How the government can put R&D tax relief to work

More targeted tax credits to boost business investment in R&D could bring a host of benefits, argues James Coe

James Coe is Associate Editor for research and innovation at Wonkhe, and a partner at Counterculture

The UK has one of the most generous research and development (R&D) tax relief systems in the world but lower than average business investment in R&D. This does not have to be the case.

In last year’s spending review the government announced significant changes to R&D tax relief. Amid wider announcements on tax, Covid-19 recovery, and R&D spending more generally, these proposals received little attention.

However, as we await the details of the full reform package in the forthcoming Finance Bill, currently awaiting its House of Commons report stage in its passage through Parliament, the benefits and pitfalls of R&D tax relief deserve specific attention.

Bluffer’s guide

R&D tax relief is designed to encourage companies to spend more on R&D activity. There are two mains forms of relief, one for smaller and one for larger businesses. Both aim to stimulate R&D activity by providing tax incentives for companies to engage in activity which “advances innovation in areas of uncertainty to research or develop a new process, product or service or improve an existing one.” This scheme has proved popular since its inception over a decade ago and both schemes cost a combined £7.5bn last year.

R&D tax relief has been shown to be effective in generating new innovation activity. In looking at the scheme for large businesses HMRC believes that for every £1 of tax deferred between £2.40 and £2.70 of new R&D expenditure was generated. This does not include any spillover benefits such new employment, investment in buildings, or shared innovations which benefited local economies.

Clearly, cutting taxes for businesses in the hope they do socially useful activity does not hold as a broad principle, but R&D tax relief demonstrates that targeted taxation measures can play a part in stimulating the wider R&D ecosystem.

The R&D tax credit has also changed over time. In the most recent spending review it was announced that this relief will cover data and cloud computing costs. The government has also stated it will look to incentivise more UK based activity. This is because the total of R&D tax relief exceeds the estimated total of private R&D activity carried out in the UK. This is not only a question of equity for taxpayers but also whether the current arrangements are contributing to wider government agendas like levelling up.

Room for improvement

As the government seeks to announce further reforms to the R&D tax relief there are ways in which they could be constructed to deliver greater social benefits.

The government ruled out using a specific R&D tax credit in its freeport programme. This may not be appropriate in every freeport in every part of the country but it is potentially a missed opportunity.

In particular, as the largest risk of freeports is that they displace existing, rather than creating new, activity then a specific R&D tax credits in freeport could encourage more R&D intensive businesses. As I set out in a previous piece for Wonkhe this could both encourage new business and reduce the risk of the movement of large employers if the credit is targeted correctly.

There is also no differentiation for different forms of R&D activity. Regardless of whether a business operates activity aligned to national R&D priorities; whether it is sustainable or not; or where it operates; the rate relief is the same.

Given the enormous challenge of reaching net zero and the contribution of private companies to both R&D expenditure and emissions more generally the government could consider a more generous credit aimed at sustainability activity. This could include both relief on activity which innovates in sustainability and provide a more generous subsidy to sustainable business practices.

Finally, the government should also consider a bonus relief where organisations are collaborating with higher education on innovation projects. NESTA’s Innovation after Lockdown work argues that there is insufficient innovation investment in areas like social care and retail which employ large numbers of people but are not always regarded as being at the forefront of technological investment. A special partnership bonus with approved partners (OfS registered providers) could be a catalyst for new collaborations.

The dual challenges of growing absolute levels of R&D expenditure and meeting national and global R&D policy changes requires a more nuanced relief system. If tax relief reform is to be successful it needs to be both more targeted and incentivise activities which line up behind these aims.

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