In many companies the leading department is the Research and Development (R&D) department, they come up with new ideas which result in technological advantages for the industry and more specifically their clients. These developments typically lead to economic growth on the long run. This is the reason why governments have huge incentives to stimulate businesses and universities in doing more R&D. Back in the year 2000, during the dotcom-bubble the government of the United Kingdom introduced a special tax credit system, alongside already existing direct R&D investments, to enhance corporate R&D investments. But has the government succeeded in stimulating R&D spending? Or to put it more generally: Did the British taxpayer see something back from this funding?
Leading up to the turn of the century the internet started to intensively develop and implemented. It was used as a marketing strategy for companies to hype their business and increase market value. This led to a huge bubble on financial markets. After the dotcom-bubble burst new high-tech initial public offerings (IPO’s) on stock markets around the world were traded less. Investors started to look more at fundamentals of companies that went to the stock market to be publicly listed and traded. This led to a lower amount of new high-tech IPO’s on stock markets overall, especially in the United States and the United Kingdom (Pilbeam & Nagle, 2009). A clear sign that the dotcom-bubble aftermath has led to lower investment and interest in innovative and technological developments.
Several years followed in which technological innovations were quick to overhaul themselves. The 2008-2009 financial crisis followed soon, this time however, evidence showed that companies with higher R&D spending comparatively performed better than ordinary companies during the crisis. During normal times R&D intensive companies tend to perform better than average, this relationship was even stronger during the financial crisis (Lome, Heggeseth, & Moen, 2016). This shows the resilience of R&D-intensive companies and their importance not only economic growth, but their economic stability also proves vital to the economy. The United Kingdom is not particularly known for its ability to innovate. This is also visible on a more macro-perspective, where the UK spends a significantly lower part of their GDP on R&D, stable around the 1.6%, compared to the United States, even below the average R&D spending of the so disputed European Union (see Figure 1).
To boost R&D spending in the United Kingdom, the government implemented a new tax reduction scheme for small and medium sized enterprises (SME’s) in 2001-2002. In this way smaller companies were incentivized to spend more on R&D and thus to stimulate their productivity. The overall rational behind this new policy was to make sure that the UK would maintain a healthy level of economic growth in the future. Economic growth is mainly driven by technological changes which make economies more efficient and increase welfare. From this point of view, it seems rather logical to cut R&D costs for businesses. It should be noted that a special R&D tax policy was already in place before the 2001-2002 change. However, this policy was not leveled in different size structures. The 2001-2002 R&D tax policy change was focused on cutting R&D costs for SME’s even more (see Figure 2). One should think of lowered taxing on employee salaries and energy costs for R&D departments, creating an incentive for business to focus more on R&D.
This new special tax policy to improve R&D was initially focused on small companies with fewer than 250 employees and a 50 million or lower turnover. Over the years this R&D tax policy was altered by the UK government. Since 2008 the threshold to be able to apply to this special regulation was doubled, companies with 500 employees and less than 100 million turnover could also benefit from these extra tax cuts. Companies which initially were too large to apply were suddenly being able to classify as SME in this tax scheme. This resulted in a higher amount of companies being entitled to more generous tax deductions.
Furthermore, the UK has also had policies in increasing the direct investments in R&D. In 2004, the United Kingdom Research and Innovation governmental body set out the ambition to increase R&D to 2.5% of the GDP by 2014. As earlier mentioned, the UK spends around 1.6% of its GDP in R&D since the turn of the century until now. In other words, the ambition of 2.5% was not met by 2014. In 2019 the UK realized that it was under-investing in R&D compared to its competitors, and it fears lacking behind even more. At the moment, the biggest international partners of the UK and leading R&D nations have already accelerated their investment in R&D and have ambitious plans to go even further, shown in Figure 3.
This stimulated policy makers of the UK to set another goal of their own. The UKRI set the ambition to achieve a 2.4% of GDP expenditure in R&D by the time of 2027, also shown in Figure 4. The UKRI wants to increase their spending because it believes that advanced economies will only continue to grow and prosper when innovation delivers a better and more productive economy. The increase in spending will largely end up in private businesses and projects, because it is believed that is the best method of stimulating innovation. Policy makers of the UKRI are also looking further than only the input target of 2.4% of GDP, namely to the destination of the R&D investment so the impact of the investments is maximized. However, the most efficient allocation of R&D funds is still an open question, according to the UKRI.
Economic Theory On Innovation & R&D Expenditure
The reason why innovation, and thus R&D investment, is important for an economy because it creates positive externalities. Benefits of innovation accrue to all, when the direct returns are not always present. Because of this, financers might need to be stimulated to invest in innovation, to make sure that economic growth through innovation takes place. Generally, governments have two types of approaches to choose from for their innovation policy; a neoclassical or a dynamic approach. A government with a neoclassical approach typically provides a framework of conditions for private sector growth, by reducing bureaucracy. Through the invisible hand of the markets, the allocation of capital will be efficient so the allocation of investment will be too, according to supporters of this type of policy. A possible unwanted consequence of this type of policy could be when R&D doesn’t generate results. R&D investments will drop because of this, which in turn creates market failures. A counterpart of the neoclassical approach is the dynamic approach. According to this approach the role of the government is to provide to proper incentives to the private market to innovate and also actively shape and participate in the innovation process. In this case the government is actively choosing industries and projects to invest in, that have the greatest positive externalities for the general well-being. The risk of this is that governments are picking their winners, while the winners of tomorrow are almost impossible to predict (Van Krevel, 2020).
