Supporting Innovation: Research and Development tax credits

1. Supporting Innovation: Research and Development tax credits James Perry Growth & Enterprise Tax Team

2. Content • Importance of innovation • Rationale for support • Overview of the UK’s schemes • Latest statistics • Evaluation

3. The value of innovation to the UK economy

4. Why does innovation matter to the economy? Five drivers framework: Investment, Skills, Competition, Enterprise and Innovation Innovation is a key driver of productivity and long-term growth A major contributor to innovation and technological progress is expenditure on research and development activity.

5. Why should government intervene to support research and development expenditure?

6. Market failure • Firms tend to under-invest in R&D activity from the point of view of society as a whole. • R&D often generates knowledge that is difficult to appropriate. Thus the benefits of one firm’s R&D activity may be shared by other firms;  Because of these spill-over effects, there is an incentive for each firm in these cases to wait for someone else to invest, and then gain from their investment without committing any cost. Hence, if left entirely to the market, firms may tend to under-invest. • Research by Zvi Gilriches[1]concluded that social returns to R&D were in the order of 40% and about one and a half times the private return. [1]Griliches, Zvi (1992): The Search for R&D Spillovers, Scandinavian Journalof Economics, 94, p24-27

7. Impact of R&D fiscal incentives on R&D spend Country Author Main findings Period of analysis UK and 8 other OECDcountries Bloom et al (2000) A 10 percent reduction in the cost of R&D leads to 1 per cent increase in the level of R&D in the short run, and a 10 per cent increase in the long run 1979-97 UK (Northern Ireland) Harris et al (2006) Own price elasticity found to be –1.36. A 10% decrease in the cost of R&D leads to a 13.6% increase in the level of R&D. 1998-2003 USA Hall (1992) Unit elastic short run responsiveness of R&D to the after-tax price of undertaking R&D. In the short run a 1% decrease in the cost of R&D will increase R&D by 1%. 1980-91 USA Hines (1993) Own tax price elasticity found to vary between –1.2 and –1.8. A 10 % decrease in the user cost of R&D leads to between 12% and 18% of additional R&D. 1984-89 Academic research suggests that a reduction in the cost of undertaking R&D results in an increase in additional R&D activity

8. Further drivers for government intervention National and supranational targets • As part of the Lisbon agenda (2000) to make the EU the most competitive and dynamic knowledge-driven economy in the world, the Barcelona European Council of March 2002 adopted the target of increasing spending on R&D and innovation to 3% of GDP by 2010. • In 2004 the UK Government set an ambition for public and private investment in R&D to reach 2.5% of GDP by 2014. International competitiveness • Historically, UK spending on R&D, as a proportion of Gross Domestic Product, has lagged behind that of many other countries (see chart on next slide).

9. How UK R&D expenditure compares internationally Source: OECD Main Science and Technology Indicators 2009

10. Why intervene through the tax system? • Support is not discretionary or sector based • Support is not capped • Less complexity • Certainty for business

11. The UK’s R&D tax credit schemes

12. There are three separate Research and Development tax credit schemes in the UK • Small and Medium sized Enterprises (SMEs) scheme (2000) • Large company scheme (2002) • Vaccine Research Relief (VRR) scheme (2003)

13. SME scheme Introduced in 2000. Notified to the European Commission as a State aid. In addition to the basic 100% deduction available for revenue expenditure on R&D, companies can deduct an extra 75% of qualifying R&D expenditure. These deductions reduce a company’s corporation tax bill. If a SME is loss-making then it may be able to surrender these losses to HMRC in exchange for a payable credit worth 24.5% of the original qualifying expenditure (14% of the loss surrendered). The losses surrendered cannot exceed the amount of enhanced qualifying expenditure. The EC also allow an enhanced SME definition for the purposes of this scheme. Companies with up to 500 employees and either turnover under €100 million or balance sheet assets under €86 million are eligible. This is effectively doubled in size from the official EU SME definition.

14. Large company scheme Introduced in 2002. Not a State aid. In addition to the basic 100% deduction available for revenue expenditure on R&D, companies can deduct an extra 30% of qualifying R&D expenditure. These deductions reduce a company’s corporation tax bill. No payable credit.

15. Vaccine Research Relief Introduced in 2003. Notified to the European Commission as a State aid. Allows extra relief for R&D expenditure on drugs and vaccines for TB, malaria and AIDS/HIV. Under both the SME and large companies scheme, companies can deduct an additional 40% enhancement of any qualifying research expenditure (on top of the deductions available through the other two schemes).

16. Basic comparison of the schemes

17. Qualifying activities Revenue expenditure (UK already has 100% R&D allowance for capital expenditure) on- • employing staff directly and actively engaged in carrying out R&D, • paying a staff provider for staff provided to the company who are directly and actively engaged in carrying out R&D, • consumable or transformable materials used directly in carrying out R&D (broadly, physical materials which are consumed in the R&D), and • power, water, fuel and computer software used directly in carrying out R&D.

18. Summary • Enhanced deduction reduces the cost of undertaking R&D for companies, incentivising higher levels of R&D activity. • Payable credit recognises that innovative SMEs face particular barriers in gaining access to finance when seeking to undertake R&D activity.

19. The schemes are widely welcomed by business and are seen as adding value to the UK economy CBI (February 2009)- ‘The credit is now an important factor for companies when deciding where to base R&D operations, and it improved the attractiveness of the UK as a destination for high value investment and jobs’.

20. National statistics

21. The latest national statistics show the continued success of the schemes • Since their introduction over 36,000 claims have been made for R&D tax credits with over £3.0 billion of relief claimed, supporting over £32 billion of R&D activity by companies. • In 2006/07, the latest year for which we have statistics, over 6,500 claims were made for R&D tax credits, providing £670 million of support for almost £7.6 billion of R&D activity by companies. • Of these, around 5,000 claims are made under the SME scheme each year, for support of just under £200m, and around 1,500 claims are made under the large company scheme each year, for support of over £400m.

22. Take up- the number of claims has steadily increased Total number of claims received for R&D tax credits by scheme

23. As have the levels of support Total support claimed through R&D tax credits by scheme (£m, accounting period basis)

24. R&D expenditure supported by the schemes has increased year on year Total R&D expenditure used to claim R&D tax credits by scheme (£m, accounting period basis)

25. Evaluation

26. Evaluation • First stage of the Government’s evaluation programme undertaken in December 2005. An independent survey of almost 1,000 R&D performing companies provided encouraging results as to the early impacts of R&D tax credits on R&D activity. • In September 2006 HMRC commissioned an independent feasibility study for the potential econometric assessment of the impact of R&D tax credits on R&D expenditure. The study concluded that, at the time, sufficient data over a sufficiently long time period was not available to enable a robust evaluation of R&D tax incentives in the UK to be undertaken.

27. Evaluation • Government intention to evaluate the schemes’ effectiveness by 2010. • State aid re-notification for SME scheme and VRR by 2013. • Qualitative research work currently out to tender.