High tax rates on production undercut impact of generous R&D incentives - CD Howe

The benefits of Canada's generous R&D tax credit system are being undercut by high levels of taxation on the production of goods and services, weakening the competitiveness of innovative businesses and resulting in low aggregate R&D intensity. The findings are contained in a new report from the right-leaning CD Howe Institute, which calls for a series of changes to the tax system that include reductions in statutory tax rates.

"Entitled Giving with One Hand, Taking Away with the Other: Canada's Tax System and Research and Development, the report was written by Dr Kenneth McKenzie, a CD Howe fellow-in-residence and an economics professor at the Univ of Calgary. McKenzie argues that the tax structure and high rates that apply to production serve to negate the advantages to businesses that utilize the scientific research and experimental development (SR&ED) tax credit program and associated provincial top-ups.

The report characterizes R&D tax credits as the "pull" to encourage companies to perform more R&D, while low taxes are the "pull" to incent firms to take greater risk. Without the appropriate pull, many of Canada's industrial sectors are reluctant to devote sufficient funding to R&D, resulting in one of the lowest rates of business expenditures on R&D (BERD) in the industrialized world.

McKenzie also takes exception to the structure of the SR&ED tax credit program, which is non-incremental in nature. There is no minimum at which the credit takes effect and it applies to a broad range of eligible R&D spending. In contrast, the US federal tax credit is both less generous, more narrowly focused and incremental. That means firms spend a certain amount before the credit kicks in. Firms accessing the US credit derive far less benefit than Canadian firms do using SR&ED, but US BERD (1.6%) is far higher than Canadian BERD (1.1%). This suggests that lower US taxation on production may hold the key to why businesses south of the border are more innovative.

The report also cites Sweden as a jurisdiction with less generous tax incentives for R&D but dramatically lower taxation rates on manufacturing and services. The result is a BERD rate of nearly 3%, second in the world to Israel.

"High effective tax rates on capital and labour inputs used in the production of goods and services act as a drag on innovative activity by lowering the rewards of R&D," concludes McKenzie. "It might be worthwhile to scale back direct tax subsidies for R&D (as well as) reductions in statutory tax rates - particularly on mobile resources such as capital and skilled labour."

McKenzie's Commentary can be found at www.cdhowe.org

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