Reform R&D tax systems to boost innovation and help young firms

Most OECD member countries use tax incentives to encourage businesses to invest in research and development (R&D) to boost innovation and drive economic growth. Other governments like China, India and South Africa, are doing the same. 

But reforming these incentives would give countries a better return on their investment and support young innovative firms that play a crucial role in job creation, according to a new OECD report. 

The report, ‘Supporting Investment in Knowledge Capital, Growth and Innovation’ says over a third of all public support for business R&D in the OECD is via tax incentives. Multinational companies benefit the most, as they can use tax planning strategies to maximise their support for innovation. This can create an inequitable situation that disadvantages purely domestic and young firms, says the OECD.

“Much more needs to be done to help young firms play a greater role in driving innovation and creating jobs. They are the future of the knowledge economy and need the same chance to succeed as the major players,” said Andrew Wyckoff, OECD Director of Science, Technology and Industry. “Improving their access to finance and making the tax rules fair for everyone is key.”

The tax rules that enable multinationals to shift profits from intellectual assets, such as patents, are being reviewed as part of the OECD’s ‘Action Plan on Base Erosion and Profit Shifting’. Governments should also review their R&D tax incentive schemes as part of this broader effort, the OECD says. This would reduce the risk that countries are foregoing significant tax revenues in the drive to boost investment but do not see a commensurate rise in innovation in their economy.

Important aspects of tax schemes that should be reviewed include the scope of eligible R&D, the firms that qualify and the treatment of large R&D performers. This is important because in many countries the current schemes may be more costly than intended, particularly as tax relief has become more generous in recent years and the full cost is not always transparent as these incentives are considered “off budget” as a tax expenditure.

Meanwhile, helping young firms is crucial: evidence from 15 OECD countries suggests that these firms generated nearly half of all new jobs over the past decade, despite accounting for only about 20 per cent of total business sector jobs, excluding finance. But these firms, of five years of age or less, often do not generate enough profit to make use of non-refundable tax incentives. Policies that would help them more would be cash refunds, carry-forwards or the use of payroll withholding tax credits for R&D-related wages.

The OECD analysis also suggests that well-designed direct support, such as grants and contracts, may be more effective in stimulating R&D than previously thought, especially for young companies.

The report also analyses other areas where governments and business could boost returns on knowledge-based capital. Systems of debt and early-stage equity finance are essential to encourage investment. Countries should review their bankruptcy laws to spur innovation, reducing the stringency of these laws from the highest to the average level in the OECD could raise capital flows to patenting firms by around 35 per cent, according to the report.

Intellectual property rules also need updating, especially to avoid an erosion of patent quality. Greater mutual recognition and comparability of rules internationally would help.