Innovation, Competitiveness and the

Role of Fiscal Policies

ISSUES PAPER No. 7

APEC Policy Support Unit

November 2014
Prepared by:

Quynh Le and Tammy Hredzak (Consultant)

Asia-Pacific Economic Cooperation Policy Support Unit
Asia-Pacific Economic Cooperation Secretariat
35 Heng Mui Keng Terrace
Tel: (65) 6891-9600 │ Fax: (65) 6891-9690
Email: [email protected] │ Website: www.apec.org

Produced for:

Asia-Pacific Economic Cooperation

Finance Ministers’ Process

APEC#214-SE-01.14

This work is licensed under the Creative Commons Attribution-NonCommercial-

ShareAlike 3.0 Singapore License. To view a copy of this license, visit
http://creativecommons.org/licenses/by-nc-sa/3.0/sg/.

The views expressed in this paper are those of the authors and do not necessarily represent
those of APEC Member Economies.
 Innovation, Competitiveness and the Role of Fiscal Policies iii

KEY FINDINGS

1. Supporting sustainable economic growth and prosperity in the Asia-Pacific region is

one of APEC's primary goals. To achieve this, and to address the challenges facing
the global economy, APEC members need to place greater emphasis on promoting
research and development (R&D) and encouraging innovation as important pathways
to strengthen the region’s competitiveness, raise labour productivity and address the
effects of changing demographics.

2. Promoting innovation has long been included in APEC’s work agenda, as seen in the
2010 APEC Growth Strategy, the 2011 Honolulu Declaration, the 2012 Vladivostok
Declaration and the 2013 Bali Declaration. As host of APEC 2014, China has also
specified “promoting innovative development, economic reform and growth” as one
of the priorities of the APEC agenda for this year, alongside “advancing regional
economic integration” and “strengthening comprehensive connectivity and
infrastructure development”.

3. The APEC region was sharply impacted by the global financial and economic crisis
that began in late 2008. Labor productivity growth was particularly hard hit,
decelerating to around 82% the expansion rate seen in the previous six years. Despite
some recovery since then, the pace of labor productivity growth in the APEC region
over the past few years has continued to be below its pre-crisis peak. There is a need
now for APEC to restore the rapid growth of labor productivity if the region desires to
reach a higher level of sustainable economic progress.

4. One of the important lessons of the past two decades has been the pivotal role of
productivity gains in the development of APEC economies. Labor productivity gains
have and will become even more critical in many APEC economies, especially as
some face challenging demographic issues. Improving the efficiency of capital and
human resources is vitally important in order to sustainably improve APEC’s labor
productivity and output. Governments can play a critical role in promoting more
efficiency in production by shaping policies to enable firms to continuously innovate.

5. Given the benefits of innovation in improving competitiveness and advancing

economic growth, many economies have recently begun to more actively promote
policies relating to innovation. Such policies range from immigration reform, so as to
encourage greater mobility of highly-skilled workers, to providing strong legal
recourse for patent infringements. There is also a range of fiscal policies that
governments can use to help promote investments in innovation in their economies,
including through direct spending to establish R&D or incubation centers.

6. Another way is through the use of subsidies and tax incentives to influence firms’
decisions to invest in R&D. R&D subsidies and tax incentives can be used to narrow
the gap between the private and social returns. Both types of fiscal policies raise the
expected returns from innovation by reducing the marginal cost of R&D investment.
R&D subsidies, mostly in the form of grants or loans, directly cover a portion of R&D
costs on qualifying projects. R&D tax incentives, such as the deductibility of expenses
relating to R&D from income or from taxes payable, lessen the tax burden for a
iv Key Findings

business. Tax incentives to support R&D can take many different forms, including tax
allowances, tax deductions, super deductions, tax exemptions and tax credits.

7. From an administrative point of view, tax incentives are the least burdensome way of
increasing business R&D and can be used to encourage an increase in R&D across the
whole spectrum of firms. Therefore, if the government’s objective is to increase R&D
intensity among firms from a relatively low level, tax incentives may be the most
sensible approach. Meanwhile, direct subsidies are better suited to encourage higher
risk projects and to meet specific policy goals. If the government’s objective is to
enlarge the R&D capacity within certain fields or R&D milieus, in this case, subsidies
would be the natural choice since it is more difficult to target specific fields or areas
of R&D activities through tax incentives.

8. This report maps out the current R&D subsidies and tax incentives currently offered
in the APEC region. All APEC members offer some type of direct subsidy in the form
of grants or loans in order to help businesses finance R&D projects. Most also have a
defined R&D tax incentive scheme in place. In some APEC economies, there are
multiple R&D incentive packages available, while in others there may be one main
incentive. In most APEC economies, the major tax incentive mechanism is usually a
tax deduction or a tax credit. Some APEC economies do not have a defined R&D tax
incentive scheme, but rely more on grant programs to promote business R&D.

9. Since fiscal support to business R&D is expensive, researchers have attempted to

evaluate their effectiveness in promoting increased private R&D. The tax incentive
scheme initiated in the United States in 1981 is among the most widely studied cases.
The wide variations in the empirical estimations of private price elasticity of R&D –
which measures the percentage change in R&D investment resulting from tax relief
for every percentage change in its after-tax price – is one of the triggers for the debate
on the effectiveness of R&D tax incentives.

10. A careful review of some key studies suggests that the results of empirical evaluations
are sensitive to the methodologies used, the time period being examined, and the
sources of the data. Early studies that were conducted less than five years since the
initiation of the tax incentive scheme tend to report a small price elasticity of R&D,
suggesting that the program has limited impact on firms to carry out extra R&D. On
the other hand, results from later studies that took place more than 10 years after the
program had been initiated found that tax incentives are not only effective in
promoting private R&D spending, but also indicated that the benefits, as measured by
increases in R&D, often outweigh the costs, as measured by foregone tax revenues.

11. The varying results of empirical studies, however, do not provide a justifiable ground
for dismissing the effectiveness of R&D tax incentives. Indeed, the results of earlier
studies were questioned on the basis of the methodological limitations in which the
various studies faced. Additionally, the short time lag between the introduction of the
incentive scheme and the evaluation exercises could also have resulted in lower
estimates of price elasticity as firms often take time to adjust to new schemes. The
results from later studies, which used more reliable and sophisticated evaluation
techniques and which took into account the high adjustment costs, provide a better
understanding of the effectiveness of R&D tax credits.
 Innovation, Competitiveness and the Role of Fiscal Policies v

12. In the APEC region, there does indeed appear to be a positive correlation between
government support to business R&D and BERD intensity, which is defined as the
amount of business enterprise research and development as a share of GDP. Those
APEC members that provide a greater amount of government support typically also
have a higher level of BERD intensity.

13. Some APEC economies, however, provide a substantial amount of government

support, but have a relatively low BERD intensity, underlining the importance of
designing incentives and schemes that are targeted to achieving policy objectives as
well as ensuring that the procedures for businesses to access the incentives are not too
onerous. The effectiveness of R&D tax incentives also depends to a great extent on
the broader regulatory environment and the stability of this environment over time.
Factors include well-functioning financial markets as well as the overall tax system.

14. R&D fiscal incentives and subsidies, while being important, are not the sole factors
influencing firms to undertake innovative activities. Tax regimes in general can also
greatly impact investment decisions, including those involving investments in
innovation, as R&D projects are evaluated for tax efficient outcomes. Although not a
precise indicator, the World Economic Forum's Executive Opinion Survey suggests
that tax systems in many APEC economies may reduce the incentive to invest in those
economies. While the region includes some of the top performers globally, many
APEC members are below the APEC average, indicating that there is significant room
for improvement for many economies.

15. The limited availability of empirical studies evaluating the effectiveness of R&D
subsidies and tax incentives in many APEC economies is a call for further research in
this area. Developing APEC economies are at different stages of technological
development and they possess different institutions and policy frameworks. Future
studies should therefore be fine-tuned to the economic context of developing
economies. APEC can stimulate this shift in research agenda and foster the links
between leading researchers, research institutions, policy makers and research
managers.

16. Despite the plethora of studies on the impact of R&D tax incentives, most of these
studies refer to programs that took place in the 1980s and early 1990s. As such, our
knowledge on recently introduced and redesigned fiscal incentive schemes remains
limited. Further refinement to the methodologies is also important in order to derive
more accurate estimations of the economic costs and benefits of tax incentives. For
instance, the effectiveness of R&D tax incentives has long been evaluated against the
price elasticity or input additionality. These approaches ignore some other benefits
that are brought about by increased innovative activities, such as employment gains
and enhanced social welfare.
vi Table of Contents

TABLE OF CONTENTS

1. Introduction ...................................................................................................................... 1
2. APEC's Competitiveness and Economic Growth ......................................................... 4
3. Fiscal and Taxation Policies in Promoting Innovation: R&D Subsidies and R&D
Tax Incentives in the APEC Region ....................................................................................... 9
A. The Rationale for R&D Subsidies and Tax Incentives .......................................... 9
B. Fiscal Policies to Promote Innovation in the APEC Region ................................ 13
4. Assessing the Effectiveness of R&D Subsidies and R&D Tax Incentives ................. 18
5. Conclusion ...................................................................................................................... 24
Annex: Fiscal and Taxation Policies Relating to R&D in APEC ...................................... 27
References ............................................................................................................................... 36
 Innovation, Competitiveness and the Role of Fiscal Policies 1

1. INTRODUCTION

It has been more than six years since the start of the 2008-09 Global Financial Crisis (GFC).
However, its legacy continues to impact APEC economies. Between 2008 and 2013, APEC
GDP expanded by less than three-fourths of the 4.7% growth rate seen in the six-year period
immediately prior to the crisis. The region’s economic recovery has remained unsteady. In
the first half of this year, APEC output expanded at 3.8%, a touch lower than the 4.1%
recorded in the second half of last year and much lower than had been expected.

