compare the two tax incentives under several distinct specifications demonstrating that the tax incentive on PSS can be a powerful mechanism fostering innovative activity and benefiting at the same time workers, firms and the economy as a whole. This study shows that the more critical for firms is attracting and motivating highly skilled workers, the larger the expected gain from employing the tax incentive on agents' compensation. We also find that the relative efficacy of this tax incentive is moderated by labor mobility and the extent of knowledge spillovers. •We propose a novel tax incentive directed on profit sharing schemes (PSS).•This is compared to the standard ‘IP box’ incentive in a knowledge economy context.•We show that the PSS incentive benefits workers, firms and the economy as a whole.•Its effectiveness rises with the role of labor relative to capital investments.•Its relative efficacy is also moderated by labor mobility and knowledge spillovers.