Tax Incentives for Innovation: A mixed Bag?

• In Event: Innovation and Taxes

Abstract

A strong economic case can be made for public support for research, experimental development, and innovation (R&D). Tax instruments can be effective in stimulating R&D, either through expenditure- (XBR) or income-based (IBR) tax incentive regimes, but interactions are not well understood, and concerns remain about tax avoidance. We use macroeconomic data on 45 advanced economies, mostly in Europe, from 2000-2021 to inform these questions using structural and quasi-experimental methods. Empirical results suggest that both types of regimes have positive impacts on R&D activities, even if they are combined. However, a careful quantitative comparison reveals that the effect of IBRs, though statistically significant, are likely to be much smaller in magnitude: a 1 percent reduction in the user cost through IBRs produces only a 0.002 percent increase in business-funded R&D expenditures, whereas a comparable decrease in the user cost delivered through XBRs is estimated to yield an increase of 0.55 percent in business-funded R&D expenditures. Distinguishing between intensive- and extensive-margin impacts of IBRs, by isolating changes in effective average tax rates and user costs, suggests that intensive-margin effects dominate. Still, income-base tax incentives have been relatively effective in the early 2000s in Europe; since then, their impacts have likely diminished as more and more countries have introduced similar regimes. While the international agreement in 2015 has indeed strengthen the link between income-base tax incentives and R&D activities, it seems unlikely, based on our results, that newly introduced regimes will be as effective as earlier ones, possibly due to first-mover advantages and cross-country heterogeneity.

Authors

• Tibor Hanappi, IMF Fiscal Affairs Department

• Li Liu, International Monetary Fund