This weaker than expected Figure 1. Evolution of the IMF forecasts for APEC GDP
economic performance in growth (%)
the post-GFC period has
effectively placed the APEC
region on a lower projected
medium-term growth path.
Information gathered from
the latest International
Monetary Fund's (IMF)
World Economic Outlook
indicates that the APEC
region is projected to grow
at an average annual rate of
4.2% between 2014 and
2018 (Figure 1). This
represents a marked Note: Figures for 2010 through 2013 are actual growth rates; figures for
downward shift in the 2014 through 2018 are projected growth rates. GDP growth for the APEC
region is a weighted average based on purchasing power parity at constant
growth forecasts of APEC 1980 prices.
output expansion. In Source: International Monetary Fund (IMF), World Economic Outlook
particular, in early 2013, the and APEC Policy Support Unit (PSU) calculations.
IMF had forecast an average
annual growth rate of 5.1% for the APEC region from 2014 to 2018. According to the latest
forecast, APEC GDP over the 2014 through 2018 period will be around USD 5.5 trillion
lower than the amount that had been projected earlier.

APEC is now at a critical juncture in which new policies are needed to bring about
sustainable, equitable and higher medium-term economic growth. APEC recognizes that
enhancing the region’s competitiveness is strategically important in order to achieve the
primary goal of supporting sustainable economic growth and prosperity in the Asia-Pacific
region. APEC economies have increasingly placed an emphasis on encouraging innovation as
an important pathway to strengthen the region’s competitiveness. Innovation has long been
included in APEC’s work agenda, as expressed in the 2010 APEC Growth Strategy, the 2011
Honolulu Declaration, the 2012 Vladivostok Declaration and the 2013 Bali Declaration
(Figure 2). As host of APEC 2014, China has also specified “promoting innovative
development, economic reform and growth” as one of the priorities of the APEC agenda for
this year, alongside “advancing regional economic integration” and “strengthening
comprehensive connectivity and infrastructure development”.
2 Innovation, Competitiveness and the Role of Fiscal Policies

Figure 2. Promoting innovation has been consistently reflected in APEC Leaders'

Declarations
2010 APEC Growth Strategy has displayed commitment
to creating an environment conductive to innovation & APEC 2014 Priorities
emerging economic sectors

Advancing Strengthening
comprehensive
2011 Honolulu Declaration highlighted the importance of regional
connectivity and
open, non-discriminatory trade and investment policies to economic
infrastructure
the implementation of innovative growth strategy integration
development

2012 Vladivostok Declaration expressed the resolve to

give full scope to the role of all APEC mechanisms in
driving innovative growth through closer regional
cooperation Promoting innovative
development, economic
reform and growth

2013 Bali Declaration stated the commitment to

achieving innovative growth through human resource
exchange, infrastructure development and financing loans

Source: APEC.

The significance of innovation in contributing to productivity gains and raising world living
standards can be traced back to the Industrial Revolution. Discoveries such as electrification
and the internal combustion engine radically transformed economies around the world. Many
aspects of modern life, from communications to health, have intrinsically benefited from
advances in technology. Theoretically, the link between innovation and economic growth was
established at least as early as 1776 by Adam Smith. In his seminal book “An Enquiry into
the Nature and Causes of the Wealth of Nations”, he stated:

“All the improvements in machinery, however, have by no means been the inventions of those
who had occasion to use the machines. Many improvements have been made by the ingenuity
of the makers of the machines, when to make them became the business of a peculiar trade;
and some by that of those who are called philosophers of men of speculation, whose trade it
is not to do anything but to observe everything; and who, upon that account, are often
capable of combing together the powers of the most distant and dissimilar objects. And the
progress of society, philosophy or speculation becomes, like every other employment, the
principal and sole trade and occupation of a pajhrticular class of citizens … and the quantity
of science is considerably increased by it.”

Enabling an environment that is conducive to innovation requires a holistic approach, ranging

from developing and maintaining an open economy that allows the flow of capital, people,
ideas, goods and services across borders, to strengthening an institutional framework that
provides effective protection and enforcement of intellectual and industrial property rights.
Many aspects of innovation promotion have been covered by a wide variety of committees
and sub-fora within APEC. Currently, the Economic Committee of APEC is examining best
practices in regulatory reforms to promote innovation in the region. In recognition of the
central role of innovation to the region’s economic growth, APEC established the Policy
Partnership on Science, Technology and Innovation (PPSTI) in 2012. The main role of the
PPSTI is to support the development of science and technology cooperation and effective
innovation policy in APEC economies. Some priority areas of the APEC PPSTI include:
 Innovation, Competitiveness and the Role of Fiscal Policies 3

 fostering an enabling environment for innovation;

 developing innovation policy frameworks;
 strengthening collaboration among APEC members;
 developing science, research and technology cooperation; and
 supporting infrastructure for the commercialization of ideas.

Aside from strengthening the environment to enable innovative activities, there is scope for
public financial policies to influence firms undertaking research and development (R&D).
R&D, which can be defined as “creative work undertaken on a systematic basis to increase
the stock of scientific and technical knowledge, including knowledge of man, culture and
social, and the use of this stock of knowledge to devise new applications” (OECD, 1993) is a
crucial component of innovation and a key factor in developing new competitive advantages.
China, as 2014 Chair of the APEC Finance Ministers' Process (FMP), has highlighted “Fiscal
and Taxation Policies for Economic Restructuring” as one of the four working priorities for
this year.

This issues paper aims to contribute to that priority by examining the role of fiscal and
taxation policies that are related to R&D and the need to sharpen APEC economies’
competitive edge and accelerate the economic restructuring process in the APEC region. The
remainder of the paper is organized as follows. Chapter 2 discusses the role of productivity
gains in APEC’s economic progress. Chapter 3 maps out the current R&D subsidies and tax
incentive schemes that are currently in place in APEC economies. Chapter 4 highlights the
evidence on the effectiveness of R&D subsidies and tax incentives. Finally, chapter 5
provides a conclusion and suggests possible future work on the role of fiscal and taxation
policies in the APEC region.
4 Innovation, Competitiveness and the Role of Fiscal Policies

2. APEC'S COMPETITIVENESS AND ECONOMIC GROWTH

2014 marks the 25th anniversary of APEC’s establishment. Over the past 25 years, APEC
economies have worked together to enhance trade and investment liberalization and
facilitation in the Asia-Pacific region and to promote greater regional integration. When
APEC was first established, there were only three free trade agreements (FTAs) in the region.
By mid-2013, APEC members had signed up to 140 FTAs as well as 800 bilateral investment
treaties (Figure 3). In addition, industrial tariffs have become progressively lower, from an
average rate of 16.9% in 1989 to 5.1% in 2011.

Figure 3. Free Trade Agreements (FTAs) in APEC APEC has also brought
(cumulative number) about significant changes
to global policy and the
economic landscape. It
has upheld the
multilateral trading
system and played an
important role in
concluding the Uruguay
Round negotiations, the
WTO's Trade in
Information Technology
Products Agreement
(ITA), and early harvest
talks of the Doha Round
negotiations held in Bali,
Source: APEC Policy Support Unit (PSU). Indonesia at the end of
2013. Increased economic integration has facilitated cross-border technology and knowledge
transfer which have helped to boost the region’s competitiveness. As explained later in this
chapter, enhanced APEC competitiveness had become the most critical source of economic
gains in the region in recent years.

In the four decades from Figure 4. Employment from 1950 to 2013

the 1950s through the
1980s, APEC economies
enjoyed rapid expansion
in the labor force, brought
about from the baby
boom following World
War II. APEC
employment grew
strongly at a compound
annual growth rate
(CAGR) of 2.3% over
this period, much higher Note: Data for Brunei Darussalam and Papua New Guinea are not available.
than the CAGR of 1.8% Source: The Conference Board, Total Economy Database and APEC Policy
seen in the rest of the Support Unit (PSU) calculations.
world (Figure 4). This demographic development provided an important boost for APEC
growth during this period, especially during the 1970s when the region’s growth was badly
 Innovation, Competitiveness and the Role of Fiscal Policies 5

affected by two major oil

Figure 5. Evolution of APEC GDP growth and the price shocks in 1973 and
contributions from employment and labor productivity 1979. On average over the
period between 1973 and
1989, the rapid growth of
employment accounted for
almost 65% of APEC GDP
expansion (Figure 5). Since
1990, there has been a sharp
drop in the rate of APEC’s
labor quantity expansion,
reflecting the steady decline in
APEC’s population growth
rate since 1970. On average,
APEC’s employment in the
Note: Labor productivity is defined as output per worker. Data for 1990s was growing at half the
Brunei Darussalam and Papua New Guinea are not available. Aggregate pace seen in the previous four
data for the APEC region prior to 1973 also excludes Russia due to data decades. Additionally, many
unavailability.
APEC economies were
Source: The Conference Board, Total Economy Database and APEC
Policy Support Unit (PSU) calculations. affected by the 1997-1998
Asian Financial Crisis which
scaled down the gains in labor productivity. As a result, the pace of output expansion in the
1990s was, on average, only three-quarters the rate achieved during the four previous
decades.

