R&D INDIRECT SUPPORT AND THE B-INDEX MODEL APPLICATION FOR SCANDINAVIAN COUNTRIES Markéta Šeligová 1

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1 R&D INDIRECT SUPPORT AND THE B-INDEX MODEL APPLICATION FOR SCANDINAVIAN COUNTRIES Markéta Šeligová 1 1 Slezská univerzita, Obchodně podnikatelská fakulta, Univerzitní nám. 1934/3,73340 Karviná seligova@opf.slu.cz Abstract: The aim of this paper is to evaluate the rate of return on investment research and development using the B-index model in the Nordic countries such as Finland, Sweden and Norway from 1980 to This paper consists of 5 chapters. In the first chapter I would like to point out how science is important in our everyday lives and how important is for the economics but also I would like to show the differences in financing science. The second chapter deals with all the aspects of R&D indirect support, the advantages and disadvantages of the different types of support. The third chapter is devoted to the methodology of the B-index model. The following chapter is devoted to the application of the B-index model to the Nordic countries. The fifth chapter includes a general summary. The B-index model shows that the rate of return on investment R&D was very stable in Finland throughout the whole analyzed period. The highest rate of return achieved Norway but not earlier than in 2001 when the rate of return exceeded 100%. The rate of return in Sweden stabilized after 1992 when the rate of return nearly reached 100%. Significant fluctuations were caused mainly by the volatility of corporate income rates. Keywords: B-index model, indirect support for research and development, response rate, corporate income rate, deductibles, investment JEL classification: H25, O31 1. Introduction Research and development (R&D), including innovation is important for economic growth, competitiveness and growing standards of living. We must pay much more attention to this part of the economy. Every single country finances its R&D in a different way. Some of the countries spend a huge amount of money on its R&D and on the other hand there are other countries that spend less money and therefore they put less emphasis on their research. Research in the developed societies has an irreplaceable position. Science, technologies, innovations are changing and transforming and they are adapting to the current challenges as well as other areas of social life. These new values strengthen the competitiveness of the economy, which also represents one of the government s priorities. According to Peková (2008) important economic variables such as economic growth, unemployment or companies competitiveness are largely dependent on a research and development results. Varadzin (2004) argued that what makes the research and development profitable looks like a temporary monopoly on the market. The good thing for the economy is that if one company innovates and spends its money on R&D, other companies might get inspired and follow such a process. Science and research is becoming a generator of positive externalities. Tax policy is a traditional mechanism through which government influences the cost of private sector R&D. Measuring the effective R&D subsidy should incorporate the relevant rate of corporate income tax; rates of depreciation for different classes of expenditure as well as explicit incentive schemes such as augmented deduction allowances, credits and rebates. The structure of public support to corporate R&D has been rapidly changing over the last decade. Two major developments can be observed in a significant number of countries: On the one hand, public funds for basic R&D performed by universities are increasing and linked via additional stimuli for technology transfer (e.g. grants for collaborative R&D projects) to corporate R&D activities. On the other hand, government R&D policies are increasingly oriented towards market signals and competition in order to minimise the potential distortions in the firm s choice of R&D -583-