R&D Policy Effectivity
Reflecting on the earlier mentioned economic theory on innovation, it can be concluded that the UK have implemented policy the last twenty years which is a combination of the neoclassical and dynamic approach. The reduction in tax is typically a neoclassical way of policy making, where the influence of the government on the market of R&D is decreased. This shows that the UK has confidence in the efficiency of the market, so that investment capital is allocated efficiently. On the other hand, the UK has expressed twice, in 2004 and 2019, to increase the direct investments in R&D. This is an example of policymaking with a dynamic approach. Both types of policies are aimed at increasing economic growth by creating positive externalities through innovation.
The effectivity of the tax reduction will be analysed. Smaller companies tend react more significantly to R&D cost reductions than larger sized companies. This can be explained by the fact that smaller companies have a higher incentive to innovate to reduce the gap in productivity to larger companies. Large companies have size advantages, smaller companies try to reduce this gap by spending more in R&D. In an analysis by (Bond & Guceri, 2012) it was showed that the main increase in business expenditure on R&D has been almost solely refrained to the high-tech sector, a trench of the manufacturing sector. Other sectors within the manufacturing sector, which accounts for 75-80 percent of R&D-expenditure in the UK, saw almost no increase in R&D-expenditure following the 2001-2002 tax policy. However, the overall R&D-expenditure intensity for this sector was significantly higher (see Figure 5).
A study done by (Guceri & Liu, 2019) compared the difference in R&D spending between newly assigned SME’s and unentitled larger companies. They found that companies which suddenly were able to apply to this tax scheme were spending on average 33 percent more as a result of this generosity. All this was done with a 21 percent tax reduction on R&D user costs. Since a higher R&D-intensity goes along with more economic growth and stability, this proves the overall success of this policy.
Next to the tax reduction policies, the UK have tried to increase the direct investments in R&D since the turn of the century. The goal, set in 2004, was to increase R&D spending from 1.6% to 2.5% of GDP by 2014. This goal was not reached, and far from it. The R&D expenditure of the government was not increased by 2014, and was still the same at 1.6% of the GDP. So this policy horribly failed in its goal. In 2019 the UK have set a similar goal, to increase the R&D spending from 1.6% to 2.4% of GDP by 2027. So it is at the least questionable whether this goal shall be achieved by the time of 2027. The focus of these policies is investing in private firms and industries, and geographically the South-East of England.
The Golden Investor Policy Proposal
At the moment UK’s R&D activity is concentrated in the East of England, South East and London, which are also the wealthiest regions of the UK. The positive externalities that innovation creates, are thus happening in the already wealthiest regions. According to the theory, this will lead to increasingly differences in long-term wealth between these regions and the rest of the UK. It is very questionable whether the UK shall achieve its R&D expenditure targets, but in either way a priority for policy makers should be to invest far more in regions located in other parts than the South-East to decrease long-term inequality. It seems that a dynamic approach in R&D expenditure, is not preferable over a neoclassical approach, because the efficient allocation of investment capital is better determined by the invisible hand than by the hands of policy makers. Policy makers seem to have found a middle way between the two approaches by actively investing in R&D of the private market, which seems to be the vision accompanying the goal of 2.4% by 2027. Nevertheless, the goal of 2.4% seems to be a somewhat shallow goal. There still exist many open questions about the destinations and impact of R&D investments of the government. Without answers about the impact of R&D investments, UK will be picking industries and projects to invest in with a blind-fold on.
Tax reductions for business do not always do well with average income citizen and rightfully so. But it seems that this governmental expenditure has proven to be fruitful. One should always stay critical and be wary, governments tend to overspend. When it is your money being spend, knowing the facts protects you from a misguiding government. However, some of the R&D policies seem to be effective in increasing R&D spending and this time it leads to benefits for the overall economy, so also for you. But the effectivity of the policies have sufficient room for improvement. Maybe it’s good that the United Kingdom leaves the European Union as it slowly turns into a liability.
Bond, S., & Guceri, I. (2012). Trends in UK BERD after the Introduction of R&D Tax Credits. Working Papers.
Guceri, I., & Liu, L. (2019). Effectiveness of fiscal incentives for R&D: Quasi-experimental evidence. American Economic Journal: Economic Policy, 11(1), 266–291. https://doi.org/10.1257/pol.20170403
House of Commons Library (HOCL). https://commonslibrary.parliament.uk/research-briefings/sn04223/. Retrieved on 28-05-20
Lome, O., Heggeseth, A. G., & Moen, Ø. (2016). The effect of R&D on performance: Do R&D-intensive firms handle a financial crisis better? Journal of High Technology Management Research, 27(1), 65–77. https://doi.org/10.1016/j.hitech.2016.04.006
Pilbeam, K., & Nagle, F. (2009). High-tech IPOs in the USA, UK and Europe after the dot-com bubble. International Journal of Financial Services Management, 4(1), 64. https://doi.org/10.1504/ijfsm.2009.026637
UK Research and Innovation (2019). The UK’s 2.4% R&D target. https://www.ukri.org/funding/funding-data/decisions-on-competitive-funding/
Van Krevel, C. (2020). Positive externalities: Innovation, Economic Policy & Public Finance