The wide-ranging structural reforms and increased economic integration that gradually took
place in the early 1990s brought about beneficial results to the APEC region in the 2000s. In
some economies, there has been a gradual shift from land-intensive commodities to higher
value-added goods. APEC’s trade rose from 28% of GDP in 1992 to a peak of 50% of GDP
in 2008. More exposure to global competition and global technology appears to have had an
advantageous impact on APEC’s competitiveness. From 2000 to 2007, APEC’s output per
worker rose by more than 31%, from USD 15,325 per worker/per annum to USD 20,103 per
worker/ per annum. In comparison, over the 10-year period between 1990 and 2000, APEC’s
output per worker improved by only 25%. This improved labor productivity contributed to
80% of GDP growth in the APEC region between 2000 and 2007.

The impressive progress in advancing APEC’s competitiveness has made APEC’s

performance clearly stand out from the rest of the world. Despite the fact that APEC’s
employment has been growing at a much slower rate than that of the rest of the world, larger
gains in labor productivity have resulted in GDP growth in the region to consistently
outperform the rest of the world (Figure 6). APEC GDP recorded a compound annual growth
rate (CAGR) of 3.7% between 1980 and 2007, more than a full percentage point higher than
the CAGR for the rest of the world over the same period. As a result, APEC's share of global
GDP rose from under 48% in 1980 to 55% in 2007. Strong economic growth has also
dramatically improved the region’s economic welfare (Figure 7). APEC GDP per capita, in
constant 2013 purchasing power parity (PPP) terms, doubled while that of the rest of the
world improved by less than 30%.
 6 Innovation, Competitiveness and the Role of Fiscal Policies

GDP in APEC and rest of world since 1980 (in 2013 purchasing power parity prices)
Figure 6. GDP Figure 7. GDP per capita

Note: Data for Brunei Darussalam and Papua New Guinea are not available.
Source: The Conference Board, Total Economy Database and APEC Policy Support Unit (PSU) calculations.

However, the APEC region was sharply impacted by the 2008-09 Global Financial Crisis.
APEC’s labor productivity growth decelerated to around 82% of the expansion rate seen in
the previous seven years. Despite some recovery since then, the pace of labor productivity
growth in the APEC region over the past few years has continued to be below its pre-crisis
peak. The deceleration in labor productivity growth occurred against the backdrop of a sharp
slowdown in labor input growth. Indeed, the expansion rate of labor input over the period
between 2008 and 2013 was, on average, the slowest since the 1950s.

The shifting performance of APEC labor productivity growth since 1990 can be explained
using a growth accounting exercise. In particular, the factors contributing to APEC GDP
growth can be decomposed into employment growth (labor utilization) and other immediate
sources of labor productivity. The elements influencing productivity gains include:

 changes in the quality of labor (human capital).

 changes in the rate of capital deepening. Capital deepening, which is the amount of
capital per unit of labor input, measures the increase in capital intensity. In this
analysis, capital services are divided into two broad types. The first is Information and
Communications Technology (ICT) assets which encompass computer hardware,
software and telecommunications equipment. The second classification of capital
services – non-ICT assets – covers investments in dwellings, buildings and structures,
transport equipment and machinery.
 changes in the rate of technological progress or Total Factor Productivity (TFP). TFP
is sometimes referred to as multi-factor productivity or the Solow residual. It is often
used as a measure of technological progress or the contribution from science or
technology. However, in practice, TFP is often calculated as the portion of real output
growth which is not accounted for by increases in inputs of labor (quantity and
composition of labor) and capital (ICT and other capital). Therefore, TFP may capture
progress not only in technology, but also through improvements in organization.
Additionally, its measurement can be affected by other cyclical factors such as
capacity utilization and business cycles.

Figure 8 provides a supply side perspective to understand the drivers of APEC's GDP growth
and labor productivity growth. It shows that the labor productivity gains in the APEC region
across the four 6-year periods since 1990 have been driven by different factors. Since 2000,
improvements in human capital have played a lesser role in labor productivity gains vis-à-vis
 Innovation, Competitiveness and the Role of Fiscal Policies 7

the contribution seen in the 1990s. Over the period between 2002 and 2007, when APEC
recorded significant gains in labor productivity growth, improved production efficiency or
technological progress accounted for more than 43% of this impressive achievement.

Figure 8. Supply side perspective to understand the drivers of APEC’s labor productivity gains
Contributions to GDP growth Contributions to labor productivity gains
(percentage points, cumulative over a period) (proportional to total gains over each period)

Note: Data for Brunei Darussalam and Papua New Guinea are not available.
Source: The Conference Board, Total Economy Database and APEC Policy Support Unit (PSU) calculations.

Despite a significant improvement in 2008, there has still been a marked decline in TFP
growth. On a cumulative basis, TFP growth contributed 3.0 percentage points to APEC GDP
in the six years between 2008 and 2013, less than one-third the contribution made between
2002 and 2007. With the contributions from labor inputs and improved production
efficiencies on the decline, APEC growth has been more reliant on capital deepening since
2008. From 2008 through 2013, the contribution of non-ICT capital to APEC labor
productivity growth was almost double its rate in the preceding six-year period. Investments
in ICT capital, however, were marginally lower since 2008 in comparison with the two
periods from 1996 to 2001 and from 2002 to 2007.

Growth decompositions based on Figure 9. Population aged 65 and over relative to

a supply side perspective provide population aged 15-64 in 2000 and 2050 in selected
some insights into new policy APEC economies (ratio)
challenges for the APEC region.
Among these is the need for
APEC to restore the rapid growth
of labor productivity if the region
is to reach a higher level of
sustainable economic progress.
Labor productivity gains will
become even more critical in
many APEC economies,
especially as demographics will
become less supportive and which
may even become a drag on
growth in some markets. This Source: OECD, 2006.
trend particularly holds true for the APEC region. According to OECD forecasts, by 2050 the
number of people aged 65 and older compared to those aged 15-64 will be more than double
the ratio recorded in 2000 in many APEC economies (Figure 9).
8 Innovation, Competitiveness and the Role of Fiscal Policies

Since 2008, increased capital accumulation has helped to avert some of the decline in output
per worker. Some new capital assets were brought about as a result of government fiscal
stimulus measures that were implemented in response to the 2008-09 Global Financial Crisis
and its aftermath. In many APEC economies, fiscal stimulus packages were unprecedented
in terms of size and coverage. A substantial number of these were dedicated to infrastructure
projects, which helped to increase capital stock. In China, for example, 86% of the fiscal
stimulus package announced in November 2008 – equivalent to USD 586 billion or 13.3% of
GDP – was allocated to infrastructure projects.

In today’s tightening fiscal environment, the ability of governments to maneuver much of the
capital deepening may be restrained. In the short- to medium-term, this momentum can only
be sustained if APEC can mobilize private savings into productive capital investments. It
should be noted that in the longer term, increases in capital input – without increasing its
efficiency – will result in diminishing returns. Nor can the quantity of capital input be
increased indefinitely. Therefore, improving the efficiency of capital and human resources is
vitally important in order to sustainably improve APEC labor productivity and output.
Governments can play a critical role in promoting more efficiency in production by shaping
policies to enable firms to continuously innovate.
 Innovation, Competitiveness and the Role of Fiscal Policies 9

3. FISCAL AND TAXATION POLICIES IN PROMOTING

INNOVATION: R&D SUBSIDIES AND R&D TAX INCENTIVES IN
THE APEC REGION

A. THE RATIONALE FOR R&D SUBSIDIES AND TAX INCENTIVES

The APEC region is undergoing rapid change and becoming increasingly integrated into fast-
evolving regional and global production and knowledge networks. Innovation provides the
region with an additional means to take advantage of increased economic integration by
deepening its capacity to move up the global value chain. The overall picture of improved
labor productivity in the region as discussed in the previous chapter, however, masks an
uneven pace of convergence across APEC economies. Generally, the gap in labor
productivity vis-à-vis output per worker in the United States is larger among developing
economies (Figure 10). Figure 11 suggests that TFP gaps account for the bulk of income and
labor productivity differences across APEC economies. The lower TFP levels in many APEC
economies, relative to that of the United States, suggests significant catch-up potential.

Figure 10. Labor productivity as a percentage Figure 11. Level of Total Factor Productivity
of US labor productivity, 2008 (TFP), relative to the US in current PPP terms

Source: Penn World Table, Version 8.0.