2 projects while increasing the overall level of R&D in combination with relatively low compliance costs. This led several countries introduce tax-based R&D incentives in addition to direct subsidies. A growing number of countries support a significant share of private R&D via tax incentives. (Elschner and Ernst, 2008). The aim of this paper is to evaluate the rate of return on investment research and development using the B-index model in the Nordic countries such as Finland, Sweden and Norway from 1980 to This paper consists of 5 chapters. In the first chapter I would like to point out how science is important in our everyday lives and how important is for the economics but also I would like to show the differences in financing science. The second chapter deals with all the aspects of R&D indirect support, the advantages and disadvantages of the different types of support. The third chapter is devoted to the methodology of the B-index model. The following chapter is devoted to the application of the B-index model to the Nordic countries. The fifth chapter includes a general summary. 2. R&D indirect support 2.1 R&D characteristics of indirect support Individual states use direct or indirect ways to support R&D. Direct support is carried out from the budgetary funds through targeted or institutional support. In most cases this support is carried out through grants and subsidies. Indirect support is provided via tax relief and incentives. Individual entities can use their own resources to support R&D. Their range is quite wide and both ways can cooperate quite well together. (Horký, 2013). 2.2 R&D tools of indirect support Various forms of R&D indirect support have been introduced in many European Union countries. Financial instruments of R&D indirect support include various tax incentives and credits, accelerated depreciation, reduction in social security contributions, relief from duties, mechanisms guarantees, soft loans, venture capital support and advantageous lease of state and local infrastructure. These instruments are usually used in small and medium- sized enterprises. Among already mentioned indirect support instruments there are others that may include deductibility of R&D non-investment expenditures from ordinary income tax credit, tax deduction, tax credit, special tax incentives, tax allowances for small and medium-sized enterprises, depreciation policy, support of venture capital, reduction of employers social security contributions, tariff policy to promote research and development, mechanism of guarantees and soft loans. Deductibility of non-investment expenditures on research and development from current income is applied in all EU countries and the OECD area as a non-discriminatory measure for taxpayers. These expenditures use for achieving, securing and maintaining revenues are taxable and they are deductible. Tax credit is a direct reduction of the tax due express in percentage and the enterprises supporting R&D can also use this type of support. This percentage is provided by R&D expenditure volume flat rate in the fiscal year (e.g. Flat rate) or by the rate of increase in expenditure on research and development in the fiscal year (e.g. Incremental rate) compared to the defined period of time or preset base. Enterprises can decrease their profits and at the same time they can decrease their tax bases via R&D tax deductions. The amount is expressed by a certain percentage. Typical examples of such tax deduction are gifts used for financing R&D. it means that enterprises can deduct the whole price of such gift (100%). We are again talking about stimulation of the companies and further investments into R&D. It is very important to apply special tax incentives to support the enterprises to employ new workers in R&D. This support includes: Tax relief to create new jobs in R&D

3 Employers reduction of social security contributions by the employer for the new R&D workers. Support the introduction and the usage of high-tech in business sector. Exemption or reduced tax revenues from the intellectual property sale. Small and medium-sized enterprises that run their businesses in R&D do not have to pay tax for a certain period of time or they can use special tax concessions. The depreciation policy enables accelerated depreciation of capital expenditures on research and development. It is an opportunity to write off 100% of the fixed assets in the first year of using it or write off quite a high amount of money expressed in percentage. Enterprises can also use extraordinary deprecation of tangible fixed assets. Accelerated depreciation helps to buy new innovative scientific instruments and equipment that go through rapid moral amortization therefore they are contributing to maintain a comparable and competitive technical infrastructure. Venture capital can be represented by tax incentives, guarantee mechanisms and direct participation of the state to support science and research. Generally speaking they stimulate greater venture capital investments to support science and research. Venture capital includes exemption from capital revenue, deferred taxes and lower income taxation of shareholders of venture capital (Horký, 2013). Reduction in employers social security contributions leads to the lower social security payments for research and development workers. Customs policy helps to support R&D through exception to customs duties on imported scientific instruments and equipment for research and development. The guarantees mechanisms include guarantees for loans, leasing, shares and capital. The advantage of indirect support may be, for example, support for science and research across the business sector, promoting flexible market allocation of investment in science and research, equal conditions for all entrepreneurs, easier and less expensive administrative compared to direct financing, ensuring stability for businesses while financing science and research, stimulating a broader public interest in science and research funding. The disadvantage of this type of support is for example, the difficult prediction of the impact on tax revenues, the impossibility to address the money to the right place, tax legislation complications by tax support and the risk of abuse. (Müller, 2006). 2.3 R&D tax incentives Countries have introduced the R&D tax incentives at different points in time and have shaped them in various ways. Even for such a generic policy instrument, the specific design, type and number of R&D tax incentives differ substantially across countries. These differences can be divided into three main categories: scope of the policy, including the type of R&D tax incentive and costs covered targeting of specific groups of firms, according to their size, age, region, etc. organization, including administrative practices and generosity The scope of an R&D tax incentive defines how the instrument works conceptually: how the incentive is applied and what type of expenditure and income qualify. R&D tax incentives can be applied in at least four ways: as a tax credit, as an enhanced allowance, by allowing accelerated depreciation, and through reduced rates. The incentive can be volume-based and apply to all R&D activity or it can be incremental and only apply to new R&D activity. The tax benefit can refer to different sorts of R&D expenditures. Usually, an R&D tax incentive applies to specific inputs that are used in R&D processes (incentive base) and requires some degree of novelty for the intended outcome (requirement of novelty). Every scheme might have some particularities, but broadly four approaches can be distinguished: tax credits, enhanced allowances, accelerated depreciation and reduced rates

