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Pekka Ylä-Anttila: Do innovation policies call for tax incentives?

"Several OECD countries have in recent years witnessed lively debate on taxation, its grounds and what makes a tax system a “good” system. Many countries have also enacted both general reforms in company taxation and reforms that create particular incentives for innovation activities and entrepreneurship."

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Fiercer tax competition – more tax incentives for research

Several OECD countries have in recent years witnessed lively debate on taxation, its grounds and what makes a tax system a “good” system. Many countries have also enacted both general reforms in company taxation and reforms that create particular incentives for innovation activities and entrepreneurship.

A majority of OECD countries (19 out of 27) have already adopted tax credits boosting research and developments.  Ten years ago such tax incentives were applied in only about a half of all OECD countries. Tax incentives for R&D are part of the overall corpoprate tax system, which in turn plays a key role in the ongoing tax competition between countries and regions.  

Tax incentives in Finland

There are basically two ways of supporting R&D: by direct support aimed at companies and through taxation. There is currently no ongoing tax-based support system for R&D in Finland. The Finnish innovation policies have, however, been deemed successful in many evaluations, and studies have shown that direct R&D support from the public sector (mainly Tekes) has been quite effective, since it has supplemented rather than substituted companies’ own R&D funding.  

Several proposals have been made in Finland to introduce tax incentives for innovation activities (e.g. Sitra’s Competitive Innovation Environment Development Programme and the 2005 and 2006 globalisation reports issued by the Prime Minister’s Office). The Research Institute of the Finnish Economy (ETLA) launched a research project in 2005 on tax incentives as a tool in innovation and entrepreneurship policies. The project has produced six reports which can be downloaded from either Sitra’s or the ETLA’s websites. Publications in the Sitra website »

International studies are virtually unanimous about the positive effect of tax allowances on R&D. They increase the volume of R&D activities slightly more than the amount of the tax concession. Many studies have shown tax credits to be somewhat more effective than direct support, but the differences between the two vary from one country to another – depending on the overall tax and innovation systems. 

Based on surveys carried out both in Finland and internationally, companies consider tax incentives for R&D a viable form of support and believe that they increase the volume of R&D activities. Based on the analysis of Finnish survey data, it seems that small, innovative and growth-oriented firms react more effectively to R&D support. Whether the support comes in the form of a tax incentive or as direct support, is less significant. 

In the international context, the tax incentive instruments in recent years have been mostly targeted at activating venture-capital investments by business angels. These have been expected to promote innovative start-up companies – in other words, competence-based entrepreneurship and growth-oriented entrepreneurship, in particular, which have been seen as a problem area in most European countries. 

There is as yet relatively little research on the effectiveness of tax incentives for venture-capital investments. Based on what we know, it appears that their impact could be significant. Countries that have introduced tax incentives for quite a while now, such as the UK and Ireland, have continued and expanded their use. The most viable form of support seems to be a tax incentive targeted at return on investment (capital gain). This should be paired with the deductibility of losses.  

Should the Finnish system be changed?

Using tax instruments as an incentive for R&D, entrepreneurship, and business angel funding is a complex question that cannot be discussed in isolation from the overall company tax system. 

The Finnish innovation policies have produced positive results. There is no certainty that tax incentives would make them any more effective than they already are. Based on available research, there seems to be little reason to introduce tax incentives for R&D in Finland. In the Netherlands and Norway, which already have adopted tax incentives for R&D and therefore make interesting points of reference for Finland, thorough evaluations on their effectiveness are currently being made and results will be published in 2007. It would be wise to wait for the results of these evaluations. 

Currently the most promising form of tax incentive is to support informal venture-capital investments, because appropriately applied it could solve the very problems that have been identified in the Finnish debate. The drawback of the Finnish innovation system has consistently been identified as the failure of growth-oriented, competence-based start-up companies to attract sufficient funding to make a difference in terms of the national economy and the relatively small size of the Finnish private venture-capital sector. 

Other than that, there really are no bottlenecks in the funding system for Finnish innovations.  

Pekka Ylä-Anttila