Given the benefits of innovation in improving competitiveness and advancing economic

growth, many APEC economies have recently begun to more actively promote policies
relating to innovation. Such policies range from immigration reform, so as encourage greater
mobility of highly-skilled workers, to providing strong legal recourse for patent
infringements. There is also a range of fiscal policies that governments can use to help
promote investments in innovation in their economies, including through direct spending to
establish R&D or incubation centers. Another way is through the use of tax subsidies and/or
incentives so as to influence firms’ decisions to invest in R&D. Contrary to direct R&D
funding where a dollar increase in government expenditure equals a dollar increase in R&D
10 Innovation, Competitiveness and the Role of Fiscal Policies

activity, the effect of tax subsidies and incentives on influencing private firms to undertake
R&D is more ambiguous. The focus of this chapter is therefore limited to providing an
analysis of subsidies and tax incentives relating to R&D activities across the APEC region.

There are numerous empirical studies supporting the view that R&D is a crucial input for
product and process innovation and an essential investment for an economy’s long-term
growth and competitiveness. Verspagen (1995) estimated the contribution of R&D to
economic growth in a broad sample of sectors and across multiple OECD economies using an
R&D augmented production function. The author found that there is indeed a positive
influence of R&D investment on output growth, especially in high-tech sectors. Another
study by Griliches and Mairesse (1982) used firm-level data to explore the relationship
between R&D and productivity in Japan and the United States. They identified a positive and
substantial impact of R&D on productivity in science-related sectors (elasticity equal to 0.2).
In Chinese Taipei, the productivity of 156 firms over the period between 1994 and 2000 was
studied by Wang and Tsai (2004). They also observed a positive and significant R&D effect
on productivity, with the impact of R&D on high-tech firms being the largest and most
statistically significant.

The rationale for government intervention in promoting R&D is well established. Seminal
studies by Nelson (1959) and Arrow (1962) attributed underinvestment in private R&D to the
imperfect appropriability conditions of new knowledge generated from R&D activities.
Newly discovered ideas, products and knowledge, which are the primary outputs of the
innovation process, have the classic aspect of non-rivalrous goods. The non-rivalry suggests
that once created, innovative output can be beneficial for others without the creator being
able to appropriate it fully. The presence of positive externalities induces a divergence
between the social and private returns of R&D activities. Griliches (1992) empirically
computed the social and private rates of return of R&D investments and found that the social
rates were significantly higher than the private ones. The difficulty in fully capitalizing on
their innovation outputs leads to firms investing less in R&D than would be socially
desirable. In addition to these classical justifications, there are other policy rationales for
public support of private R&D. R&D investments often involve complex and soft
information that is difficult to verify and the outcomes are also uncertain. Information
asymmetries also make it difficult for external investors to correctly assess and efficiently
monitor innovation projects. Therefore, external investors or financial institutions often
impose higher risk premiums for innovation projects. R&D performing firms may be credit
constrained as obtaining Figure 12. R&D expenditure in high-income economies
external bank funding for
R&D can be difficult.

The impact on performance in

research and innovation in the
aftermath of the 2008-09
Global Financial Crisis
provides another call for
government support in R&D.
There is a tendency for
innovative firms to scale back
their R&D expenditures and
investments in risky projects
during times of economic Source: World Bank, World Development Indicators.
 Innovation, Competitiveness and the Role of Fiscal Policies 11

turmoil, a trend confirmed by the OECD (2009). In addition, Archibugi (2013) showed that
companies were decreasing their R&D efforts in the aftermath of the crisis. Meanwhile,
Filippetti and Archibugi (2011) demonstrated that the number of firms that were able to
expand their R&D had dramatically dropped. Figure 12 shows that R&D expenditure in high-
income economies was indeed affected by the recent crisis. In 2011, the ratio of R&D
expenditure to GDP in high-income economies fell by 8.5% from the peak witnessed in 2009.

R&D subsidies and tax incentives can be used to incentivise firms to undertake R&D projects
by narrowing the gap between the private and social returns. Both types of fiscal policies
raise the expected returns from innovation by reducing the marginal cost of R&D
investments. R&D subsidies, mostly in the form of grants or loans, directly cover a portion of
R&D costs on qualifying projects. R&D tax incentives, such as the deductibility of expenses
relating to R&D from income or from taxes payable, lessen the tax burden for a business. Tax
incentives to support R&D can take many different forms and are discussed in Box 1.

Box 1. Definitions of tax incentives commonly used to support R&D

Tax allowance – a sum to be deducted from gross income in the calculation of taxable income.
Tax deduction – a sum to be deducted from taxable income; usually expenses incurred to produce
income and often subject to limitations or conditions.
Super deduction – a sum to be deducted from taxable income that is greater than the amount of
qualifying expenses.
Tax exemption – reduces taxable income like a tax deduction, but often subject to fewer restrictions.
Tax credit – an amount that can be offset against a tax liability.

The key theoretical as well as practical difference between a subsidy as opposed to a tax
incentive is that in the former, an informed government agency can maximize social benefits
by selecting projects that would generate the highest social benefits. An advantage of direct
R&D subsidies is that a public agency can have greater influence on the way R&D projects
are conducted. In particular, in order to maximise knowledge spillovers and the overall
benefit to society, the government can require firms that have received government grants or
loans to collaborate and network within the project. However, a drawback of a direct subsidy
is that its effectiveness depends on who qualifies. In practice, the costs associated with
applying and fulfilling administrative burdens as well as other requirements may prevent
many eligible firms from applying.

In comparison with subsidies, R&D tax incentives are often considered to be more neutral
and market oriented as the decision of allocating R&D investment is placed more firmly on
private companies (Atkinson, 2007). From the firm’s perspective, tax incentives are often
more transparent and predictable. This transparency, combined with lower application and
compliance costs relative to subsidies, makes R&D tax incentives more attractive to a wider
group of firms. A caveat of R&D tax incentives is that private firms would typically choose
projects that generate the highest expected private returns. Only in those cases where the
social and private returns are aligned will R&D tax incentives induce the most socially
optimal projects.

R&D tax incentives are increasingly used throughout the world, including by emerging and
developing economies as they seek to promote R&D investment by both domestic and
foreign companies in their economies. Tax incentives are relatively easy to administer
12 Innovation, Competitiveness and the Role of Fiscal Policies

through the existing tax system and can also be easily altered in terms of size and scope.
R&D tax incentive schemes can therefore be designed according to policy objectives. The
most commonly used incentives are tax deductions or allowances and/or tax credits, although
the structure and implementation of these incentives often varies significantly between
economies. Some of the main considerations when examining the R&D tax incentive scheme
of an economy include the following:
1. eligible industries and/or enterprises: Under most R&D tax incentive schemes, all
businesses in all industries are eligible to claim the incentives, provided that they are
conducting qualifying R&D. However, some economies may wish to promote R&D
investment in targeted industries or areas, such as biotechnology or energy efficiency, and
therefore allow only businesses conducting R&D in those industries to claim the
incentives. Similarly, governments may wish to target specific geographical regions with
incentives offered to businesses establishing themselves in specially designated zones.
Some schemes may also offer enhanced R&D tax incentives with more generous benefits
that can be claimed only by SMEs. Governments may also require pre-approval before
businesses can claim the incentives. This can range from simply stating their intent to
relevant tax authorities in advance, to requiring that businesses go through an approval
process before being eligible to claim the incentives.
2. eligible R&D activities and expenses: Although the definition of R&D differs across
economies, eligible R&D activities generally include those which are systematically
conducted for the purpose of acquiring or applying new scientific and technical
knowledge, thereby developing or improving technologies, techniques, or products and
services. Most tax incentive schemes allow businesses to deduct current expenses only,
such as salary expenditure and materials costs that are directly related to qualifying R&D
activities. Capital expenses such as facilities and buildings and machinery and equipment
used in R&D usually do not qualify for the tax incentives, although some schemes may
allow for accelerated depreciation of some capital expenses. Additionally, some tax
incentive schemes allow companies to claim expenses incurred through offshore R&D
activities.
3. volume basis or incremental basis: Volume-based tax incentives typically allow income
to be reduced by the total amount of qualifying R&D spending in the current tax year.
Some schemes also offer super deductions, under which businesses can deduct an amount
that is even greater than their actual R&D expenses. Governments may elect to limit the
amount of expenses that can be deducted by applying a cap (the amount credited cannot
be greater than a percentage of the company's total tax liability, for example).
Alternatively, some schemes offer tax incentives on an incremental basis, under which the
amount of R&D expenses that can be deducted is based on an increase in research
expenditures above a baseline amount, which could be a percentage of average R&D
expenses in the prior three years, for example.
4. refund or carry forward provisions: For businesses that receive no income or experience
losses in a given tax year, the tax incentive scheme may allow for either a full or partial
refund of the eligible expenses and/or allow that amount to be carried forward and
claimed in tax filings in future years.
 Innovation, Competitiveness and the Role of Fiscal Policies 13

B. FISCAL POLICIES TO PROMOTE INNOVATION IN THE APEC REGION

Since financing for R&D is a vital component to achieving innovation, we have limited our
analysis in this section to a review of the tax incentives and other fiscal policies relating to
R&D across the APEC region. Annex 1 provides an overview of the major fiscal policies
relating to R&D at the federal or central level in each APEC economy, while Table 1
summarizes some of the more common R&D incentives that are currently used in the APEC
region. While all APEC members offer some type of direct subsidy in the form of grants or
loans in order to help businesses finance R&D projects, most also have a defined R&D tax
incentive scheme in place. In some APEC economies, there are multiple R&D incentive
packages available, while in others, there may be one main incentive in the form of a tax
deduction or credit.

