Dr Margaret Dalziel, associate professor, University of Waterloo and VP Research, The Evidence Network.

Canada needs separate tax credits for R & D

By Dr Margaret Dalziel

Readers of RE$EARCH MONEY know that Canada is plagued by a low level of business expenditures on research and development. This is troubling because investment in the generation of new, knowledge-based products, processes, and services is the means by which firms create offerings that are globally competitive. And there is evidence that Canadian firms are less competitive than they once were, especially in the manufacturing sector, which is more vulnerable to competition from imports than the service sector.

Notwithstanding the fact that some new Internet-based offerings and services can be created without formal or extensive research activities — in sectors such manufacturing, health, and information and communications — investment in R&D remains essential to the generation of new products, processes and services.

Canada is among the few nations that provide the majority of support for business R&D indirectly via tax credits, rather than directly via the transfer of funds to companies or to innovation intermediaries that provide funding or services to companies. Are R&D tax credits effective in spurring firms to increase their investments in R&D?

Many researchers have examined this question and the consensus view is that R&D tax credits have a small positive effect on the propensity of firms to invest in R&D. But this effect can disappear when variables such as firm size are taken into consideration.

Changing the research question, one study examined the effect of R&D tax credits on innovation and economic outcomes and found a positive effect on the former but no effect on the latter. In sum, R&D tax credits may have a positive effect on R&D spending, but that may not translate into firms with greater prospects.

The combination of low business investment in R&D, and high reliance on R&D tax credits that may or may not be effective, has many calling for an alternative approach to business support. Canada needs transformative business support. Transformative business support provides knowledge-based services, sometimes combined with funding, to help firms expand their horizons and networks, generate new knowledge, and adopt new technologies and business practices.

The Ontario Brain Institute, the National Research Council's Human Health Therapeutics Portfolio, the Canadian Light Source, and Communitech offer potentially transformative services to their client companies. Tax credits, though popular, are not transformative.

Where business support is not transformative, it needs to be highly selective and targeted at the small number of Canadian firms that are high performing or have high potential. Such firms may not need advice or services, but we may wish to incent them to grow in Canada as a consequence of their disproportionate contribution to our prosperity, both present and future. Despite the efforts of the Canada Revenue Agency to ensure that R&D tax credits are awarded fairly and wisely, it's not clear that this is happening.

I propose that we split R&D tax credits into tax credits for research and tax credits for development. The two programs would have different objectives and expected outcomes, and the eligibility criteria and terms would vary as well. The research tax credit would aim to generate new knowledge and support knowledge sharing networks. Consistent with the spillover argument for subsidizing private investments, the expected outcomes would be learning that extends beyond the subsidized firm.

To be eligible for research tax credits, the firm would have to demonstrate a capacity for participating in scientific research and the dissemination of research findings. Such a program would appeal to a select group of leading or high-potential firms that aim to advance the state of knowledge, likely in partnership with external collaborators. The terms could be generous.

The development tax credit program would be less selective and less generous. It would aim to support the development of new products, processes, and services in the interests of the competitiveness of the subsidized firm. While knowledge spillovers may occur, they are not the objective. Both technology development and market development activities could be supported.

Of course such a subsidy risks becoming so broad that it may make more sense to abandon it in the interests of lower corporate taxes or investments in infrastructure. But before making that decision, a development tax credit could be evaluated in terms of its effect on firm prospects, relative to its costs.

The benefit of my proposal is that before diminishing the investment in R&D tax credits, we distinguish between the knowledge impacts of subsidized research activities that were the target of the original 1944 tax credit for scientific research, and the economic impacts of subsidized development activities that are more widely distributed.

The economic justification for R&D tax credits is spillovers. Because knowledge spills over to firms in the same or neighbouring industries, the social returns to investments in research exceed the private returns. If spillovers are our objective, we should increase the likelihood of their occurrence by requiring that sponsored research is collaborative and disseminated. But if our objective is more competitive firms, we can weigh the benefits of potentially transformative business support services, development tax credits, investments in infrastructure, and reduced taxes.

The country that takes the boldest step in the revision of R&D tax credits may be the country that is in the greatest need of a better approach. With its large expenditure on R&D tax credits, and its low performance in terms of business R&D expenditures, Canada may very well be that country.

Dr Margaret Dalziel is an associate professor with the Conrad Centre for Business, Entrepreneurship and Technology at the University of Waterloo and VP Research with The Evidence Network.