R&D is the key driver of productivity growth. Productivity growth on the other hand, is the main driver of economic growth. Government expenditure on R&D projects has been a hot debate matter in economic policy. Some argue this government spending is crucial for R&D progress around the world. They cite the projects that have been funded by the United States National Science Foundation (NSF). Many drugs, therapies and diagnostic instruments in the last 100 years have been invented thanks to generous fundings of NSF. However, other analysts think that government spendings (especially in less developed countries) is not as productive as if the fundings had been invested through private firms.
A new method for the government to boost R&D expenditures is to introduce tax deductions for firms that spend parts of their income on R&D projects. This method also has its own critics and its fans. There’s a long-standing concern among economists that corporate tax incentives increase R&D spending without having much effect on real innovation progress. For example companies may simply relabel existing projects to take advantage of the tax deductions or only expand very low-quality R&D projects.
A paper that has been recently published in the American Economic Review by Antoine Dechezleprêtre and his colleagues, provides some insight on the real-world effect of these tax incentives on the firms in the United Kingdom. In 2008 the UK government enacted R&D Tax Relief Scheme, under this new law small companies would receive more tax deductions on their R&D spending. In order to be eligible for new tax deductions, the firm total assets should be lower than €86 million.
Dechezleprêtre and his colleagues gauged the effect of this new scheme on R&D spending of the firms. The result is simply encapsulated in this graph. After the introduction of this tax deduction scheme, the difference between the number of patents by firms below and above €86 million has intensified. This means the law has worked. Of course the quality of these spending and their efficiency compared to government funded projects are still open questions.
As you can see in this graph there is another effect. The closer a company’s assets to €86 million, the more patents have been registered by it after the law was enacted. This highlights the distorting effect of this incentive scheme. Those companies whose total assets were close to €86 million but lower than that, had even spent more on patenting. The first thing that comes to mind is that they just used their patenting activities as a tax shield to pay lower taxes right now and to remain below this €86 million threshold so they can benefit from this tax incentive in the subsequent years. The quality of these kinds of patents is also an open and interesting question.
Source: Do R&D tax incentives actually increase innovation?
American Economic Review