4 Tax credits (R&D expenditure): tax credit decreases the corporate income tax rate a firm has to pay. Rate can be applied to either corporate tax, payroll tax paid for R&D workers or personal income in case the incentive is targeted to self-employed. Enhanced allowances (R&D expenditure): an enhanced allowance effectively decreases the base amount that is taxed by allowing to inflate the R&D expenditure base. Accelerated depreciation (R&D expenditure): accelerated depreciation scheme permits to depreciate the purchased fixed assets at higher rates in the first year of the asset s life. This allows, therefore, to decrease the overall taxable income in the specific periods. Reduced corporate tax rate (IP income): reduced corporate tax rate on intellectual property income are an outcome related incentive. It reduces the corporate income that firms pay on commercialization of innovative products that are protected by intellectual property rights. R&D tax incentives also differ by the nature of the incentive base. In particular, some of the schemes are related to the income generated by R&D rather than its costs. R&D tax incentives that are based on costs can be targeted to different expenditure sub-categories. They are as follows: R&D costs: this category includes a variety of eligible expenditures. Some countries limit the type of costs and expenditures that qualify as R&D expenditures to machinery and equipment. Other countries restrict the qualifying expenditures to R&D costs that are carried out domestically. R&D wages: incentive is based on wage bill tax (payroll-withholding tax) IP expenditures: this category includes the costs and expenditure for acquiring patents, investments in intangible assets, or the purchase of new technologies R&D and IP expenditures: this is a combination of the first two categories Discretionary: a limited number of countries provide lower corporate tax rates for qualified R&D firms as such IP income: incentive is applied to profits gained from commercialization of products that are protected by intellectual property rights The category R&D costs and expenditures can be divided into different sub-categories. For instance, in some countries only R&D wages are eligible costs, while other countries employ a much broader definition including buildings and overhead costs. (Straathof et al., 2014). 3. The B-index Methodology For determining the rate of return on investment R&D will be used an annual date from 1980 to The period and frequency of observation was subordinated to the availability of the required data. The analysis will be performed using the B-index model. The all variables have been drawn using Thomson (2012) and OECD databases. The B-index model measures the relative attractiveness of R&D tax treatment in the country or region. It is based on well-founded economic theory and designed so that it is easy to apply and capable of including all tax parameters, and can be used as a policy analysis tool. The model is based on the marginal effective tax rate approach. The marginal model is designed specifically to look at the tax burden on income generated by an additional dollar invested in R&D, and to construct an overall measure of the corporate tax burden on marginal R&D investments in different countries. The marginal model provides a useful summary of the main features of business taxation and is effective in making international comparisons. The model includes the following components of R&D cost structure and applicable tax provisions: Current expenditures: wages and salaries of R&D personnel and the cost of materials used in the R&D process. Capital expenditures incurred in R&D: the cost of machinery and equipment (ME) and facilities/buildings (B)

