Incentivising business innovation through taxation

Innovation is an essential driver of long-term progress. Whilst economies can generate growth simply by adding more inputs, such as workers, innovating means applying new ideas and technologies that fundamentally improve our goods and services, or make their production more efficient. In a world with limited resources, innovating means getting more ‘bang for our buck’ and is vital in ensuring long-term prosperity.

The argument for government to play an active role in promoting innovation is strong. If a business creates something innovative, this knowledge may ‘spillover’ to other businesses that can also learn from this research. These knowledge spillovers are positive externalities, justifying government intervention to incentivise more innovation. As well as having theoretical justification, government-backed innovation has a good track record. Jet engines, radar, nuclear power, the Global Positioning System (GPS), and the internet were all built on government-sponsored Research & Development (R&D). Whilst it seems clear that government should play a role in promoting innovation, what is less clear is how best it should do so given the wide range of policy levers at its disposal.

R&D tax credits is one such policy lever. The idea is simple – if a business spends money on R&D, it is eligible for a reduction in its corporation tax bill or in, the case of some loss-making SMEs, a cash credit. The idea is also popular – the OECD reported in 2018 that 22 of the 43 countries it examined provided tax relief through tax credits, with a further 14 providing relief in the form of a tax allowance. Most importantly, tax credits are effective – there is a healthy body of empirical evidence that suggests R&D tax credits do lead to increased R&D spending.

For example, a 2016 academic study exploits a 2008 policy reform in the UK which raised the size threshold, in terms of number of employees, under which firms can access a more generous R&D tax credit. The study found a clear increase in R&D and patenting for those firms that became eligible for the better tax treatment, without a significant change for similar firms that remained ineligible. Other studies have also demonstrated the efficacy of tax credits in the UK. HMRC’s 2019 evaluation of the Research and Development Expenditure Credit scheme (RDEC) found that as much as £2.70 of R&D expenditure is stimulated by every £1 of tax forgone. In a 2019 academic paper, tax credits are endorsed as being one of the best policy levers to promote innovation in terms of strength and conclusiveness of evidence.

Overall, it seems there is a strong case for R&D tax credits to play a role in incentivising innovation. However, there remain other important questions for governments to consider when designing effective innovation policy, including:

1. What type of innovation should governments incentivise? In the case of R&D tax credits, governments can change the scope of eligible R&D spending, or adjust the extent of tax deductions, to incentivise different types of innovation. Incentivising spending on specific areas such as green technology can help achieve specific goals, such as net zero, and boosting businesses’ digital capabilities, such as by incentivising data and cloud computing spending, can facilitate more efficient and effective business growth and R&D across the board.
2. Are there any barriers to business uptake of government assistance? Various factors can lead to businesses exploiting government incentives less than they might want to, whether this be a lack of awareness of the system and its complexities, a lack of guidance helping businesses take advantage of the system, inefficient processes or systems that lead to slow utilisation of the incentives, or a perception that the strength of the incentive is not sufficient.

CBI Economics, the CBI’s economic consultancy division, is well placed to carry out research and analysis to help answer questions such as these. Our report for GovGrant built the evidence base on how the UK compares to other countries in driving prosperity from innovation in all stages of the R&D process, identifying several areas for policy development, including developing and expanding the scope of the UK patent box. There is a variety of services that CBI Economics offers that can help uncover actionable innovation policy recommendations, including:

1. Business surveys: Surveying UK businesses of a range of sizes and sectors to understand their views on current UK innovation policy. Such a survey could uncover the key barriers to usage of government assistance, including R&D tax credits.
2. International benchmarking: Benchmarking UK innovation policy against that in other countries to uncover areas of relative strength or weakness. Regarding R&D tax credits, a study could analyse the scope of eligible R&D spending in other countries and/or the extent of tax deductions and benefits associated with such spending.
3. Policy evaluations and impact assessments: Analysing the impact of a change in innovation policy by quantifying impacts in terms of GVA, employment, tax revenue and more, to add to the evidence base for a policy change.
4. Cost-benefit analysis: Quantifying the positives and negatives of an innovation policy or policies to help decide between various options.

CBI Economics’ unique blend of policy awareness, business insight and economics expertise allows us to produce work that resonates with both government and business. If you are interested in commissioning a piece of economic analysis, within innovation or another policy area, please contact us at CBIeconomics@cbi.org.uk.