Recent Research: Tax Credits Are Good for Companies, But Do They Make Good Policy?

Do tax credits pave the way for more investment in R&D and equity investments in new enterprises? Or, do they reward companies and venture capitalists for investments they would have made anyway?

Discussions on these questions can become quite heated and fueled by data supportive of both sides, as two new academic analyses demonstrate.

The recent studies examine two Canadian business tax credits, but come to opposite conclusions. One study reviews the impact of Canadian R&D tax credits, a permanent feature of the Canadian tax code. A second study focuses on a Quebecquoise investor credit established a decade ago to encourage local venture capital to the region.

In Evaluating the Impact of R&D Tax Credits on Innovation: A Microeconometric Study on Canadian Firms, Dirk Czarnitzski, Petr Hanel and Julio Miguel Rosa use national survey data to compare firms who claimed the credit with similar firms who did not. Canada offers companies an R&D tax credit of 35 percent for the first $2 million and another 20 percent on any excess amount (see article above for U.S. comparison). Individual provinces provide additional credits so that some companies can write off up to as much as 50 percent of their R&D expenditures. Roughly a third of all companies take advantage of the Canadian R&D tax credit.

Based on econometric modeling, the authors found that R&D tax credits had the following positive impact:

• Canadian firms were more likely to conduct R&D with the credit.
• Tax credit companies increased innovation output in terms of novel inventions, new products and new sales.
• Companies claiming the credit produced more product innovations than firms who did not.

According to the analysis, one-third of the firms taking the credit might not have conducted R&D without the credit. Czarnitzski, Hanel, and Rosa found tax credit recipients were twice as likely to introduce a world-first invention (17 percent versus 8 percent) and were a third more likely to have a unique Canadian product (40 percent versus 24 percent) than the non-credit-taking firms. However, the authors found no significant difference on general performance indicators between the credit recipients and the control group based on analysis of company responses to subjective questions on the national survey.

In the second paper, Cecile Carpentier and Jean-Marc Suret of Laval University analyze the ownership and operating performance of the tax-sheltered investor groups established under a Quebec tax law. In their paper, On the Usefulness of Tax Incentives for Business Angels and SME Owners: an Empirical Analysis, the authors conclude tax incentives for venture capital were not effective in Quebec.

The tax benefits for small business capitalization have failed to deliver its desired results ­ and may only provide tax credits for informal investors related to the venture in some way. The Quebec program appears to benefit “companies with low profitability, most of which disappear after a few years.” Based on their analysis, Carpentier and Suret note that the tax incentives appear to add to market inefficiencies ­ investors can write off such a high level of their investment they are not motivated to actively monitor their investment nor negotiate some element of control.

Carpentier and Suret suggest that tax credits focus on external investors, who might take on the high risk of a new venture that is untried and demand greater controls and accountability from the new enterprise. The authors note the Quebec program actually prohibits any shared risk via convertible shares ­ a contractual arrangement favored by investors in the U.S. In fact, Quebec issued a moratorium on their investor tax credit in 2003 pending a review by the Ministry of Finance.

Editor's Note: An Organisation for Economic Co-operation and Development (OECD) study compared R&D tax relief programs for its member countries, ranking nations in terms of tax relief and style. Canada ranked in the top five for both large and small company relief, while the U.S. came in 10th for large and 13th for small companies. The study notes that the U.S. favors direct funding while Canada uses primarily tax incentives to promote R&D funding. See R&D Tax Incentives: Trends and Issues at http://www.oecd.org/dataoecd/12/27/2498389.pdf

Evaluating the Impact of R&D Tax Credits on Innovation: A Microeconometric Study on Canadian Firms is available at:

www.cirst.uqam.ca/PDF/note_rech/2005_02.pdf.

On the Usefulness of Tax Incentives for Business Angels and SME Owners: an Empirical Analysis is available at: http://d.repec.org/n?u=RePEc:cir:cirwor:2005s-13&r=all.