Modeling the impact of the R&D tax credit on firms

What is it about?

Purpose – Unlike many areas of economics, there are few models for evaluating the likely effects of subsidies and tax incentives on a firm’s R&D expenditures. This paper proposes a microeconomic model for evaluating the probable effects of increasing levels of R&D tax credits on the employment of R&D resources, with special attention to start-up firms. Design/Methodology/Approach – The model assumes two primary drivers of cost reduction in new technologies: R&D (learning by searching) and production capacity expansion (learning by doing). These are embedded within a model of the firm’s wealth maximizing behavior. Analytical results are obtained by using the model in conjunction with scenarios that assign values to the model parameters. The findings are relevant to applied as opposed to basic R&D. Almost all R&D carried out within industry is applied R&D. Findings – The main findings are as follows: 1) Increasing levels of R&D tax credits have a diminishing effect on start-up firms. Their impact on the employment of additional R&D resources for a start-up firm is one-half to one-third that of an ongoing firm. If leveling the playing field as between ongoing and start-up firms is a worthwhile object, then new incentive models should be developed for start-up firms. 2) R&D tax credits lower the initial optimal pricing of products when they are launched commercially. That, combined with learning by doing, generates a higher level of consumer surplus than would exist without the tax credit. Through this mechanism, tax credits lower the social cost of R&D subsidies such that the net tax subsidy is less than the tax credit awarded to the firm. Originality/Value – The proposed approach should give policy makers a starting framework for evaluating some aspects of public support for commercial R&D. It should provide a basis for further model development.

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