An assessment of R&D tax credits and their role towards innovation within Irish industry

The goal of the research and development (R&D) tax credit is to encourage R&D investment by indigenous and foreign-owned firms of all sizes by rewarding qualified research. This tax mechanism offsets against tax liability, because the credits can help companies to increase their cash flow and earnings per share, reduce their effective tax rate, hire more staff, develop new products, and finance other business objectives. R&D tax incentive schemes are widely adopted in advanced economies to promote innovation thus making companies more competitive and productive.

In terms of R&D and innovation, the main justification for public intervention resides in the lack of incentives for private agents to invest, as well as their lack of means (Martin and Scott, 2000). The Organisation for Economic Co-operation and Development (OECD) recognises the fundamental importance of R&D, as defined in its Frascati programme and the scale of opportunity that investment in innovation can bring (Irish Tax Institute, 2015). It is well known that R&D tax policies are written to encourage firms to innovation – a crucial driver of business growth. However, evidence on the effectiveness of tax benefits for innovation is largely anecdotal and the influence of innovation on firm-level taxation is still underexplored, in terms of empirical examination (Gao, et al., 2016).

Economic theory provides a strong justification for government support for R&D, including subsidies and incentives for business research. Without such support, companies are likely to underinvest in research (from the standpoint of the economy), because the results of R&D cannot be fully appropriated by the investing firm (Tyson and Linden, 2012). Economists and other social scientists have demonstrated that the R&D activities of private firms generate widespread benefits enjoyed by consumers and society at large. Thus, the overall economic value to society often exceeds the economic benefits enjoyed by innovating firms, through their research efforts. This excess of the social rate of return over the private rate of return enjoyed by innovating firms is described by economists as a positive externality or spillover.

Knowledge spillovers are likely to result from basic research, but they are also produced by applied research and technology development (Jaffe, 1996). However, despite their best efforts and the benefits of patent protection, firms cannot prevent the knowledge gained through their R&D from leaking out, or spilling over, to other firms. These spillovers occur, for example, as researchers exchange ideas at professional meetings and as they move from firm to firm. More generally, discovery in one firm can trigger new avenues of research, inspire new research projects, or find new applications in other firms (Lester, 2012).

While the market function is to reward commercialisation after intellectual property (IP) development, market failure may still exist, because competitors may reap the benefits of innovation without incurring the costs of development. Despite the presence of R&D tax benefits, one firm’s efforts in bringing an innovation to market can create a spillover effect to firms that did not commit the investment in R&D (Atkinson and Andes, 2011). Apple’s iPad offers an example: despite being protected by patents in the United States (US) and Europe, once the device became popular, similar competing tablets quickly emerged, suggesting that Apple was unable to capture anywhere near all of the returns from its innovation (Jones et al., 2016).

However, innovation is essentially about bringing new ideas to the market. If the purpose of R&D tax incentives is to foster innovation, it is relevant to consider not only what type of R&D costs are eligible, but also whether R&D is primarily intended for true innovation or for learning from other firms (Straathof et al., 2014). The study conducted by Straathof et al. (2014) found that countries that introduced the R&D tax incentives at different points in time shaped them in various ways. Even for such a generic policy instrument, the specific design, type and number of R&D tax incentives differ substantially across countries. These differences can be divided into three main categories:

Scope of the policy, including the type of R&D tax incentive and costs covered.

The amount of additional R&D induced by government support is a key evaluation consideration: all else being equal, the higher the responsiveness to a subsidy, the higher the net benefit (Lester, 2012). More than 20 OECD countries currently support private R&D investments through this type of scheme, including advanced countries and developing economies (non-OECD), such as Brazil, India, China and South Africa (OECD, 2010).

R&D tax incentives, which are tax deductions that firms can claim if they are involved in R&D activities, thus provide companies with an incentive to increase their innovation efforts. Tax credits are typically directed at all firms in the economy and hence allow private agents to decide what type of project to apply for (Castellacci and Lie, 2015). Tax incentives are a market-orientated means of delivering an increase in private R&D expenditure, also allowing firms to avail of the support offered by the credit flexibility to respond to market demand. Tax credits allow expenditure to be directed by market-aware firms, rather than by a centralised authority. While the flexibility of such credits to respond to market demand is useful, it also creates an uncertain and unlimited demand on the Exchequer. Their operation varies between countries but in general, companies can deduct a percentage of eligible R&D expenditure from corporation tax liability (Department of Finance, 2013).

