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December 12, 2023

Innovation output

Do R&D tax incentives actually increase innovation?

Tyler Smith

Source: BGStock72

In recent years, many of the world's most advanced economies have changed their approach from directly funding research and development (R&D) to relying more heavily on corporate tax breaks. But there’s a long-standing concern among economists that corporate tax incentives increase R&D spending without having much effect on innovation: companies may simply relabel existing projects to take advantage of the tax relief or only expand very low-quality R&D projects.

In a paper in the American Economic Review: Economic Policy, authors Antoine Dechezleprêtre, Elias Einiö, Ralf Martin, Kieu-Trang Nguyen, and John Van Reenen found empirical evidence that R&D tax breaks do have a positive impact on corporate innovation.

The findings come from analyzing the effects of a change in 2008 to the UK R&D Tax Relief Scheme. The scheme reduced corporate tax liabilities by enhancing deductions for R&D spending, but only for companies with less than €43 million in total assets. The 2008 adjustment raised that threshold to €86 million.

By comparing firms just above the new asset threshold to those just below it, the researchers were able to estimate the impact of the tax break on patenting—a key indicator of innovation. Figure 2 from the authors’ paper tracks firms who were at the new threshold, showing the discontinuity of their average patent filings before and after the change.

Figure 2 from Dechezleprêtre et al. (2023)

The x-axes indicate the total assets of companies in 2007, in millions of euros. The y-axes indicate the average number of patent filings. Panels A and B plot values for the periods 2006–2008 and 2009–2013, respectively. The shaded areas indicate 95 percent confidence intervals.

The chart shows that prior to 2008 there was no significant jump in patent filings at the €86 million threshold, indicated by the vertical red lines. But after the new policy went into effect, firms just below the threshold—which benefited from more generous tax breaks—filed significantly more patents than firms just above the threshold, roughly 5 percent more.

Firms below the new cutoff level were small- to medium-sized companies more likely to be financially constrained than their larger counterparts, and the authors note that this might account for the large impact of the tax breaks. Nonetheless, the results show that tax incentives for R&D can boost innovation in the right circumstances.