Table 1. R&D tax incentives and project financing relating to R&D in APEC, 2014

Source: Compiled by the APEC Policy Support Unit (PSU) using publicly available sources, including domestic
tax authorities and other government agencies as well as information made publicly available by Deloitte, EY
and KPMG.

Some APEC members have recently scaled-back their R&D tax incentive schemes. Although
remaining as one of the most generous schemes globally, Canada recently curtailed its R&D
tax incentive scheme by decreasing the federal tax credit from 20% to 15% and excluding
certain qualifying R&D assets from immediate deduction for tax years ending after 2013.
Australia's 2014-15 Federal Budget, currently under legislation, also reduces the tax credit
rate by 1.5 percentage points. There is also a proposal currently being legislated in Australia
to exempt very large companies (those with aggregate assessable income of AUD 20 billion
or more) from claiming the incentive.

Meanwhile, other APEC members have recently expanded their R&D tax incentive schemes.
Japan, which already has a mature R&D tax incentive scheme providing extensive benefits to
firms conducting R&D, introduced the Asian Business Location Law in 2012. This incentive
allows Japanese subsidiaries of qualifying multinational companies that establish R&D
14 Innovation, Competitiveness and the Role of Fiscal Policies

operations in Japan to deduct up to 20% of income that is attributable to its R&D activities
for the first five years. There are also several emerging APEC economies, such as Chile and
Russia, that view increasing investment in innovation as the key to promoting
competitiveness in their economies. In the past few years, both Chile and Russia have
progressively introduced a wide range of incentives to promote R&D activities in their
economies and to develop hubs of innovation and entrepreneurship.

There are also some APEC members that do not have a defined R&D tax incentive scheme,
namely Indonesia; Mexico; and New Zealand. However, these economies still offer a number
of other incentives in order to promote business investment in R&D. In Indonesia, although
not specifically designed as an R&D tax incentive, businesses conducting R&D are eligible
for various tax incentives under the general tax law as well as under schemes to promote
investment more generally. Meanwhile, Mexico and New Zealand both offer direct subsidies
in the form of grants and other funding schemes for qualifying R&D projects in order to
support the development and commercialization of innovative technologies.

Governments often use a combination of direct spending and tax incentives in order to
support business R&D in their economies. Data from the OECD shows the breakdown in
government spending between
Figure 13. Government support to business R&D in direct spending on business
selected APEC economies, 2011 enterprise research and
development (BERD) and the
amount of indirect support
provided through R&D tax
incentives in selected APEC
economies in 2011 (Figure
13)1. The total amount of
government support to
business R&D, measured as a
share of GDP, as well as the
composition of that support,
varies significantly across
APEC members. Some
Note: Data for Australia and Chile are from 2010; data for China are economies, such as Russia
from 2009. The OECD states that this is an experimental indicator and and the United States, spend
that international comparability may be limited. considerably more on direct
Source: OECD, Directorate for Science, Technology and Industry, funding of BERD than they
Measuring R&D Tax Incentives online data. do on providing indirect
support through R&D tax incentives. In other economies, such as Australia; Canada; and
Japan, the amount of indirect support provided through R&D tax incentives is considerably
higher than that which is directly funded.

As discussed earlier, the structure and implementation of tax incentives can also vary
significantly between economies. Table 2 describes some of the main features of the major
R&D tax incentive in each APEC economy, allowing for a closer examination of the schemes
across the region. In most APEC economies, the major tax incentive mechanism is usually a

1
It is important to note that the R&D incentives offered in an economy, and therefore the amount and
composition of government spending, may have changed since 2011 in order to reflect current policy priorities.
For instance, Russia has gradually reduced direct spending on R&D since 2011 in favor of providing indirect
support through R&D tax incentives.
 Innovation, Competitiveness and the Role of Fiscal Policies 15

Table 2. Features of the major R&D tax incentives in APEC, 2014

Source: Compiled by the APEC Policy Support Unit (PSU) using publicly available sources, including domestic tax
authorities and other government agencies as well as information made publicly available by Deloitte, EY and
KPMG.

tax deduction or a tax credit2. However, in some economies where there is more than one
major incentive offered, an attempt has been made to consolidate the features of the various
incentives for the purpose of this analysis. Additionally, in those economies without a defined
R&D tax incentive scheme, the major fiscal package to promote business R&D, such as a
grant program, is referenced instead.

In nearly all APEC economies, businesses in any industry that are conducting qualifying
R&D activities are eligible to claim the main incentives that are offered. Some economies
also offer additional incentives to businesses operating in targeted industries in order to
strategically develop specific sectors of their economy (e.g., Chinese Taipei). In only a few
2
Please see Annex 1 for more details about the R&D incentives offered in each APEC economy.
16 Innovation, Competitiveness and the Role of Fiscal Policies

APEC economies is the eligibility to claim the main R&D tax incentive limited to businesses
operating in certain industries. Most APEC members also require some form of prior
notification or approval process before businesses can claim the incentives. In general, it is
important that the procedures to apply for R&D funding or to become eligible for an R&D
tax incentive are not too onerous. Otherwise, businesses may be limited in their use of the
incentives if accessing them is too burdensome, particularly SMEs which may often lack the
necessary resources to comply (OECD, 2000).

Examining the structure of major R&D incentives across the APEC region also allows for a
better understanding of the differing levels of generosity of the schemes as well as the policy
objectives behind the incentives. For example, several APEC members, such as Australia;
Canada; Japan; and Korea provide more generous R&D incentives for smaller companies
(e.g., higher tax credit rates than those offered to larger companies) in an effort to promote
R&D investment and innovation by smaller firms. Also, although off-shore expenses relating
to R&D activities conducted abroad are excluded from the incentives in most APEC
economies, some, including Chile; China; Japan; Korea; and Singapore, allow such expenses
to be claimed in an attempt to attract foreign R&D investment in their economies as well as
to build international R&D networks.

Nearly all of the R&D tax incentives offered in the APEC region are based on volume
amounts of qualified expenditure, with six economies offering super deductions and most
also providing relief for some capital expenses. The United States is the only APEC member
with an R&D tax incentive scheme that is based on incremental amounts of spending, while
the incentive schemes offered in Japan and Korea are based on a combination of both volume
and incremental amounts. About half of the APEC members apply some form of a cap to the
amount that can be deducted or credited (or granted in direct funding schemes) in order to
limit the cost of the incentive scheme.

In addition, most APEC Figure 14. Implied tax subsidy rates on R&D
members with an R&D tax expenditures in selected APEC economies, by firm size
incentive scheme allow and profit scenario, 2013
businesses to carry-forward the
allowance if they are in a loss
position in a given tax year.
Although some economies
allow the amounts to be carried
forward indefinitely or until
fully utilized (Australia; Chile;
Malaysia; Singapore), other
APEC members usually set a
limit of 5 years up to 20 years
(Canada and the United States).
Canada and the United States
also offer a carry-back
Note: The implied tax subsidy rate is calculated as 1 minus the B-index,
provision, while Australia and which is defined as the minimum present value of before-tax income
Canada allow small businesses necessary to pay the cost of R&D and to pay the corporate income taxes
to claim a refund of the tax so that it becomes profitable for the firm to conduct R&D. The OECD
credit. Given these provisions, states that this is an experimental indicator and that international
data calculated by OECD comparability may be limited.
Source: OECD, Directorate for Science, Technology and Industry,
indicates the implied tax Measuring R&D Tax Incentives online data.
 Innovation, Competitiveness and the Role of Fiscal Policies 17

subsidy rate on R&D based on firm size and profit scenario for several APEC economies in
2013 and illustrates the more generous treatment of SMEs in Australia; Canada; and Korea
(Figure 14) 3.

3
According to the OECD, the implied tax subsidy rate is calculated as 1 minus the B-index, which is the present
value of before-tax income that a firm must generate in order to cover the cost of an R&D investment and pay
the applicable corporate income taxes. Taking into account provisions in the tax system that allow for special
treatment of R&D expenditures, it therefore reveals the impact of a tax system on private sector decisions to
invest in R&D. It is customary to present this indicator in the form of an implied subsidy rate, or 1 minus the B
Index (1-B Index). More generous R&D tax incentives imply a lower breakeven point for R&D expenditures
and therefore a higher implied subsidy. For example, there is an implied tax subsidy rate of 12% for R&D
expenditures incurred by large, profitable firms in Australia and 18% for those incurred by profitable SMEs.
 18 Innovation, Competitiveness and the Role of Fiscal Policies

4. ASSESSING THE EFFECTIVENESS OF R&D SUBSIDIES AND R&D

TAX INCENTIVES

While it is generally agreed that markets may fail to provide the socially optimal quantity of
R&D as it has some characteristics of a public good, there is also much debate over whether
governments should in fact provide tax support for business R&D, and if so, to what extent.
One of the considerations in providing R&D support is the fiscal cost. Figures 15 through 18
provide stylized presentations on the rationale for R&D support and the costs that accrue to
the government through different fiscal policies. Among the three instruments being
analysed, project-based R&D support is the most cost-efficient. However, criticism of direct
government spending on R&D includes that it may “crowd out” investment from the private
sector. In addition, with direct spending programs it can be difficult to determine whether the
most beneficial projects are actually the ones that receive funding. Due to the intrinsic
uncertainty of knowledge creation, subsidies may not actually be granted to those projects
with the highest spillover gap.

