R&D tax incentives have become much more popular in the last two decades. Part of their popularity can be explained by their generic nature – governments can stimulate innovation while firms remain free to choose the R&D projects they invest in. In addition, R&D tax incentives have low administrative costs in comparison to direct subsidies for innovation. These characteristics make R&D tax incentives a form of innovation policy that is unlikely to lead to unintended market distortions.
The economic recession has further raised interest in the effectiveness of these tax incentives, and for two opposing reasons. First, R&D tax incentives are viewed as tools that protect innovative activity at economically challenging times and potentially promote growth. A second, emerging, reason is that large government budget deficits trigger a re-examination of innovation policies associated with large amounts of foregone tax revenue. The tension between promoting growth and reducing deficits has led to a call for ‘smart consolidation’ – growth-enhancing policies should be protected from budget cuts. Veugelers (2014) argued that the evidence on the effectiveness of innovation policies is insufficient to guide ‘smart consolidation’ measures.
Figure 1 displays the adoption of R&D tax credits in European countries for the period from 1994 to 2014. The figure suggests that, so far, concerns about economic growth have clearly prevailed over concerns about budgetary deficits. Nine European countries have introduced R&D tax incentives since 2008, while no country has discontinued them.
Figure 1. Proliferation of R&D tax credits in Europe
Source: Data collected by authors.
Not only have more countries adopted fiscal policy for R&D, but the budgets for these instruments have also increased – sometimes dramatically. Figure 2 shows the forgone tax revenue associated with R&D tax credits as a percentage of GDP. The costs of the French incentives, in particular, have grown substantially as they moved from an incremental to a volume-based scheme. Part of this increase might have been unanticipated.
Figure 2. R&D tax credit budgets
Sources: HMRC (2014), Cour de Comptes (2013), Department of Finance (2013), Finance Act 2013, and RVO (2014).
But are R&D tax incentives really the key to restoring economic growth in Europe? In a recent report (CPB et al. 2015) we have reviewed the empirical literature on R&D tax incentives. Most studies find that R&D tax incentives promote R&D. Yet, there is little agreement on the size of this effect. The more advanced and precise studies find that one euro of foregone tax revenue leads to slightly less than one euro of additional private R&D (see, for example, Lokshin and Mohnen 2012 and Mulkay and Mairesse 2013). Roughly, this outcome implies that a country that wants to raise its aggregate R&D expenditure by 1% of GDP should spend at least the same amount on tax incentives.
Whether the additional R&D has contributed to innovation is less studied. The few studies on this topic suggest that R&D tax incentives stimulated creation of new products and innovation (see Czarnitzki et al. 2011, Ernst and Spengel 2011, and Westmore 2013). However, while R&D tax incentives appear to be effective in increasing incremental innovations, they might not result in more radical innovations as shown in Cappelen et al. (2012) and Ernst et al. (2014). In order to draw robust conclusions, more evidence is needed.
The observations at the macro level suggest that it is unlikely that the presence of R&D tax incentives will determine a country’s innovativeness. Figure 3 plots a country’s innovativeness according to the Bloomberg Innovation index against the share of tax incentives in the R&D policy budget. Any relation between tax incentives and innovation is dramatically absent. In particular, the most innovative European countries did not even have an R&D tax incentive in 2011. Germany still has none.
Figure 3. No relation between a country’s innovativeness and R&D tax credits
Source: OECD, based on OECD R&D tax incentives questionnaire, publicly available sources, and OECD, Main Science and Technology Indicators Database, www.oecd.org/sti/msti.htm, December 2014 and Bloomberg (2014), www.bloomberg.com/visual-data/best-and-worst/most-innovative-in-the-world-2014-economies, December 2014.
Does the absence of a relation between a country’s innovativeness and its expenditure on R&D tax incentives mean that the distinction between tax incentives and direct subsidies for innovation is irrelevant? Not necessarily. Unfortunately, only a few studies compare the effectiveness of tax incentives with that of direct subsidies. A firm-level study of Norwegian firms shows that tax credits appeared to have a slightly larger effect than direct support measures (Hægeland and Møen 2007). Yet, empirical findings from a panel of 19 OECD countries indicated that direct support seems to have a larger impact than R&D tax incentives (Westmore 2013).
Tax incentives can induce firms to invest more in R&D, but it appears the innovativeness of an economy is unlikely to depend on their presence. Simply introducing an R&D tax incentive or making an existing scheme more generous in countries where framework conditions for innovation are lacking might be a waste of government resources. Policymakers should first focus on policies that enhance the overall entrepreneurial environment, in which R&D tax incentives can be a nice addition.
Bloomberg (2014), “Most innovative in the world 2014: Economies”.
Cappelen, A, A Raknerud, and M Rybalka (2012), “The effects of R&D tax credits on patenting and innovations”, Research Policy 41(2): 334–345.
Cour de Comptes (2013), Le Financement Public de la Recherche, Un Enjeu National.
CPB, CASE, ETLA, and IHS (2015), “A study on R&D tax incentives: Final report”, DG TAXUD Taxation Paper 52.
Czarnitzki, D, P Hanel, and J M Rosa (2011), “Evaluating the impact of R&D tax credits on innovation: A microeconometric study on Canadian firms”, Research Policy 40(2): 217–229.
Department of Finance (2013), “Review of Ireland’s Research and Development (R&D) Tax Credit 2013”.
Ernst, C, K Richter, and N Riedel (2014), “Corporate taxation and the quality of research and development”, International Tax and Public Finance: 1–26.
Ernst, C and C Spengel (2011), “Taxation, R&D tax incentives and patent application in Europe”, ZEW Discussion Paper 11-024.
Hægeland, T and J Møen (2007), “The relationship between the Norwegian R&D tax credit scheme and other innovation policy instruments”, Statistics Norway.
HM Revenues and Customs (2014), “Research and Development Tax Credits Statistics”.
Lokshin, B and P Mohnen (2012), “How effective are level-based R&D tax credits? Evidence from the Netherlands”, Applied Economics 44(12): 1527–1538.
Mulkay, B and J Mairesse (2013), “The R&D tax credit in France: assessment and ex ante evaluation of the 2008 reform”, Oxford Economic Papers 65(3): 746–766.
OECD (2013), OECD Science, Technology and Industry Scoreboard 2013, OECD Publishing.
Veugelers, R (2014), “Undercutting the future? European research spending in times of fiscal consolidation”, Bruegel Policy Contribution Issue 2014/06.
Westmore, B (2013), “R&D, Patenting and Growth: The Role of Public Policy”, OECD Economics Department Working Paper 1047.