The main economic rationale for using any of these tools rests on the notion that market failures reduce or may even deter private R&D investment. These failures derive mostly from knowledge spillovers and from asymmetric information. This can lead to difficulties is appropriability, through imitation by rivals; asymmetric information between investors and inventors may result in financing constraints (Busom et al., 2014). Although tax credits may provide a stimulus to overall R&D activity, some authors have stressed that they are less suitable than grants to address the sources of market failure, that is, due to the lack of capital to be invested (Czarnitzki et al., 2011). In addition, they are likely to encourage firms to undertake R&D activities resulting in short-term revenues, rather than projects with high rates of social return or long-term exploratory activities (Hall and Van Reenen, 2000). Although there is substantial evidence that R&D tax incentives do increase the amount of R&D investment, there is considerable variation in estimating the intensity of the effects (Evers, 2014).

To coincide with the global studies, the 2016 Department of Finance report on the evaluation of the R&D tax credit has calculated that for each euro in foregone revenue, an additional €2.40 is generated in R&D. This suggests that the policy is achieving its aim of increasing R&D, but with considerable deadweight. Fundamentally, the calculations have shown that roughly 40% of the R&D observed over the period would have occurred anyway, that is, in the absence of the tax credit, while 60% of the R&D observed was due to the tax credit, namely, additional R&D. However, the report does acknowledge that until further work has been undertaken on R&D grants, preferably using a non-self-assessment method, no conclusion can be made on whether the tax credit with 40% deadweight is more efficient than R&D grants (Department of Finance, 2016).

From an Irish context, the R&D tax credit administered by the Irish Revenue Commissioners is open to all companies in Ireland that undertake qualifying R&D activities in Ireland, or within the European Economic Area. During the time frame of this work (pre 2019), the Qualifying R&D expenditure generated a 25% tax credit to offset against corporate taxes. Please note, since this survey and work was assessed from 2017 to 2018 and the time the paper was under review, changes were made in Budget 2020 regarding R&D Tax credits namely an increase from 25% to 30% for micro and small companies.

To achieve such a policy for Ireland, particularly in a base erosion and profit shifting (BEPS) environment, it is important to be clear about the nature of the innovation activities that are carried out in Ireland – both by multinationals and by domestic-based companies (Irish Tax Institute, 2015). A recent Irish Business and Employers Confederation (IBEC) survey (IBEC, 2013) involving 247 firms showed that participation in the tax credit scheme leads to improvements in the R&D process in firms. Almost two-thirds of firms saw an improvement in how they planned R&D activities; 70% improved on the recording of their activities; and 69% improved in the way they retained their R&D-related documentation. Also, the scheme is regarded by most firms as a key element in their decision to invest in Ireland. In several cases, it was noted that without the scheme, the R&D function would be under threat within the country. SMEs and multinationals confirmed that it was an essential part of increasing their productivity, improving offerings for customers, and increasing employment (IBEC, 2013).

With this in mind, the premise of the current work is to look at business expenditure on research and development (BERD), via published data from the Central Statistics Office (CSO) and government agencies, and to consider how the R&D tax credit mechanism has grown with the increase in BERD. In parallel, the views from the survey responders are assessed to reflect the challenges and merits of the R&D tax credit scheme.

This study used several methods in its approach, such as desk research, consultation via a survey, and an interview programme. The desk research reviewed and assessed recent quantitative data from government departments and the CSO, as well as reviewing the relevant national and international literature. Between January and June 2017, interviews with the Department of Business, Enterprise and Innovation (DJEI) and IBEC took place, after which a questionnaire was developed. Subsequently, a survey of Irish firms was conducted, regarding their experience, knowledge and awareness of R&D tax credits. Consultation and guidance were provided by Professor Frank Barry, the DJEI and IBEC.

