Innovation is recognised as a key driver of productivity and long-term growth. It is also instrumental in responding to societal and economic challenges, including those posed by the COVID-19 pandemic. Due to various failures in the market for research and development (R&D), businesses are likely to underinvest in R&D relative to the socially optimal level, in the absence of government intervention (OECD, 2015; Hall, 2019). To foster business R&D investment and innovation, governments adopt a mix of various financial and non-financial measures. Financial support can take the form of direct government funding (e.g. R&D grants, government procurement of R&D services) or of tax incentives that grant preferential treatment to R&D expenditures or to the income derived from R&D and innovation. In OECD countries, expenditure-based R&D tax incentives are the most favoured policy instrument, representing 55% of total government support for business R&D, or around USD 60 billion, in 2018 (OECD, 2021). The role of R&D tax incentives within the business innovation support policy-mix varies across countries, with most countries balancing both direct and indirect forms of financial support (OECD, 2021). Direct funding typically represents a more discretionary and selective form of support, allowing governments to fund specific areas of research that are considered to offer high social returns. Tax incentives, on the other hand, are in principle available to all firms carrying out R&D subject to some pre-defined rules. Generally, this makes them easier and less costly to administer than direct support measures, although administration and monitoring costs could still be substantial. Expenditure-based R&D tax incentives aim at increasing R&D activities by lowering their after-tax cost. The design of these provisions varies widely across countries, making a direct assessment and comparison of the tax benefits derived from R&D tax incentives difficult. Compounding this challenge, the globalisation of the economy has made the fragmentation of R&D activities possible (Galindo-Rueda et al., 2018) by offering firms more flexibility to choose where to locate their R&D functions. This development may strengthen countries’ efforts to attract R&D through policy, including tax policy, thereby further raising the importance of tax policy indicators that allow for an assessment of the cost of R&D that firms face when making R&D investment decisions. Building on the effective tax rate (ETR) framework of Devereux and Griffith (2003), this paper develops a methodology to analyse the effect of expenditure-based R&D tax incentives on firms’ effective tax rates, taking countries’ baseline tax system, i.e., the tax treatment of non-R&D investments, as a benchmark. This extended framework of ETRs for R&D considers a single hypothetical R&D investment with a fixed cost structure where only the baseline tax treatment and preferential tax treatment of R&D varies across countries. The extended framework is applied to derive two sets of synthetic indicators that summarise the impact of all tax provisions (bases and rates) on firms’ tax liability when undertaking R&D investments. The first is the cost of capital for R&D. It measures the required rate of return that a firm would need to break-even after tax, i.e. to yield zero economic profit. This indicator is used to compare decisions at the intensive margin, i.e. how much to invest in R&D at any given location. The second is the effective average tax rate (EATR), which measures the average tax liability on a profitable investment. This indicator is used to compare decisions at the extensive margin, for instance, where (i.e. in which jurisdiction) to locate an R&D site. The two indicators – the cost of capital and the EATR for R&D – are conceptually linked to the established B-Index indicator, the tax component of the cost of capital, and build upon the same modelling of R&D tax incentives. However, they complement and extend the B-Index indicator in two important ways. First, by accounting for additional costs and taxes that firms face when evaluating R&D investments at the intensive margin; and second, by capturing decisions that refer to the extensive margin, such as the R&D location choices of multinational enterprises (MNEs). The first estimates for 2019, presented in this paper, show how expenditure based R&D tax incentives affect the cost of capital and EATRs of large profitable firms in 48 countries. Based on headline tax credit/allowance rates, they provide an upper bound of the generosity of R&D tax relief. The preferential treatment for R&D within countries is measured by the reduction in the cost of capital or the EATR for the R&D investment against a comparable investment that does not qualify for relief. This comparison isolates the preferential treatment provided to R&D by removing the impact of baseline provisions available to other investment types. The results suggest that R&D tax incentives reduce the cost of capital on average by 3.5 percentage points and EATRs by 8.8 percentage points among OECD countries that offer R&D tax incentives in 2019. Across country comparisons show that the most favourable tax treatment provided to R&D differs at the intensive and extensive margins, measured by the cost of capital and EATR for R&D respectively. This result suggests that some countries offer greater incentives for the (re)location of R&D investment while others provide a greater incentive for existing firms already carrying out R&D activities in the country to expand their R&D investments. This study also investigates the sensitivity of results to the use of different shares of current and capital expenditure and the use of different private rates of return to R&D. This variation in the generosity of R&D tax support can be attributed to policy choices and the availability of other support measures among other factors. A seemingly modest generosity of tax relief might simply reflect a country’s preference to use direct funding to promote business R&D. Furthermore, the generosity of tax treatment of R&D, as measured by the cost of capital, EATR or B-Index, may not necessarily reflect one to one the actual cost of R&D tax relief incurred by countries (Appelt, Galindo-Rueda and González Cabral, 2019) or permit any direct conclusions about the effectiveness of tax incentives in stimulating business R&D. Several factors, alongside tax and direct support measures, are considered to be important in the development of an environment that is conducive to R&D and innovation. This includes the availability of a skilled workforce, stable macroeconomic and regulatory conditions, competition and openness to trade, and policies that help overcome various barriers to innovation (e.g., regulatory barriers to competition or insufficient human capital) (Andrews, Criscuolo and Menon, 2014; OECD, 2015; Bloom, Van Reenen and Williams, 2019). González Cabral, A., S. Appelt and T. Hanappi (2021).
