Tax credit for R&D: What’s the point?

So in National’s tax package they have dumped the R&D tax credit. Businesses seem disappointed – but this isn’t enough information in of itself to tell me whether getting rid of the credit is socially optimal or not.

In order to analyse this we have to think about why an R&D tax credit could be socially optimal and then see whether that scheme actually worked in the appropriate way to increase social welfare.

Let’s give this a go 😉

R&D increases “productivity” so it is good right

This is a popular argument, however it is also one of the most misunderstood.

If R&D expenditure increases “productivity” then the whole benefit of this is captured within the market for the good.  If the increase in productivity reduces the marginal cost of production, then the firm will increase production until the marginal benefit equals the marginal cost.

Now, the firm will want to invest in R&D until the benefit it makes from its investment is equal to the cost.  As a result, if the firm extracts the WHOLE benefit of R&D it will make the socially optimal choice.

Since firms do not extract the whole benefit of production (as consumer surplus also increases in output) we may try to make the case that there is an externality here – however, this is likely to be inappropriate, as Coase bargaining is avaliable.

In this case, the price will adjust to take into account that there is some surplus associated with the R&D process which isn’t captured in the standard competitive process.  This implies that the price will increase such that the market surplus gained from further R&D investment is split between the consumer and producer.

This makes sense as the transaction costs in this case are minimal – we are talking about an externality that exists intra-market, as a result there is a price mechanism which already exists to take account of it.

As a result, I wouldn’t take this as a reason for the R&D credit.

Positive externalities!

This is the kicker – there are positive externalities from some R&D investment.

The positive externality stems from “spillovers” in knowledge between firms.  If one firm invests in R&D then this creates knowledge and ideas that also benefit other firms.  As the individual firm does not take into account the benefit that there research has on other firms we end up with “less” R&D investment than is socially optimal (Note that I am assuming that efficient Coase bargaining solution will not appear – as I think there are sufficient transaction costs to prevent a co-operative equilibrium).

In this case we could use a tax credit to increase the amount of R&D investment towards the socially optimal level – as long as the benefit of this exceeded the cost of raising the funds this would be socially optimal.

However, this isn’t what the scheme was focused on it was looking at all R&D.  Given the poor focus of the package I wouldn’t take this as a reason for the R&D credit.

And competition

Another area where R&D investment can increase social outcomes stems from the competitive environment.

Expenditure on R&D investment is “sunk” when the firm chooses its output level (competes) as a result, the cost of R&D does not impact on its output choice.  However, higher levels of R&D reduce the cost (or increase the revenue) of producing an additional unit.

This reduction in marginal costs (or increase in marginal revenue) allows the firm to be sneaky and “commit” to producing a higher level of output when competition occurs.  If a firm commits it can increase its profit – to the cost of the other firm.  However, if both firms commit, we end up with higher output and lower profits – a situation which brings us closer to the competitive outcome, and as a result leads to greater social welfare.

By reducing the cost of this commitment resource, the government can increase the amount of “commitment” private firms invest in through R&D, pushing us towards the competitive outcome.

Now any gains in this sense will be incredibly small – especially given that the dynamic nature of the competitive process makes it likely that firms will solve the above “prisoner’s dilemma“.  As a result, I wouldn’t take this as a reason for the R&D credit.

Conclusion

So there are multiple channel through which an R&D tax credit can increase social welfare.  However, I haven’t found any of the channels particularly convincing.  As a result, I’m going to stick to my prior belief that the tax credit was a dumb idea to start with.

People believe that things that “increase productivity” are good – however, this view ignores where the benefits of productivity go, and whether there is already a market mechanism that deals with that productivity.

If it was possible to observe the cases where positive spillovers exist then the government may be about to create a tax credit that would increase social outcomes – however, I am not convinced that we are in that case.

Furthermore, if you are wondering why businesses are complaining about missing out on it, think of it this way:  The businesses that were going to invest in R&D anyway would be getting money from taxpayers to do it – of course it is in their interest to say it is a good idea!

  • Agreed. Considering Labour’s monged drafting of other legislation, you’d have businesses encouraged to paint stripes on white elephants and pass them off as zebra, just for the tax credit. Another wishful thought poorly executed. There must be a brighter way of incentivisation.

  • ian reid

    one of the issues about research and development is the scale of enterprise. one issue in new zealand is that firms are often too small to capitalise on innovation, which increases the extent to which r&d is externalised – with greater chance of flow own. This type of incentive changes the risk profile and also creates infrastructure and culture of r&d.

  • Well said, Matt. Despite my tech industry background, I’ve always disliked the R&D credit idea. Likewise R&D grants (from FORST, etc). They are like many other “tax and give back schemes”: not only do they not incentivise (those who don’t already do real R&D aren’t likely to be start or be much good at it, and those who already do real R&D will do so regardless), but also they add bureaucracy and agency costs. The tax credit and the grants have to be administered and processed by both companies and govt.

    The tax holiday to attract companies to transfer here (proposed by Messrs. Skilling and Weldon) is even more dubious. A 2 year tax holiday just isn’t enough to bring a business of scale to NZ (I can’t think of anything of that nature that would work), So what about tax holidays for those who are planning to leave, to encourage them to stay? Do we all threaten to leave, and everyone gets a tax holiday?

    If govts insist on implementing these stupid ideas, I’ll continue to maximise any benefit for my businesses from them. But, being an altruistic and high-minded sort, I much prefer the simpler option: save the deadweight agency costs, save the cost of grants and tax credits, and cut the corporate tax rate accordingly. That will do far more than these tinkering gimmicks.

  • “There must be a brighter way of incentivisation”

    Enforcing property rights and providing information – it is vanilla stuff, but its the best way to run the government.

    “one of the issues about research and development is the scale of enterprise”

    The scale of enterprise is something that is internal to the functioning of the economy. Our scale is limited as our population is small – larger population would lead to more capital investment which would increase scale. There is not much we can do about that – trying to push businesses to invest in increasing scale would be counter-productive if we don’t have the capacity in the first place.

    “If govts insist on implementing these stupid ideas, I’ll continue to maximise any benefit for my businesses from them. But, being an altruistic and high-minded sort, I much prefer the simpler option: save the deadweight agency costs, save the cost of grants and tax credits, and cut the corporate tax rate accordingly. That will do far more than these tinkering gimmicks.”

    Very true!

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