Figure 15. Rate of private R&D investment Figure 16. Cost of volume-based tax incentives
with and without R&D subsidies or incentives to the government

Figure 17. Cost of incremental tax incentives to Figure 18. Cost of project-based R&D support
the government to the government

Note: R&D* denotes the number of projects undertaken by the private sector without any subsides or tax incentives, while
R&D** denotes the number of R&D projects that is socially optimal.
Source: APEC Policy Support Unit, adapted from producer tax subsidy theory.

Worldwide, there has been a trend towards R&D tax incentives. Critics of R&D tax
incentives, however, argue that they create distortions in tax policy and that such schemes can
be expensive for governments. As seen in Figure 16, the costs of providing volume-based tax
incentives are comparably expensive. These programs may transfer a large cost from the
 Innovation, Competitiveness and the Role of Fiscal Policies 19

private sector to the government by supporting pre-existing R&D which would have been
carried out even in the absence of R&D tax credits. Theoretically, incremental R&D tax
incentive schemes, which only subsidize R&D that exceeds a base level, reduces the cost to
governments, provided that the base is defined so as to avoid disincentive effects. However,
the sheer complexity of an incremental R&D tax incentive scheme makes it difficult and
costly to administer. Incremental schemes may also potentially lead to market distortions and
uncertainty among firms. Some studies (Hollander et al, 1987) have found that such schemes
encourage firms to exhibit recycling behaviour in order to maximize the benefits of the tax
incentives.

Given the higher cost of tax incentives to the government, questions are raised as to whether
they are effective in promoting increased private R&D expenditure. One of the most widely
studied fiscal incentive mechanisms is the R&D tax credit scheme in the United States, which
was introduced in 1981. Many researchers have attempted to estimate the tax price elasticity
of total R&D spending, but with disparate results. Table 3 presents a summary of the results
of some of the key studies. At a glance, it appears that empirical evidence concerning the
effectiveness of R&D tax incentives is mixed. Estimations of private “R&D price elasticity”
– which measures the percentage change in R&D investment resulting from tax relief for
every percentage change in its after-tax price – vary significantly.

Table 3. Overview of the literature on the effectiveness of fiscal incentives for R&D

Note: Input additionality refers to the change in R&D spending by per one unit of forgone tax revenue.
Source: Compiled by the APEC Policy Support Unit (PSU).

Einser et al. (1984) concluded that the 1981 tax credit program in the United States had a
limited potential for stimulating R&D expenditure. Their conclusion was echoed by
Mansfield (1986) who assessed the relevance of tax incentives to R&D spending in over 200
firms in Canada, Sweden and the United States using a survey approach. The results showed
20 Innovation, Competitiveness and the Role of Fiscal Policies

that less than 2% of firms reported increases in R&D as a result of tax incentives. These early
studies are at odds with later work by Berger (1993), Hall (1993) and Hines (1991) which
found that the tax price elasticity of total R&D spending during the 1980s in the United States
is on the order of unity or higher. In other words, these later studies found that the 1981 tax
incentive scheme in the US effectively produced roughly a dollar-for-dollar increase in
reported R&D spending. These studies also estimated the additionality effect and suggested
that the benefits to society could, in some cases, be two or three times larger than the cost of
R&D4. Hall (1993), for example, used data from over 1,000 manufacturing firms in the
United States between 1981 and 1991 and found that tax credits had been successful in
increasing private R&D investment. It was also estimated that firms increased their R&D
spending by around USD 2 billion at an annual cost of around USD 1 billion in forgone tax
revenue, a ratio of 2 to 1.

The disparate findings on the effectiveness of the R&D tax credit scheme in the United States
can be attributed to many factors, including differences in methodologies and different data
sets and sample sizes. One common thread among the evaluations in the 1990s is that the data
from US firms was extracted from Compustat, a relatively comprehensive dataset. In
contrast, earlier studies that were conducted in the 1980s had limited data sources available,
e.g. internal tax data, surveys and interviews. Additionally, there are doubts about the
robustness in the methodologies used in some studies. For example, the results obtained by
Eisner were questioned on the ground that the R&D equation appeared to be mis-specified
and that it did not contain any variable to capture the effect of the tax credit. Similar critiques
were also raised on McCutchen’s study of large pharmaceutical firms in the United States
(1993), which also found a low tax price elasticity of R&D.

Finally, estimation results appear to be highly sensitive to the time lag between the
implementation of a policy measure and the evaluation of its impact, with the earlier studies
having been conducted following a rather short period of time. It might be the case that it
takes some time for firms to adjust their R&D spending to the new tax incentive scheme due
to the presence of adjustment costs that firms incur when increasing their investment in R&D
(e.g., the hiring of scientists and engineers). Therefore, in the initial years following the
introduction of a new or enhanced tax incentive scheme, the response from firms can be
weak. Evidence from a wide range of econometric studies confirms that the responsiveness of
investment to prices is lower in the short run than in the long run (Rao, 2013).

One should be cautious in interpreting the large estimates of price elasticity of R&D,
however. There is a tendency that once firms learn about the tax incentives, they will shift
expenses around in their accounting in order to maximize the portion of R&D that can qualify
for the tax reduction. Whereas prior to the preferential treatment, firms may be indifferent
about labelling expenditures as R&D or classifying them as any other outlays. This
phenomenon, which is known as “relabelling”, may lead to a spurious increase in reported
R&D. Some studies, including Hall (1995) and Mansfield (1986), however, suggest that the
incidence of this is relatively small, particularly in the long-term.

Outside of the United States, empirical studies on the impact of R&D tax incentives on other
APEC members are limited to a few advanced economies. Czarnitzki et al. (1999)

4
The input additionality of R&D tax incentives refers to the amount of R&D investment increases for every
dollar foregone in tax revenues. It is measured by dividing the amount of R&D generated by the R&D tax
incentives by the net tax revenue loss. An estimation of input additionality larger than one implies that tax
incentives boost private R&D expenditure at an amount larger than the foregone tax revenues.
 Innovation, Competitiveness and the Role of Fiscal Policies 21

investigated the effectiveness of the tax incentive scheme in Canada, but from a different
angle. The authors looked at the impact of R&D tax incentives on the innovation success of
firms in terms of the frequency of new product development, the introduction of new-to-the-
market products and the sales share of new products. They found a positive impact from the
Canadian R&D tax credit on innovation success.

Figure 19. Government support to business R&D & While the US and Canada
business R&D intensity in selected APEC economies, demonstrate good cases for
2011 the use of R&D tax credits, it
is not possible to make a
broad assessment as to the
impact that fiscal policies
may have on increasing
investment in R&D in other
economies. This is due to
variations in the incentive
schemes across economies as
well as the time lag between
the implementation of a
policy measure and the
evaluation of its impact,
particularly since tax
Note: Data for Australia and Chile are from 2010; data for China are
incentive schemes may be
from 2009. Fitted trend line is a linear regression of changes in total
government support to business R&D against changes in BERD frequently adjusted. On the
intensity for the 10 economies shown. The OECD states that this is an surface, there does indeed
experimental indicator and that international comparability may be appear to be a positive
limited. correlation between
Source: OECD, Directorate for Science, Technology and Industry, government support to
Measuring R&D Tax Incentives online data.
business R&D and BERD
intensity, which is defined as the amount of business enterprise research and development as
a share of GDP, in the APEC region (Figure 19). Although it is only one contributing factor,
those APEC members that provide a greater amount of government support typically also
have a higher level of BERD intensity. Korea, for example, provides one of the highest levels
of government support (as a share of its GDP) among the APEC members, but also has one of
the highest levels of BERD intensity. Russia, however, also provides a substantial amount of
government support, but has a relatively low BERD intensity, underlining the importance of
designing incentives and schemes that are targeted to achieving policy objectives as well as
ensuring that the procedures for businesses to access the incentives are not too onerous5. On
the other hand, Japan has been quite successful in achieving a high level of BERD intensity
while providing one of the lower levels of government support (as a share of its GDP) among
the APEC members.

Empirically, studies that examine the effectiveness of R&D tax incentives in multiple
economies offer inconclusive evidence. Bloom et al. (2003) used data from nine OECD
members to estimate the correlation between aggregate R&D expenditure and the user cost of
R&D, taking into account economy-specific effects. The results suggested that fiscal R&D
incentives have a significant impact, but it varies over time: a 10% fall in the cost of R&D
5
It is important to note that the R&D incentives offered in an economy, and therefore the amount and type of
government support as well as its impact on BERD intensity, may have changed since 2011. For instance,
Russia has substantially changed its R&D incentives scheme since 2011.
22 Innovation, Competitiveness and the Role of Fiscal Policies

would stimulate an approximately 10% rise in the R&D level in the long run and just over a
1% rise in the short run.

McKenzie and Sershun used a similar data set, but yielded different results. In their study, the
value of R&D price elasticity was half the amount found in Bloom et al.’s report. An
essential difference between the two studies is that McKenzie and Sershun also took into
account the economy-wide tax system. The authors argued that while tax subsidies may lower
the cost of R&D, high taxes on production – or the fruit of R&D (new products and
processes) – may punish success. As a result, the positive effect from R&D incentives may be
countervailed by a high tax level in general. Their findings confirmed the decisive role of the
general tax system in the extent of R&D activities. In this vein, Box 2 provides a brief
examination of the overall tax systems in the APEC economies and their impact on the
incentives for firms to invest.

