Aiming for Well-Being through Taxation (FM nr. 160) 2019/5.6:5.6 Effectiveness and efficiency of tax incentives for innovation

Aiming for Well-Being through Taxation (FM nr. 160) 2019/5.6

5.6 Effectiveness and efficiency of tax incentives for innovation

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Question 6 of the assessment framework requires states to substantiate the predicted or actual effectiveness and efficiency of tax incentives for innovation in achieving their well-being aims.

As it seems uncommon for tax measures that aim to stimulate innovation to be expressly related, in their wording or goal setting, to well-being,1 assessments of tax measures that aim to stimulate innovation often focus on concepts of welfare,2 or of economic well-being.3 Inferences regarding generic design and implementation issues, and recommendations as concerns the effectiveness and efficiency of tax incentives for innovation are drawn here from such research.4 That said, there is of course no single way in which tax incentives for innovation should be designed, implemented, or evaluated.5

Hall and Van Reenen discussed advantages and disadvantages of the following methods to assess the effects of R&D support.6 Event studies, as methods to assess effectivity, involve comparing behaviour before and after the legislation introducing the tax incentive, although such studies do not condition out other events that may have possibly also influenced innovation.7 A variation involves retrospective event studies, or case studies, often a combination of surveys and econometric analysis, so as to control for other factors. However, in the case of surveys, answers may not always be wholly reliable.8 Another method uses natural experiments, whereby an equation is constructed that attempts to predict the level of innovation, time as a function of innovation, output, expected demand, price variables et cetera. A downside to such natural experiments is that the measurement is relatively imprecise, as the equation may not capture all relevant forces at play.9 Finally, Hall and Van Reenen discussed quasi-experiments, as variations to natural experiments that include price elasticity estimations. Such quasi-experiments however suffer from vulnerability of, for instance, overestimations.10 When focusing on the efficiency of tax incentives for innovation, such can for instance be substantiated through desk studies (e.g. literature reviews, for the more factual aspects), interviews and online surveys (for more subjective input), or econometric analyses.11

Governments should explain how, and how often, the effectiveness and efficiency of tax incentives for innovation are monitored and evaluated. Tax incentives for innovation should be subject to systematic, rigorous evaluations, with high-quality firm-level data collected according to international standards,12 which may in some cases be far removed from current political reality. It is agreed with Wijtvliet that, for a tax expenditure, the necessity, suitability, effectiveness, and proportionality not only need to be substantiated and supported by figures before introduction of said tax expenditure, but must also be borne out continually, with statistical interim evaluations.13 Fedderke and Teubes remarked that monitoring is as important in the context of R&D incentives as it is in any situation of conflict between self-interests and others’ interests.14 Routine public consultation has for instance been suggested as a way to help states gather the information necessary for effective design and organisation of tax incentives for innovation.15

Tax incentives for innovation should be reconsidered for amendment or abolition if they are shown to be ineffective or inefficient. That said, it is recalled that stability and predictability are conductive framework conditions for both innovation and well-being, and that states should therefore have a long-term view to changes to innovation policies and instruments.16 Larger policy and instrument changes could for instance be linked to pre-agreed system evaluation cycles (for instance over periods of 5 years) to improve predictability and stability.17

From existing research, a number of issues that concern the effectiveness of tax incentives for innovation can be identified (listed in random order):

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IP box tax regimes are often ranked as least effective means of incentivising innovation through taxation, for a number of reasons.18 IP box tax regimes typically concern already protected IP, which IP is less likely to generate innovation spillovers.19 IP box tax regimes are often targeted at IP and related income instead of at research, and are therefore assessed to include large deadweight losses (i.e. reduced taxes for activities that would have occurred anyway, or for already existing or acquired IP).20 Interconnected patent systems for IP may slow the diffusion path of innovation to less than optimal from a well-being perspective (notwithstanding that, in some circumstances, patent systems may in fact reduce an otherwise too fast, and thus suboptimal, diffusion path).21 Furthermore, IP box tax regimes are difficult to evaluate because of tax planning and tax competition.22 IP box tax regimes may, all things considered, result in overall (global) lower welfare, depending on the tax competition between states.23 And while on a regional scale, IP box tax regimes may be successful in attracting IP activities or income in the short run, in the long run such advantages from a tax competition perspective are not likely to last, as other countries are likely to introduce similar benefits.24