The research strategy taken used the archival research approach, in order to complement the survey response. This study involved 122 respondents from 438 companies, which gave a 28% response rate. Of these respondents, 38% were from CEO’s, which gives validation to the relevance of this work and its timing. Unless otherwise stated, the values presented below are the percentage values associated with the 122 responses.

As a background to this paper, and to give the reader an appreciation of the level of BERD expenditure, the findings from a 2017 CSO study (CSO, 2017) on business expenditure on R&D between 2015 and 2016 is presented in Table 1. The CSO survey showed that more than €2.2bn was spent on R&D activities by enterprises in Ireland in 2015, with €2.3bn estimated for 2016. A comparison between the 2013–2014 and 2015–2016 CSO findings is also reviewed in Table 1.

As with most R&D projects, there is an associated risk, hence the cost, and to reduce such risk and promote innovation, government incentives such as R&D tax credits are a mechanism by which risky projects can be justified. However, in practice, they can also be used to reduce the corporation tax paid by established companies or to generate cash flow back into smaller or start-up companies. Therefore, the purpose of this finding was to evaluate the trends associated with the R&D tax credits, in order to gain a strategic understanding of the environment. Specific data was collated from several official sources: the information is presented in Table 2 and selected data is graphically presented in Figure 1.

Figure 1

When asked if there was an awareness of the R&D tax credit within their organisation, 95% of those surveyed replied ‘Yes’. It should be noted that there were 101 responses to this question. A breakdown between company groupings is presented in Table 3.

Leading on from this question, companies were asked if they use or continue to use R&D tax credits. The, results including a breakdown of the company size, are presented in Table 4.

When asked if the R&D tax credit has helped to create jobs within their organisation, the following findings emerged, as presented in Table 5. These findings are comparable with a study IBEC carried out in 2013, which looked at R&D employment (see Table 6).

Table 6 shows that dedicated R&D employment in the firms increased during the period from 355 to 2,990, while total employees using some part of their time for R&D rose to 3,016. The difference between the two readings is likely because many companies perform R&D in cross-functional teams, rather than having specific R&D positions, so there are usually more people in R&D-related jobs than dedicated R&D jobs. Total employment in the firms increased from 13,558 in 2003 to 33,898 in 2011.

From the information presented in Tables 1 and 2, there is a noted difference between the R&D active companies versus R&D-active companies claiming the R&D tax credit. As part of this work, it was important to explore the reasons why a company would not avail of a 25% rebate of qualifying R&D expenditure. Selected views from the responders are shown in Table 7 and recommendations to improve the R&D tax credit process from industry are presented Table 8.

In 2015, 1,900 R&D-active firms were registered in Ireland, of which 694 (or 37%) had R&D spend of under €100,000, which was the most popular spend category for manufacturing firms. Therefore, with the establishment of strong reputations in the manufacturing sector, as well as the formation of clusters, the emergence of a strong multidisciplinary approach has lent itself to unpresented growth in innovation within the economy. This is a great indication of the importance of R&D, which lends itself to manufacturing and further innovations. Thus, at a macro level, this is a real indicator of an innovation-led economy.

Looking at the government R&D tax supports that are used to promote innovation, the Department of Finance has calculated that for each euro in foregone revenue, an additional €2.40 is generated in R&D. From an IBEC study involving 247 firms, comments on the impact of the scheme were almost wholly positive and most firms cited its presence as a key element in their decision to invest in Ireland. But, the tax credit scheme is not without its challenges and it is important to note that, after 13 years in existence, there is still confusion surrounding it; and this will have a major influence on the promotion and growth of innovation.

Some of the key findings from this study are: ➢

95% of the respondents said they were aware of the R&D tax credit.

Although there is substantial evidence that R&D tax incentives increase the amount of R&D investment, the estimates from literature vary considerably. In addition, R&D tax incentives may induce R&D investment to be shifted between different locations instead of increasing the overall level of local investment. R&D tax incentives have now become a popular innovation policy instrument and competition is growing between countries to attract investment. These incentives are important for a small and open economy like Ireland, as it maintains a balanced playing field for foreign direct investment inflows and facilitates knowledge transfer from innovative multinationals, with a potential to create cluster spillovers.