Box 2. Assessment of the general tax systems on investment incentives in APEC

In a progressive tax regime – a system where different levels of income are taxed at different
rates according to income brackets, as opposed to a flat tax system – the top marginal rate is
the rate applied to each additional unit of taxable income above the highest income
threshold. It differs from other rates, such as the average tax rate, which is the ratio of total
taxes paid to total taxable income (taxes paid/taxable income), and the effective tax rate,
which is the ratio of total taxes paid to total income (taxes paid/total income). The top
marginal tax rate applied by the federal or central government to individuals and
corporations resident in an economy is typically used to analyse how changes in income will
impact tax obligations. For this reason, it is a useful measure in order to evaluate the
difference in tax obligations between two different scenarios or strategies.

Figure 20. Top marginal tax rates on corporate and personal income, 2014

Note: Rates shown are the top marginal tax rates applied at the federal or central level to resident
corporations and individuals as at 25 June 2014. Taxes applied at the state or provincial level are
not included.
Source: APEC Policy Support Unit (PSU) based on publicly provided information from domestic
tax authorities .

In most APEC economies, central governments apply a marginal income tax rate of at least
20% to corporations and a marginal income tax rate of at least 30% to individuals (Figure
20). It is very important to note that these rates do not include taxes that are applied at the
state or provincial level, which can vary between states or provinces and which can also
 Innovation, Competitiveness and the Role of Fiscal Policies 23

substantially add to the overall tax burden in Figure 21. Effect of taxation on
an economy. In addition, the thresholds upon incentives to invest, 2013
which these tax rates are applied can vary
significantly, particularly for personal income.
For example, the top marginal rate of 39.6% is
applied to personal taxable income above USD
406,750 for single taxpayers in the United
States, while the top marginal rate of 45% is
applied to personal taxable income above
AUD 180,000 in Australia (approximately
USD 170,000). Nevertheless, the top marginal
corporate and personal income tax rates
applied by federal or central governments
allows for a useful comparison of tax rates
across the region.

The effect of tax policies on incentives to

invest varies greatly across the APEC region.
Although not a precise indicator, the World
Economic Forum's Executive Opinion Survey
suggests that tax systems in the region may Note: APEC average is a simple average. Data for
reduce the incentive to invest in many APEC Papua New Guinea are not available.
economies (Figure 21). While the region Source: World Economic Forum, Global
includes some of the top performers globally Competitiveness Report 2013-2014 (Executive
(Singapore; Brunei Darussalam; and Hong Opinion Survey).
Kong, China), many APEC members are below the APEC average, indicating that there is
significant room for improvement in this regard for many economies. A tax regime that is
more conducive to investment will help to unleash the potential for innovation across the
region.
24 Innovation, Competitiveness and the Role of Fiscal Policies

5. CONCLUSION

As host of APEC 2014, China has specified “promoting innovative development, economic
reform and growth” as one of the three priorities of the APEC agenda for this year,
emphasizing the importance of innovation in APEC growth strategies. Indeed, innovation has
long been a focus for APEC, as reflected consistently in APEC Leaders’ Declarations since
2010. The analysis of the drivers of APEC growth since 1950 in this paper highlights the
fundamental role played by innovation and technological capabilities in supporting economic
progress in the region.

Over the past few decades, APEC has achieved impressive economic gains vis-à-vis the rest
of the world. GDP growth in the region has outperformed the rest of the world,
notwithstanding the diminishing trend of APEC’s labor force expansion. Since 2000, the
APEC region has reaped the benefits of earlier economic reforms and increased economic
integration. Labor productivity gains have become the engine of APEC growth, contributing
to 80% of APEC GDP growth between 2000 and 2007. The differences in economic growth
between the APEC region and the rest of the world can be largely explained by the
differences in the ability to generate and adapt to new technologies. The results of the growth
accounting exercise conducted in this paper indicate that the single most significant factor
driving APEC’s labor productivity gains between 2002 and 2007 was enhanced production
efficiencies, which were captured in the rapid rise of Total Factor Productivity growth.

Two emerging trends in recent years underscore the need for APEC's continued focus on
promoting innovation. First, the 2008-09 Global Financial Crisis continues to impact APEC's
competitiveness, with the contribution of TFP growth to the region’s economic progress
being reduced to one-third the contribution seen between 2002 and 2007. Going forward,
with the APEC labor force being forecast to grow at a progressively slower rate, further
boosting the region’s productive efficiencies by expanding technological capacity is critical
for the region to sustainably enhance economic welfare. Second, there exists a wide gap in
the output produced per worker among APEC economies. The difference in TFP levels
accounts for the bulk of labor productivity gaps across APEC economies. The lower TFP
levels in many APEC economies, relative to that of the US, suggest a significant catch-up
potential. Promoting innovative capability in firms should therefore become the cornerstone
of economic development policies.

The focus of this paper has been on the role of fiscal and taxation policies in promoting R&D
investment, which is viewed as one of the important inputs of innovative outcomes. In many
economies, fiscal subsidies and tax incentives have become an integral part of a broader
strategy to increase investment in R&D and promote innovation. Businesses have long
considered tax incentives to be an important and sometimes necessary relief given the
typically high costs of conducting R&D. However, a successful R&D fiscal incentive strategy
depends to a large degree on understanding the different advantages and costs of the various
instruments and designing them to best suit the government’s overall economic growth
policies. Tax incentives and direct subsidies, for example, have different roles within a policy
mix for business R&D and are complementary to each other.

From an administrative point of view, tax incentives are the least burdensome way of
increasing business R&D and can therefore be used to encourage an increase in R&D across
the whole spectrum of firms. Therefore, if the government’s objective is to increase R&D
 Innovation, Competitiveness and the Role of Fiscal Policies 25

intensity among firms from a relatively low level, tax incentives may be the most sensible
approach. Meanwhile, direct subsidies are better suited to encourage higher risk projects and
to meet specific policy goals. If the government’s objective is to enlarge the R&D capacity
within certain fields, subsidies would be the natural choice since it is more difficult to target
specific fields or areas of R&D activities through tax incentives.

In recent years, APEC members have increasingly implemented fiscal incentives to

encourage firms to undertake R&D, with all members offering some type of direct subsidy in
the form of grants or loans in order to help businesses finance R&D projects. However,
APEC economies differ widely in the use of R&D tax incentives. In some APEC economies,
there are multiple R&D incentive packages available, while in others there may be one main
incentive in the form of a tax deduction or credit. Some APEC economies, including
Indonesia; Mexico; and New Zealand do not have a defined R&D tax incentive scheme.
Therefore, the total amount of government support to business R&D varies significantly
across the APEC members.

While it is generally agreed that markets may fail to provide a socially optimal quantity of
R&D on the basis that it has some characteristics of a public good, R&D tax incentives are
expensive. Volume-based R&D tax incentives may transfer a large cost from the private
sector to the government by supporting pre-existing R&D which would have been carried out
even in the absence of R&D tax incentives. Given their high costs, the dynamics of R&D
subsidies and tax incentives have been widely debated, underscoring the need to better assess
firms’ reaction to the policies and the potential efficiency effects.

Among the APEC economies, the R&D tax credit scheme introduced in the United States in
1981 provides a good empirical base for evaluating the effectiveness of this instrument. This
report summarises the findings of key econometric studies. At first glance, it appears that the
empirical studies are inconclusive in terms of determining the effectiveness of R&D tax
incentives. However, a careful review of some key studies suggests that the variations in the
results are due to the methodological limitations which the various studies faced. In some
studies that were conducted in the early 1980s, estimations of price elasticity of R&D –
which measures the percentage change in R&D investment resulting from tax relief for every
percentage change in its after-tax price – were generally lower. However, these studies were
either conducted using a less robust data set or the R&D equation was not well specified.
Additionally, the short time lag between the introduction of the incentive scheme and the
evaluation exercises could also have resulted in lower estimates of price elasticity as firms
often take time to adjust to new schemes.

Since 1990, evaluation techniques have become more reliable and sophisticated. The longer
time lag since the introduction of the US tax credit in 1981 has also allowed for a longer time
frame in order to evaluate its impact to a fuller extent. As a result, later studies found a
statistically significant relationship between R&D tax incentives and increased levels of R&D
investment. Many of these later studies not only concluded that R&D tax incentives have
been effective in encouraging firms to undertake more R&D, but also suggested that the
increases in private R&D often outweigh the fiscal costs of the tax incentives. In some
studies, the estimated input additionality effects are larger than two, indicating that for every
dollar forgone in tax revenue due to the tax credits, firms raise their R&D investment by 2
dollars. One can conclude that R&D tax incentives have been a useful tool to stimulate
private R&D and raise the level of business R&D expenditure to a higher level in the United
States.
26 Innovation, Competitiveness and the Role of Fiscal Policies

The findings for the United States, however, cannot be generalised for other APEC
economies due to the variations in incentive schemes across the region. Studies on the effects
of the Canadian R&D tax credit scheme on the innovation success of firms found that the
program had a positive impact on the frequency of new product development, the
introduction of new-to-the-market products and the sales share of new products. Outside the
United States and a few advanced APEC economies, empirical literature evaluating the
effectiveness of R&D tax incentives is limited. Additionally, there are very few studies
assessing incentive schemes across multiple economies, making it challenging to understand
the economy-specific conditions and policy design features that determine the success or
failure of an R&D tax incentive scheme. An examination of the data on the amount of
government support to business R&D and BERD intensity across selected APEC economies
reveals that there does indeed appear to be a positive correlation between the generosity of
the R&D scheme and private R&D investment. Although it is only one contributing factor,
those APEC members that provide a greater amount of government support typically also
have a higher level of BERD intensity.

