12/31/2013 01:21 pm ET Updated Mar 02, 2014

In Search of Elusive Growth: Making the Most of R&D Tax Incentives

By Andrew Wyckoff

Andy Wyckoff

Finding new sources of growth right now is tough. And in a time of rising inequality, to do so equitably and fairly is even tougher. Innovation -- which fosters competitiveness, productivity, and job creation -- can help but with budgets stretched to the limit how can governments boost innovation in their economies?

Tax incentives for business R&D is a good place to start. As of 2011, 27 of the OECD's 34 members provided tax incentives to support business R&D -- more than double the number in 1995. By 2011, over a third of all public support for business R&D in OECD countries came through tax incentives -- a share that jumps to more than half when the U.S. -- with its large direct procurement of defence R&D -- is excluded. Other economies -- including Brazil, China, India, Singapore and South Africa -- have also instituted new tax provisions to stimulate investment in R&D.

As they have proliferated, R&D tax incentives have become more generous. Over the period 2006-2011, about half of the 23 countries for which complete data are available increased their generosity, with R&D tax support rising by almost 25 percent in some countries. This probably underestimates the shift towards greater generosity because the economic crisis caused a decline in both profits (and hence taxes) and R&D. This growing popularity of R&D tax incentives as a policy instrument is due to a variety of reasons including being exempt from EU and WTO "state aid" rules, and the fact that tax expenditures tend to be "off budget, " meaning they escape the scrutiny that applies to direct expenditures.

A new OECD report shows that in a relatively short period of time, R&D tax incentives have become among the most widely used policy instruments to promote innovation. Some have asked "is this too much of a good thing?" and in this era of tight public budgets "are governments (and citizens) getting value for money?" The answer depends on the exact design of the R&D tax incentive.

Most firms engaging in R&D are multinationals that can use cross-border tax planning strategies that result in tax relief that may exceed what was originally intended. This in turn may cause an unlevel playing field vis-à-vis purely domestic firms that do not benefit from these same tax planning strategies. This may also disadvantage young firms that have been the disproportionate source of net job growth and tend to be the origin of radical new innovations that spur growth.

Evidence from 15 OECD countries over 2001-11 suggests that young businesses, many of which are among the most innovative, play a crucial role in employment creation regardless of their size. Over this period, young firms (less than or equal to five years of age) accounted for almost 20 percent of total (non-financial) business sector employment but generated about 50 percent of all new jobs created. And, during the economic crisis the majority of jobs destroyed generally reflected the downsizing of large mature businesses, while most job creation was due to young enterprises.

Some will argue that R&D tax incentives are preferable to direct support policies so as to avoid picking winners. But this isn't an either/or situation. A mix of incentives could be the smartest path forward. Recent OECD analysis shows that well-designed direct support measures - contracts, grants and awards for mission-oriented R&D - may be more effective in stimulating R&D than previously thought, particularly for young firms that lack upfront funds. Direct support that is non-automatic and based on competitive, objective and transparent criteria can stimulate innovation.

It's the policy package that matters. Tax incentives should be designed to better meet the needs of domestic companies and young, innovative companies that do not benefit from cross-border tax planning opportunities. There should be a balance between indirect support for business R&D (tax incentives) and direct support measures to foster innovation. And governments should ensure that R&D tax incentive policies provide value for money.

Do this and growth might be a bit less elusive than we think.

Andrew Wyckoff is Director for Science, Technology and Industry at the OECD.

This blog was originally published on October 11, 2013.

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