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Improving R&D in Canada Through Federal Taxes (2011)

At SREDucation, we’re taking the time to document all of the changes that have occurred to the SR&ED program over the years. In our “From the Archives” series, you’ll be able to see how the program has evolved since its inception in 1986. For a timeline of these events, check out the SR&ED Tax Credit page on Facebook. Stay current with the program by understanding the historical context. 

In 2011, the C.D. Howe Institute issued a report called Rewarding Innovation: Improving Federal Tax Support for Business R&D in Canada. The author, Mark Parsons (a former economist with the Department of Finance), examined what he called Canada’s “troubling” track record in innovation, and what could be done to improve it.

“Canada’s low levels of business R&D have called into question the effectiveness of Canada’s generous R&D tax incentives, particularly the flagship federal Scientific Research and Experimental Development (SR&ED) program,” the report stated.

“A deeper analysis, however, reveals that tax incentives are effective in stimulating more R&D – that is, Canada would have lower levels of business R&D in the absence of these inducements.

“Instead,” the report continued, “the root cause of Canada’s business R&D deficit appears to stem from structural aspects of the economy and, more importantly, a lack of demand-related pressure to pursue innovation.”

This article summarizes the report below.

SR&ED: a Narrow Benefit

Parsons narrowed in on the SR&ED tax credit, saying that there has been a “narrow net benefit” to Canada. But he had some cautions when proclaiming this.

“There is a great deal of uncertainty regarding the size of this net benefit, given the wide range in estimates from the literature, particularly those relating to spillovers. Second, the observation of a net benefit does not imply that the current SR&ED incentives are optimal, or that improvements cannot be made.”

He added that the SR&ED program could become a net loss “in the absence of change.” Indeed, Canada is already showing weakness in the area of multi-factor productivity (defined as increases in labour activity exclusive of growth in physical capital such as equipment, or workforce skills). Canada lags behind the G7 in this metric, the report stated. Further, Canada’s business R&D investment is far below the average of the OECD countries, ranking 20th in a list of 38 nations.

Effectiveness of Government Support

Combined, the provincial and Federal governments spend more than $7 billion annually on R&D grants, with more than half of that going to post-secondary institutions. This puts the nation near the top of OECD nations, the report stated.

Additionally, there are investments in R&D, with SR&ED taking the lion’s share of that. Governments pour $3 billion annually into this tax credit.

“Canada’s sub-par business R&D spending arises despite the fact that the country offers one of the world’s most generous R&D tax regimes,” the report stated.

“This observation has called into question the effectiveness of the R&D tax incentives. While it is tempting at first glance to conclude that Canada’s R&D subsidies are not working, a deeper analysis is required.”

Analyzing the R&D Lag

Items that must be considered when criticizing SR&ED include these factors, the report stated:

  • The business R&D-to-GDP ratio has doubled since the early 1980s;
  • Business spending on R&D might be suppressed because tax incentives lower the cost of it. To increase R&D, demand must increase. Traditional drivers include foreign competition and corporate cultures. On that front, Canadian companies appear to leave innovation aside.
  • Canada has fewer industries with heavy R&D work, such as telecommunications;
  • Canada’s economy includes a substantial number of foreign-owned multinational enterprises, which do a lot of their R&D outside of the country.

When taking into account various costs and benefits, a 2007 federal working paper on SR&ED, quoted in this C.D. Howe missive, said that SR&ED likely generates a net welfare benefit of 11 cents per dollar of subsidy.

“In other words, the additional R&D stimulated by the credit appears to generate a high enough social return to more than offset the costs,” the C.D. Howe report stated, but cautioned that metric is highly dependent on knowledge “spillovers” that spread to the rest of the economy as well as other factors.

How to Increase R&D in Canada

While pointing out that lowering the corporate tax rate and reducing the GST helped with business innovation, the report criticized the tax support system as too “front-end loaded, pushing firms to undertake R&D through upfront subsidies.”

“Meanwhile,” it added, “the rewards from R&D and other innovative activities are taxed, often at rates above many of Canada’s international competitors, creating a disincentive to commercialize, develop and produce new products and services in Canada.”

Some of the report’s recommendations to address the problem include:

  • Tax the “fruits” of R&D labours at a lower rate. “R&D and production are, to some extent, complementary,” the report stated. “The linkages of innovation activity – from R&D to subsequent production – within regions or countries may help explain why pull tax factors are empirically important drivers of R&D activity.”
  • Reconsider Canada’s current method of giving small- and medium-sized enterprises more generous tax incentives over larger firms, as market problems are limited not only to small firms. “The preferential treatment of small firms may have the unintended consequence of encouraging young, innovative firms to stay small and not grow into larger companies,” the report states.

The report concluded by saying that Canada is taking steps towards improving R&D, but it must go further to go head-to-head with its international competitors.

“Overall, it seems that the Federal government’s best bet is to concentrate efforts on creating a competitive tax system across the entire innovation value chain. Innovation is a multi-stage, integrated process that encompasses more than R&D,” the report stated.

“It often starts with the discovery of new knowledge, spreads to the commercialization and adoption of ideas and progresses toward the development of new and improved products, services and processes. Each stage of the innovation chain is important, and this should be reflected in Canada’s tax system.”

This article is based upon a C.D. Howe Institute article: Rewarding Innovation: Improving Federal Tax Support for Business R&D in Canada. The report was written by Mark Parsons, a manager and senior economist at PricewaterhouseCoopers LLP and a former economist with the Department of Finance Canada.

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