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Tax incentives for innovation that use as novelty requirement, for gaining access to such incentives, a requirement that the innovation is ‘new to the firm’, may stimulate imitation rather than innovation.25 Likewise, a novelty requirement ‘new to the country’ to a certain extent results in competition between states for innovation that would have already occurred elsewhere.26

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Depending on elasticities, which differ across countries, industries, and time, tax incentives for innovation may for instance translate into increased input prices (such as R&D wages). On the one hand, such increased prices may stimulate innovation that would otherwise not have been performed, or not in the region concerned. On the other hand, an increase in input prices may also partially or wholly relate to innovation that would have been performed anyway, and thus not (fully) achieve the generation of additional innovation.27

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Stimulating R&D alone may not be enough for incentives to translate into innovation and/or well-being. It is, for instance, uncertain whether causal relations exist between R&D and innovation, or between innovation and well-being.28

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The importance of small and medium sized firms for innovation is debated. Although small firms seem more sensitive to tax incentives,29 spillover effects appear larger when it concerns multinational enterprises.30 More in general, research suggests that innovation may be more related to firm age than to firm size, whereby younger firms are more likely to innovate.31 Size-based preferential tax treatment can furthermore create distorting (dis)incentives to firm growth.32

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Tax incentives generally leave the choice of which innovation to pursue up to markets, while markets are not likely to take up risky, long-term innovation (that may actually generate most social return).33

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More generous tax incentives may lead to lower productivity and employment growth if their benefits go to incumbent firms (i.e. firms that already have an established position in the market), raising barriers for innovative entrants, and reducing competitive pressure for those incumbent firms.34

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The positive effects of tax incentives for innovation may be largely diminished if such incentives are frequently subject to change (considering for instance the long-term investment horizons involved in, or needed for, innovation).35 Uncertainty and instability are bad for both innovation and well-being.36

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Level-based (or volume-based) tax incentives for innovation, whereby firms can apply for such incentives regardless of their past innovation activities, face deadweight losses (in the form of supporting already existing innovation activities) that may overshadow the additional innovation generated by such incentives.37 Incremental tax incentives (whereby benefits are only applied for the increase in innovation, and not for the totality) face less deadweight losses, but may distort innovation investment planning.38

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Tax incentives for innovation may create perverse incentives for firms with regard to the monetisation or timing of profits and investment planning, as many of such incentives cannot be used if firms do not have sufficient profits, or have a cap on the maximum benefit.39

Likewise, a number of recommendations concerning the effectiveness of tax incentives for innovation can be identified (again listed in random order):

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Improving the effectiveness of IP box tax regimes in stimulating innovation has recently, and in a number of countries, been taken up via implementation of the nexus approach (before discussed in section 5.1). This nexus approach aims to only allow a taxpayer to benefit from an IP box tax regime to the extent that the taxpayer itself has incurred expenditures (such as R&D) which (presumably) gave rise to the IP income.40 Innovative effectiveness, when viewed from a state’s perspective, can thus perhaps be improved through limiting beneficial treatment to intangibles created or activities conducted in a state’s own territory, through excluding marketing intangibles and trade names, through excluding windfall gains in the form of benefits for acquired, existing, or foreign IP, and through stricter active ownership and tighter substance requirements.41 Perhaps, as there is not necessarily a causal connection between R&D expenses and innovation or income. In addition, IP box tax regimes may become more effective in stimulating innovation if such regimes also include income from internal use of IP (as such internal use may also generate positive spillovers).42

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To stimulate innovation diffusion, tax incentives can aim at early adaptors and be granted for a limited period of time rather than indefinite.43

