Recent Research: Unravelling the paradox of R&D tax credits

Research and development (R&D) tax credits are a common cornerstone of federal and state innovation policies and are offered to companies in hopes of spurring economic growth. But do R&D tax credits deliver the economic boost policymakers expect? Previous studies addressing this question often focused exclusively on either firm-level data or aggregate economic data. Firm-level studies typically found that R&D tax incentives significantly boost companies' investment in research and development. In contrast, macro-level analyses suggested a more modest impact on overall economic growth.

A recent discussion paper from The Centre for Economic Performance (CEP) at the London School of Economics, How effective are R&D tax incentives? Reconciling micro and macro evidence, seeks to explain the gap between these two types of assessments. Authors Silvia Appelt, Matej Bajgar, Chiara Criscuolo, and Fernando Galindo-Rueda employ a dual approach by analyzing both micro-level data from individual firms and macro-level economic data. This approach allows them to assess how R&D tax incentives influence individual company behaviors and the broader economy and understand the reasons behind the differing conclusions drawn from micro and macro analyses.

The study uses detailed data from individual firms to examine how R&D tax incentives influence the firm’s investment behaviors. This micro-level analysis focuses on R&D expenditure, innovation outputs, and financial performance. Aggregate economic data is analyzed to assess the overall impact of R&D tax incentives on the economy, including examining indicators such as total R&D spending, productivity growth, and economic output. Advanced econometric techniques are employed to control for confounding variables and isolate the causal impact of R&D tax incentives on investment behaviors and economic outcomes.

This work reveals that while individual firms often respond positively to R&D tax incentives by increasing their investment in innovation, this does not always translate into substantial gains at the macroeconomic level. The authors speculate that aggregating data may obscure the nuanced effects observed at the firm level, leading to underestimating the incentives' effectiveness in macro analyses. Also, the benefits of increased R&D investment by individual firms may not fully reach the broader economy, limiting the overall impact. Differences in how firms utilize R&D tax incentives may also lead to uneven effects, with some firms significantly boosting innovation while others show minimal change.

For policymakers in U.S. states, these findings suggest that R&D tax credits can effectively encourage individual firms to invest in innovation, however, the broader economic impact may be limited. To enhance the effectiveness of these incentives, states might consider:

• Targeting small and medium-sized enterprises (SMEs), which often face greater financial constraints and may benefit more from R&D tax incentives than larger firms, possibly leading to increases in innovation activities. For instance, the UK's R&D tax credit plan offers more generous relief to SMEs, recognizing their pivotal role in driving innovation.
• Creating R&D tax credits that are transferable or supplemented with direct grants, innovation vouchers, or support for collaborative research between industry and academia. These complementary measures can address specific barriers that tax incentives alone might not overcome.
• Establishing mechanisms to continuously assess the impact of R&D tax incentives to help identify areas for improvement and ensure that the policies remain effective and aligned with economic goals.
• Promoting partnerships between large corporations and SMEs to facilitate knowledge transfer and amplify the benefits of R&D activities across the economy.

In summary, while R&D tax incentives are a valuable tool for promoting innovation, U.S. states may wish to consider a nuanced approach that includes targeting support to SMEs, implementing complementary policies, and fostering collaboration to maximize the overall economic benefits.