Further Proof R&D Tax Cuts Spur Innovation

Large fiscal deficits eventually will cause lawmakers to look once again at balancing the federal budget. Although spending on large entitlement programs is the main driver of future budget deficits, higher tax rates inevitably will be part of any budget compromise. But one place lawmakers should not look to raise money is the research and development (R&D) tax credit. In fact, a significant cut in the R&D credit would likely increase the debt-to-GDP ratio, which is the best measure of the deficit’s economic impact.

Although cutting the tax credit would raise revenue in the short term, it would make the economy worse off, especially in the long run, as less innovation leads to slower growth in productivity and income. Numerous studies show that the R&D tax credit is successful at getting companies to increase their research spending and that this spending creates large social benefits. One of the most recent studies looks at a natural experiment in the United Kingdom and finds that a generous credit to small and medium-sized enterprises (SMEs) has a significant effect on both research spending and patents, and that these advantages have spilled over to technologically related firms.

Economist Antoine Dechezleprêtre of the London School of Economics and his colleagues took advantage of a change in the UK’s tax laws to measure the impact on research spending by SMEs. Starting in the 1980s, the ratio of business R&D to GDP began to fall in the UK, even though it was rising in other developed countries. To reverse this trend, the UK in 2000 enacted an R&D tax incentive for SMEs. In 2002 it extended this credit to large companies. The credit allowed SMEs to deduct 150 percent of their research costs from their taxable income. If a company did not have taxable profits, then it could apply a credit to its payroll taxes equal to a portion of its research spending. Large companies were limited to a deduction of 125 percent of their research spending. The definition of an SME was based on a combination of assets, employment, and sales.

The UK made the law more generous in August 2008, increasing the deduction rate for SMEs to 175 percent of research spending, and for large firms to 130 percent. More importantly, it doubled the size of firms that would qualify as an SME: The asset limit rose from €43 million to €86 million, the employment limit increased from 249 to 499, and the sales limit went from €50 million to €100 million. This gave the authors a chance to see how the newly qualified firms responded to their sudden ability to take advantage of the higher deduction rate for R&D spending. The change in definition only affected the research incentive, so the researchers could reasonably attribute any changes in behavior to the incentive’s existence.

The results were impressive. The firms more than doubled their research spending. A 1 percent decline in the after-tax cost of research increased research spending by roughly 2.6 percent. One worry would be if the incentive merely results in companies reclassifying expenses as research—or researchers demanding higher salaries. But firms also increased the number of patents they filed by 60 percent, even though the incentive was not linked to patenting.

Econometric tests showed that the quality of patenting did not decline. The researchers also identified positive spillovers on innovation in technologically related firms. This is consistent with the fact that private firms are able to capture only part of the benefits that their research creates. The authors cite previous research estimating these spillovers at 30 to 50 percent of the total benefits, compared to between 7 and 15 percent for the firm doing the research. Finally, the study concluded that, between 2006 and 2011, business research would have been 10 percent lower than it was if not for the tax incentives. Combining the incentives for small, medium-sized, and large businesses, every lost dollar in tax revenue generated $2 in private research.

The authors make a few general observations. The first is that the difficulty of measuring spillover benefits likely underestimates the full impact of tax incentives on the economy. On the other hand, they also estimate that the results are likely to be greater for SMEs than for large firms because SMEs have a harder time raising money to fund good research projects, especially during the Great Recession, which occurred during the time period in question. However, they document that higher research spending and patenting continued for at least seven years, making a temporary explanation less likely. SMEs with good research ideas may face fewer financial constraints in the United States with its strong venture capital market. In contrast, the more dynamic U.S. business environment may produce larger spillover effects.

This is just one of numerous studies showing that R&D tax incentives make society better off. Yet, U.S. policymakers have let the value of its tax credit fall in relative terms. The current credit reduces the marginal cost of additional research by only 5 percent. That currently ranks 30th among OECD countries. The UK rate for profitable SMEs is roughly 30 percent.

One of the best fixes for higher deficits is faster economic growth. To that end, the case for boosting research tax incentives, including the R&D credit, continues to strengthen.