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Tax incentives that promote the development of people (such as wage tax credits for R&D workers, or tax incentives for education) can help build a strong base for innovation, considering the importance of people for innovation.44

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Tax incentives that aim for new innovation starters, or young firms, are relatively more effective in bringing about innovation.45 Ways to aid new firms that experience start-up losses are for instance to offer refundable, or alternatively carry-over, R&D tax credits.46

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Tax incentives for innovation that use as novelty requirement ‘new to the world’ stimulate true innovation, when viewed from a global perspective.47

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While tax incentives for innovation are in many cases targeted towards technological innovations, it is often that the more mundane innovations (e.g. innovations that lift people from poverty, that take away undesirable consequences for the environment, or that improve working conditions) generate more well-being.48

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Empirical and theoretical research suggests that tax incentives for innovation that are related to the input side (e.g. to R&D expenditure, or to wages) are more likely to be effective in stimulating innovation than tax incentives for innovation that are related to the output side (e.g. IP box tax regimes).49

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Tax incentives for innovation should be simple, stable, and predictable, with a fixed design and benefit for at least a number of years (e.g. at least 5 years), in order for firms to be able to fully take such incentives into account in their innovation investment decisions.50

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Tax incentives for innovation are best combined with, and attuned to, complementary governmental policy instruments that promote innovation,51 such as policies that reduce business cycle volatility in economically challenging times, investments in education, infrastructure, and institutions (partnerships), legal frameworks (including patent protection and bankruptcy systems) et cetera.52

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Gradually expanding tax incentives for innovation, rather than implementing large immediate increases, may reduce the risk that the additionally provided benefits translate into increased input prices (such as R&D wages) rather than into additional innovation.53 Granting innovation support in stages, available for successive phases after submission of new applications, increases monitoring possibilities, and reduces moral hazard risks (e.g. firms undertaking second best or very risky projects).54

With respect to the efficiency of tax measures that aim to stimulate innovation, certain general observations on issues and recommendations can also be made (listed in random order below):

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If additional taxes need to be raised in order to finance tax incentives for innovation, such a raise creates a potential welfare and well-being cost by distorting economic behaviour (for instance distorting the choice to save, work, or invest).55

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Next to the distortive aspects of taxes, tax incentives for innovation can come with relatively large additional administrative and compliance costs (e.g. due to increased bureaucracy). Some estimate total business compliance costs and state administrative costs to be around 10 per cent of the total benefit claimed.56 This, as tax incentives for innovation typically involve technical assessments, strict documentation requirements, and complex determinations of which expenditures or activities qualify.57 There is an interplay here between effectiveness and efficiency: incentives with more strictly defined conditions (e.g. more targeted, and with stricter novelty requirements) come with higher administrative and compliance costs, which may as a side effect deter new starters or young firms.58 Administrative procedures can reduce administrative and compliance costs for instance via offering one-stop-shop and/or online applications.59 Of course, the administrative capacities of states also play a role in determining operational efficiency.60

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Incremental schemes appear less efficient than volume-based schemes, as incremental schemes may distort optimal investment planning, and likely require higher administrative and compliance costs.61 The before discussed increased effectiveness of incremental schemes over volume-based schemes may not be sufficient to make up for such efficiency losses.62

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Private enterprises are assessed to make more efficient allocations of investments than states (thus pleading for more generally framed tax incentives), save for situations where states can precisely target desired innovations based on appropriate information regarding the size and nature of spillovers.63

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Different tax treatment of different legal forms (e.g. where IP box tax regimes are only available for entities subject to corporate income tax) may distort organisational efficiency.64

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Research suggests that many existing tax incentives for innovation reduce the marginal cost of innovation by too little to achieve socially efficient corrections (some estimate the breaking point to be around 50 per cent of innovation costs).65

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Overlap of different tax incentives for innovation (for instance, carry-over of R&D tax credits in combination with application of an IP box tax regime) can reduce overall policy efficiency if not properly coordinated.66

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