Most OECD governments use tax incentives to encourage businesses to invest in research and development (R&D) to boost innovation and drive economic growth. Others, 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.
Supporting Investment in Knowledge Capital, Growth and Innovation says that over a third of all public support for business R&D in the OECD is via tax incentives. Multinational enterprises (MNEs) benefit the most, as they can use tax planning strategies to maximise their support for innovation. This can create an unlevel playing field 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. Improving their access to finance and making the tax rules fair for everyone is key,” said Andrew Wyckoff, OECD Director of Science, Technology and Industry at the launch of the report in Brussels.
The tax rules that enable MNEs to shift profits from intellectual assets, such as patents, are already 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. This would reduce the risk that countries are foregoing significant tax revenues in their 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 as 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.
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% of total business sector jobs, excluding finance. These firms, of five years of age or less, often do not generate enough profit to make use of non-refundable tax incentives. Better policies to help them would be cash refunds, carry forwards or the use of payroll withholding tax credits for R&D related wages.
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 firms.
The report also analyses other areas where governments and business could boost returns on knowledge-based capital, a key driver of growth in today’s global economy. Systems of debt and early-stage equity finance are essential to encouraging 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%, 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.