5 Depreciation of capital assets used in R&D: these assets are typically depreciated over the useful life according to two methods. Additional allowances on R&D expenditures: these provisions allow firms conducting R&D to deduct more from their taxable income than they actually spend on R&D. Tax credits: credits are applied against income tax payable. The benefit of the credit can be non-taxable or taxable. Statutory corporate income tax rates. For consistent comparisons, the model measures country B-indexes under constant and uniform technical assumptions. These assumptions include: R&D expenditures are split into current expenses and capital expenses, using an average proportion of 90 per cent and 10 per cent, respectively. Wages and salaries (a component of current costs) are assumed to represent 60 per cent of total R&D expenditures. Capital expenses are divided equally between machinery and equipment (5 per cent), and buildings (5 per cent). Time factor: the B-index model is expressed in present value terms (net return over time). It is assumed that for all the countries compared, the discount rate is constant and holds at 10 per cent. (Warda, 2005). The model does not include taxes and related incentives that do not pertain to corporate income taxation. As such personal income taxes, value added taxes, commodity taxes, property taxes, payroll taxes, taxes on wealth and capital, and grants and subsidies (i. e.positive taxes) are not included. It has to be notes, however, that some of these element can be included in the index provided appropriate information is available an example are direct measures such as grants and subsidies and procurement contracts. (Warda, 2005). Formula for B-index is following: B = 1 A 1 t (1) Where A is the net present discounted value of depreciation allowances, tax credits and other R&D tax incentives available (i.e. after-tax cost), t is corporate income tax rate. In economic terms, the model represents a before tax rate of return on one euro ( 1) of R&D investment in present value. In accounting terms, the B-index formula represents a ratio of the after-tax cost (ATC) of 1 of expenditure on R&D divided by 1 less the corporate income tax rate. The ATC enters the numerator of the B-index equation. It is defined as the net cost to the company of investing in R&D, taking account of all available tax incentives for R&D. Tax incentives lower the ATC of an R&D project. Corporate income tax rates influence the level of ATC, as well. The higher the tax rate the lower the ATC of R&D, which gives an impression that having high corporate income tax rates is beneficial to the firm. To eliminate as much as possible the impact of tax incentives from the impact of the corporate income tax rate, the study applies the measure of the before-tax index. (Warda, 2005). 4. The B-index model application We applied the B-index model to compare the rate of return on investment R&D in Finland, Norway and Sweden. The resulting values are presented in figure no

6 th International Scientific Conference For the calculation were used the following variables: the corporate income rate the tax price of labour related R&D expenses the tax price of machinery and equipment used for the purposes of R&D the tax price of buildings and structures the tax price of other current (non - labour) expenses (these are the same as labour expenses in all countries except where there exist special credits or deductions for wages and overheads or per employee) the tax price for R&D expenditure that applicable to cross border R&D, that is, where the firm undertaking the R&D is domiciled in a different country to the firm which will own the resultant intellectual property. Figure 1. The development of B-index model from 1980 to % 100% 80% 60% 40% Finland Norway Sweden 20% 0% Source: Own elaboration based on data from a study by Thomson (2012) and OECD Figure no. 1 present the development of B-index values from 1980 to Figure no. 1 shows that the rate of return on investment R&D has an alternating trend in Norway and Sweden. In contrast to Finland where the rate of return on investment R&D develops steadily. In case of Norway, the rate of return on investment R&D began to increase from This was caused mainly by corporate income rate decrease and by the tax price of machinery and equipment used for the purposes of R&D and the tax price of buildings and structures decrease. The corporate income rate dropped after 1991 almost by half. After 2001 the rate of return on investment R&D exceeded to 100%. This was caused mainly by the tax price of labour related R&D expenses decrease. Sweden showed substantially alternating trend. After 1984 the value of the B-index began to decline. This was caused mainly by sharp increase in the corporate income rate. The rate of return on investment R&D went up to 80 %. After 1989 the rate of return investment R&D began to rise and went up to 100%. This growth was again driven by changing the corporate income rate. In 1989 the rate decreased almost twice its original corporate income rate

