On 28 July 2021 the OECD published on its website tax working paper no 54 entitled Corporate Effective Tax Rates for R&D: The case of expenditure-based R&D tax incentives, written by Ana Cinta González Cabral, Silvia Appelt and Tibor Hanappi.

The paper notes that innovation is an important driver of productivity and of economic growth. There is a tendency for businesses to under-invest in research and development (R&D), owing to deficiencies in the market, and for this reason government intervention is necessary to raise the levels of R&D performed.

Governments use a combination of financial and non-financial measures to encourage firms to engage in more R&D. The financial support can be in the form of direct funding such as grants or government procurement of R&D services; or it can take the form of tax incentives.

Expenditure-based R&D tax incentives are the incentive measure most favoured within the OECD and they represent 55% of total government support for business R&D (around USD 60 billion in 2018). Generally, most countries use a combination of both direct and indirect forms of financial support.

Tax incentives are generally available to all firms performing R&D, and rules are set out as to eligible companies and how the incentives are calculated and given. As they are not selective but are given to all qualifying taxpayers, the tax incentives are easier and less costly to administer than direct support measures. The administration and monitoring costs can however be significant.

The paper notes that expenditure-based R&D tax incentives incentivise R&D by lowering their after-tax cost. The different design of the various provisions offered by governments means that a direct comparison of the tax benefits derived from R&D tax incentives can be complex.

Owing to the globalisation of the economy it is possible for companies to fragment their R&D activities as they have more flexibility to choose where their R&D functions are to be located. This development gives a greater reason for governments to try to attract R&D through tax or other policy measures. It is therefore important for governments to have access to tax policy indicators that permit them to assess the cost of R&D that companies face when they make decisions on investing in R&D.

The OECD working paper has developed a methodology for analysis of the effect of expenditure-based R&D tax incentives on companies’ effective tax rates, taking countries’ baseline tax systems as a benchmark. This method considers a single R&D investment with a fixed cost structure where only the baseline tax treatment and preferential tax treatment of R&D vary across countries. The framework is applied to derive two sets of indicators that summarise the impact of all tax provisions (affecting tax bases and tax rates) on the tax liability of companies making R&D investments, these two indicators being the cost of capital for R&D and the effective average tax rate.

The results of using this methodology indicate that R&D tax incentives reduced the cost of capital on average by 3.5 percentage points and reduced effective average tax rates by 8.8 percentage points in the OECD countries that offered R&D tax incentives in 2019. The results indicate that some countries offer greater incentives for the location of R&D investment, while others provide a greater incentive for companies currently engaging in R&D activities to expand their R&D investments.

Other factors can also be important in creating a favourable environment for R&D and innovation, including the availability of a skilled workforce, stable economic conditions, openness to trade, and policies that help overcome barriers to innovation.