Jacek Warda

Rethinking the SR&ED Program

By Jacek Warda

Canada continues to provide one of the most attractive R&D tax environments among the OECD countries. However, our relative advantage is slipping with competitor countries offering tax incentive programs of similar attractiveness. Today, two thirds of OECD countries offer tax incentives for R&D either in form of a tax credit or additional deduction from company taxable income. R&D tax treatment is no longer a distinguishing factor in assessing the attractiveness of a country or region as an investment location.

This suggests that our federal R&D tax incentive program —and provincial programs as well — require careful evaluation with regard to effectiveness, impact and design. The most recent public evaluation of the federal Scientific Research and Experimental Development (SR&ED) program by the Department of Finance took place in 1997 in a completely different environment for business R&D than in 2006.

International evidence suggests that R&D tax incentives do work and help to increase R&D expenditures. But this is a "qualified yes", as most evaluations have concentrated on the level of first-order effects (i.e. firm-based influences on R&D), neglecting assessment of long term impacts on firms and the economy. Given the limitations of the available evidence, the "qualified yes" needs to be looked at with some reservation. In particular, evaluations of fiscal incentives need to be shaped in the context of other innovation policy measures such as direct support. Three steps — Conducting an Evaluation, Assessing the Policy Mix and Strengthening the Incentive — are proposed to ensure future success of Canada's SR&ED program.

CONDUCTING AN EVALUATION

Most importantly, publicly assessing the overall tax system with a view to its impact on innovation is necessary and long overdue. Canada can learn from the efforts of other countries in evaluating its R&D tax incentive schemes. In 2005-6, the European Union (EU) initiated a review of evaluation and design issues pertaining to R&D tax incentives. The EU working group made the following observations:

* Employ an integrated approach using a variety of different methods to understand not only the effects of the measure but also how it actually functions

* Focus on quality of R&D induced and whether this causes improved economic performance of beneficiary firms

* Include broader context of innovation policy, e.g., effects on learning, productivity and standard of living

* Ensure independence of evaluators and evaluations

* Establish an international network to share experiences and examples of good practice in methods for the evaluation of R&D tax incentives

ASSESSING THE R&D-INNOVATION POLICY MIX

As said a decade ago, "Since research and development is just one facet of innovation, financial support to R&D is an incomplete way of encouraging that entire process ... The question therefore arises as to whether the base of the tax credit should be broadened to include, alongside research and experimental development activities, spending on industrial development (and) market development."

What has been done in tax policy over the past 10 years to recognize that innovation is just as important as R&D for the economy and society? The answer is "not much." Canada and most other OECD countries have been reluctant to expand the definition of R&D for tax purposes to include beyond-R&D innovation activities. But there are positive signals. The 2006 federal budget introduced a new tax credit for employers that train new apprentices and a review is underway to explore the merits of expanding its scope.

R&D (as part of the innovation process) is considered to be an "easy" step. Innovative products are often the outcome of R&D but many activities outside R&D contribute to innovation's success. Innovation is then much harder to define than R&D, as are its policy design and support mechanisms. The key is to design and coordinate these policy instruments into a system that effectively promotes business R&D and innovation.

STRENGTHENING THE INCENTIVE

Many observers agree that the best incentive for innovation is to simplify the business tax system and lower the corporate tax income rate. But a significant reduction in corporate tax rates often involves broadening the tax base. The trade-off is that, at some point, some incentives may have to be reduced or eliminated.

There is an opportunity for government to rethink the functioning of the SR&ED program and outline ways for strengthening its fundamentals in order to stimulate private sector R&D. Major change in the system may encompass shifting the policy mix from incentives for R&D to incentives for innovation/commercialization. Or, it could allow some room in the existing SR&ED program for selective innovation activities that normally do not fit the definition of R&D (e.g. market research, corporate training etc.). This may also include aspects of refundability or other forms of extended access to SR&ED tax credits.

ENSURING SUCCESS

Taking on a full fledged evaluation of such a complex issue as R&D tax incentives is expensive and takes time. There is always a risk that, in the meantime, sensible proposals for incremental change will have to wait, get stale or be ignored altogether pending the findings of a lengthy evaluation. But nothing should preclude worthy proposals being accommodated on a temporary basis while the program is evaluated.

From the taxpayer perspective, evaluations that can ensure cost-efficiency of the tax incentives will pay off their cost. We need to remember that the SR&ED program is Canada's largest innovation policy instrument. At nearly $2.5 billion annually it dwarfs all other federal innovation programs. Put simply, it's too large an asset to have it reviewed only once upon a time. A system allowing for more frequent — even continuous — monitoring of the impact may reduce the cost, speed up decision making and improve overall efficiency of the program. In the end, taxpayers want a fine-tuned and cost effective program ready to withstand the 21st century's economic challenges.

Jacek Warda is managing principal of JPW Innovation Associates Inc.

jpwinnovation@rogers.com.