Issues in the design and implentation of an R&D tax credit for the UK

R&D tax credits have become a popular policy tool for encouraging research and development (R&D) spending by business, with many countries offering subsidies of this form. The divergence between private and social rates of return to R&D expenditure by private firms provides one of the main justifications for government subsidies to R&D.2 In order to achieve the optimal level of R&D investment, government policy aims to bring private incentives in line with the social rate of return. An R&D tax credit does this by reducing the cost to the firm of doing R&D. Recent empirical evidence suggests that R&D tax credits are an effective instrument in stimulating additional R&D. However, in order to be desirable, a policy needs to be cost-effective and implementable. This Briefing Note reviews some of the major issues in the design and implementation of R&D tax credits. In Section 2, we briefly discuss the existing tax treatment of R&D in the UK. In particular, we outline the new Research and Development Allowance - which is an allowance for expenditure on plant, machinery and buildings for use in scientific research and which is available to firms of all sizes - and the tax credit for R&D that is available to small and medium-sized enterprises (SMEs). We then discuss, in Section 3, some of the main design features of tax credits that have been implemented in other countries. The discussion mainly concerns the question of how to target new or incremental R&D so as to keep down the total exchequer cost. We discuss problems that arise in defining incremental R&D and how these can be tackled. In Section 4, we provide estimates of the amount of new R&D and the exchequer cost that would be likely to result from implementing different designs of R&D tax credit in the UK. Section 5 concludes. Some technical details are dealt with in the Appendix