7 th International Scientific Conference The rate of return in Finland throughout the analysed period was almost 100%. It is clear from the figure that after 2002, Norway in research and development reached the highest the rate of return on investment R&D, but with significant fluctuations throughout the analysed period. This was caused mainly by changing in the corporate income rate. The stable rate of return was recorded in Finland due to growth in corporate income rate throughout the analysed period. After 1992 the rate of return on investment R&D has stabilized and reached almost the same values in Finland, Norway and Sweden. This was caused mainly by the same values in corporate income rate after 1992 in Finland, Norway and Sweden. 60% 50% 40% 30% 20% 10% Figure 2. The development of corporate income tax from 1980 to 2006 Corporate income tax 0% Finland Norway Sweden Source: Own elaboration based on data from a study by Thomson (2012) and OECD Figure no. 2 present the development of corporate income tax from 1980 to Figure no. 2 shows that the corporate income tax has an alternating trend in Norway, Finland and Sweden. Sweden had the highest corporate income tax from 1984 to This corporate income tax reached 50%. After 1989 the corporate income tax began to decrease. This corporate income tax decreased to 28%. Norway had the highest corporate income tax from 1984 to This corporate income tax reached almost 51%. After 1991 the corporate income tax began to decrease. This corporate income tax dropped below 30%. In case of Finland, the corporate income tax was decreasing to This rate was 20% in After this year, the corporate income tax began to rise. This corporate income tax was 30%. After 1996, Finland, Sweden and Norway reached the same corporate income tax which was around 30%. These fluctuations in corporate income tax correspond with development values of B-index model. If the corporate income tax decreased, the rate of return on investment R&D rose. It means, that companies reached higher rate of return on investment R&D

8 5. Conclusion The aim of this paper was to evaluate the rate of return on investment research and development using the B-index model in the Nordic countries such as Finland, Sweden and Norway from 1980 to The B-index model measures the relative attractiveness of R&D tax treatment in the country or region. The model represents a before tax rate of return on one euro ( 1) of R&D investment. The B-index model shows that the rate of return on investment R&D was very stable in Finland throughout the whole analysed period. The highest rate of return achieved Norway but not earlier than in 2001 when the rate of return exceeded 100%. The rate of return in Sweden stabilized after 1992 when the rate of return nearly reached 100%. Significant fluctuations were caused mainly by the volatility of corporate income rates. These fluctuations in corporate income tax correspond with development values of B-index model. If the corporate income tax decreased, the rate of return on investment R&D rose. It means, that companies reached higher rate of return on investment R&D. Acknowledgement: This paper ensued thanks to the support of the grant SGS/17/2015 " Financial instruments of public support for research and development in the European Union. Literature [1] Elschner, Ch. and Ernst Ch The Impact of R&D Tax Incentives on R&D Costs and Income Tax Burden. Discussion Paper No [2] Horký, Š. and L. Kouba Financování výzkumu a vývoje v nových členských státech EU a jeho efektivnost. Mendelova univerzita v Brně. Provozně ekonomická fakulta. Zemědělská 1, Brno. [3] Müller, K Inovační výkonnost nových členských zemí EU situace ČR. Politická ekonomie. roč. 54, č. 6, s [4] OECD (1996). Fiscal Measures to Promote R&D and Innovation. Paris, OECD. [5] OECD (1998). Technology, Productivity and Job Creation. Best Policy Practices. Paris, OECD. [6] OECD (2000). STI Outlook 2000: National Policies. Country Response, Korea, OECD. [7] OECD (2002). Frascati Manual 2002: Proposed Standard Practice for Surveys on Research and Experimental Development. Paris, OECD. [8] OECD (2002). Tax Incentives for Research and Development: Trends and Issues. Paris, OECD. [9] OECD (2005). Innovation Policy and Performance a Cross Country Comparison. Paris, OECD. [10] OECD (2006). Science, Technology and Industry Outlook Paris, OECD. [11] OECD (2007). OECD Tax Database. Paris, OECD. [12] Peková, J. et al Veřejná správa a finance veřejného sektoru. 3, přepracované vydání. Praha: ASPI, 712 s. ISBN [13] Straathof B. et. al A study on R&D Tax Incentives. Final Report of the Netherlands Bureau for Economic Policy Analysis, The Hague. [14] Thomson R Measures of R&D Tax Incentives for OECD Countries. Melbourne Institute Working Paper Series. Working Paper No. 17/12. ISSN

9 [15] Varadzin, F. et al Ekonomický rozvoj a růst. Praha: Professional Publishing, 329 s. ISBN [16] Warda, J Measuring the Value of R&D Tax Provisions. A primer on the B-index Model for Analysis and Comparisons. JPW Innovation associates Inc. 5 Pineglen Crescent, Ottawa ON K2E 6X