Governments are often concerned that firms are not conducting enough research and development (R&D). Through the 1990s, the level of business expenditure in the UK in this area, as a percentage of GDP, declined significantly relative to other G5 countries. This was mostly due to a reduction of R&D intensity within manufacturing industries rather than a sectoral shift of activity towards low-R&D sectors.

The UK government is looking to raise the ratio of total (business plus public sector) R&D spending from 1.9 to 2.5 per cent of GDP by 2014. As an indicative scenario towards reaching this target, the government proposes a rise in business R&D intensity from around 1.2 to 1.7 per cent.

R&D tax credits are used in many countries to encourage more innovative activity by business, and two such tax credits for larger firms and small and medium-sized enterprises (SMEs) have recently been introduced in the UK. They aim to reduce firms’ costs of undertaking R&D by allowing them to deduct more than 100 per cent of current R&D expenditure from their taxable profits.

One potential advantage of R&D tax credits compared to other, more direct forms of support for innovative activity is that decisions on where and how to spend are made by firms themselves.

The annual cost of the SME tax credit is estimated to be over £250m. Due to greater-than-expected take-up of the repayable aspect of the credit, this is larger than the initial forecast of £100m a year.

The large firms’ credit was forecast to cost £400m a year. Although there are currently no published figures on the number of claims or actual costs, as with the SME credit it seems likely that the total costs could be significantly higher than forecast (particularly as large firms account for the majority of R&D spending).

In addition, although there are no published numbers on take-up by industrial sector, given that 80 per cent of formal research and development is done in the manufacturing sector, the R&D tax credits are more likely to affect business expenditure in the manufacturing sector than in the service sector.

So is there any evidence that R&D tax credits work? There is evidence from several other OECD countries that they are effective in generating additional R&D, though this evidence suggests that it could take as long as 10 years for the full effects to materialise. Hence it is still too early to evaluate the effectiveness of the UK R&D tax credits.

However, a simple back-of-the-envelope calculation suggests that, even on the most optimistic estimates, the current tax credits will not on their own contribute significantly to achieving the government’s ambition to increase UK business R&D intensity by 2014.

A generous estimate, assuming that all business expenditure on research and development is eligible for relief under the tax credits, and that all companies make sufficient taxable profits to benefit from the credits, suggests that UK tax credits might raise business R&D intensity by up to 0.1 per cent of GDP. This is less than one quarter of the 0.5 per cent of GDP increase that would be required to meet the government target and raise business R&D expenditure to 1.7 per cent.

Laura Abramovsky and Rupert Harrison are
research economists at the Institute for Fiscal Studies