The limited availability of empirical studies evaluating the effectiveness of R&D subsidies
and tax incentives in many APEC economies is a call for further research in this area.
Developing APEC economies are at different stages of technological development and they
possess different institutions and policy frameworks. Future studies in this area should
therefore be fine-tuned to the economic context of developing economies. APEC can
stimulate this shift in research agenda and foster the links between leading research
institutions and policy makers. APEC’s Finance Ministers’ Process is an ideal platform to
bring together tax policy experts and tax officials to share policy successes and failures and to
engage in mutual learning.

Another observation is that despite the plethora of studies on the impact of R&D tax
incentives, most of these studies refer to programs that took place in the 1980s and early
1990s, with only a few exceptions. As such, our knowledge on recently introduced and
redesigned fiscal incentive schemes remains limited. Further refinement to the methodologies
is also important in order to derive more accurate estimations of the economic costs and
benefits of tax incentives. For instance, the effectiveness of R&D tax incentives has long
been evaluated against the price elasticity or input additionality. Future approaches should
take into account some other benefits that are brought about by increased innovative
activities, such as employment gains and enhanced social welfare.

The effectiveness of R&D tax incentives depends to a great extent on their design and on the
broader regulatory environment and its stability over time. Factors include well-functioning
financial markets as well as the overall tax system. These factors can enhance the returns to
investing in knowledge-based assets, thereby making R&D investment more attractive to
private investors. R&D policies should also be transparent and consistent. OECD analysis
suggests that the impact of R&D credits on private R&D expenditure will generally diminish
in economies that have experienced a large number of R&D tax policy reversals (OECD,
2013a). It is therefore important that governments minimize policy uncertainty for firms by
maintaining the continuity of R&D policies as long as possible.
 Innovation, Competitiveness and the Role of Fiscal Policies 27

ANNEX: FISCAL AND TAXATION POLICIES RELATING TO R&D IN APEC

The following table provides an overview of the major R&D incentives that are currently in place at the federal or central level in each APEC
economy as at September 2014.

Economy Fiscal and taxation policies relating to R&D

Australia  R&D Tax Incentive: Tax credit scheme open to firms in all sectors who are conducting eligible R&D in Australia and who have registered
their R&D activities by lodging an application annually with AusIndustry. There is a 45% refundable tax credit (equivalent to a 150%
deduction) to eligible entities with aggregated turnover of less than AUD 20 million per annum and a 40% non-refundable tax credit
(equivalent to a 133% deduction) to all other eligible entities. (The non-refundable tax offset can be carried forward indefinitely.) Most
current and some capital expenses directly incurred while conducting either “core” or “supporting” R&D activities are eligible. Some
offshore R&D expenses may also qualify subject to approval. The 2014-15 Federal Budget will reduce the tax credit rates to 43.5% and
38.5%, respectively, following the passage of legislation. Additionally, there is a proposal currently being legislated that would exempt
companies with aggregate assessable income of AUD 20 billion or more from claiming the incentive.
 Australia also has a number of grants and other incentives available to encourage innovation, including the recently announced
Entrepreneurs’ Infrastructure Programme with funding of AUD 484.2 million to support eligible businesses to develop and commercialize
new ideas.

Brunei  Investment Incentives Order 2001: An enterprise operating in a designated pioneer industry can apply for Pioneer Status and be eligible for
Darussalam a corporate income tax exemption period of 5 years (businesses with fixed capital expenditure less than BND 2.5 million) or 8 years
(businesses with fixed capital expenditure of BND 2.5 million or more). The tax exemption period can be extended for an additional 3
years, but cannot exceed 11 years in total. Those businesses located in a Hi Tech Park are eligible for a tax exemption period of 11 years,
which can be extended for an additional 5 years, but cannot exceed 20 years in total. In addition, businesses with Pioneer Status are exempt
from import duties on machinery, equipment, component parts, accessories, as well as raw materials not available or produced in Brunei
Darussalam and intended for the production of pioneer products. The scheme also allows for carry-forward of loss and allowance.
 Income Tax Act: Qualifying R&D expenditure (excluding capital expenditure) is allowed as a deduction in deriving chargeable income.
 Brunei Research Incentive Scheme (BRISc): Government funding to finance research projects in the energy, environment, health
28 Innovation, Competitiveness and the Role of Fiscal Policies

Economy Fiscal and taxation policies relating to R&D

care/health sciences, food security, and ICT sectors with up to BND 5 million available per project (an additional BND 5 million available
on a case-by-case basis). Local companies are eligible for 80% funding; foreign firms who undertake research with the Institute of Higher
Learning or a local government agency are eligible for 70% funding; foreign firms who undertake research independently are eligible for
50% funding.

Canada  Scientific Research and Experimental Development (SR&ED) Program: Tax credit scheme open to businesses in all sectors conducting
eligible R&D work in Canada. There is a tax credit of 15% on qualified SR&ED expenditures carried out in Canada, which can be carried
forward for 20 years and carried back for 3 years. For small Canadian-controlled private corporations, this credit is increased to 35% on the
first CDA 3 million of qualified SR&ED expenditures (subject to reductions). The 35% tax credit is 100% refundable for non-capital-
related expenditures and 40% refundable for capital expenditures.
 Starting in 2014, capital expenditures will no longer be eligible under the SR&ED tax credit scheme. However, under Canada's general
corporate tax system, these R&D assets may qualify to be depreciated over a 3 year period. (Certain R&D assets, such as computer
hardware, may be eligible for other accelerated depreciation schemes.) They may also qualify for manufacturing or processing investment
tax credits ranging from about 5% to 10% of the qualifying expenditures.
 Canada also has a large number of grant programs available to help fund R&D in Canada, including those to conduct applied research,
those to develop R&D networks between academia and the private sector, and those to encourage international R&D partnerships.

Chile  Research and Development Investment Tax Incentive: Foreign and domestic businesses in all sectors conducting R&D are required to seek
pre-approval in order to claim the incentives. The scheme offers a tax credit of up to 35% of expenses incurred in certified in-house R&D
projects or up to 35% of payments associated with certified R&D contracts entered into with research centers accredited by the Chilean
Economic Development Agency (CORFO). For international companies, up to 50% of R&D activity conducted outside of Chile can be
claimed as eligible expenses. The amount of the tax credit is limited to UTM 15,000 (approximately USD 1.1 million) and may be carried
forward until fully utilized. The remaining 65% of R&D expenditures can be taken as a tax deduction. Uncertified R&D projects or
uncertified R&D contracts are eligible for the 65% tax deduction, but not for the 35% tax credit.
 CORFO also offers a large number of programs that provide grants and financing in order to fund R&D projects and support their
commercialization and to attract international companies and institutions to establish R&D centers of excellence in Chile.

China  Companies in encouraged industries that are granted High and New Technology Enterprise (HNTE) status pay a reduced corporate income
 Innovation, Competitiveness and the Role of Fiscal Policies 29

Economy Fiscal and taxation policies relating to R&D

tax rate of 15% instead of 25% for three consecutive years.

 IT outsourcing, business process outsourcing, and knowledge process outsourcing companies in designated cities that are granted Advanced
and New Technology Service Enterprise (ATSE) status pay a reduced corporate income tax rate of 15% instead of 25%. Staff education
expenses of up to 8% of total salaries can be deducted from corporate income tax. Business tax exemption on revenue derived from off-
shore outsourcing services.
 A 150% super deduction for qualifying R&D expenditures when calculating taxable income, which can be carried forward for up to 5 years.
 Specified R&D equipment imported by qualified foreign-invested R&D centers is exempt from customs duty, value-added tax (VAT), and
consumption tax; input VAT on domestically manufactured equipment purchased by qualified domestic R&D institutes and foreign-
invested R&D centers is refundable.
 Business tax exemption on revenue derived from the transfer of qualified technology; the first RMB 5 million of profit is exempted from
corporate income tax, while profit above RMB 5 million is eligible for a 50% reduction.

Hong Kong,  A 100% deduction is available for direct R&D expenditure conducted in-house, payments to approved research institutes, and capital
China expenditure on plant or machinery that is used for R&D purposes.
 Innovation and Technology Fund (ITF): Provides funding through four schemes to support mainly applied R&D projects. The ITF will
support up to 90% of the total project cost for platform research projects (those which are conducted by R&D centres or designated local
public research institutes and which aim to benefit the entire industrial sector or a large segment of the sector) and up to 50% for
collaborative research projects (those between R&D centres or designated local public research institutes and private companies).

Indonesia  There is currently no defined R&D-based tax incentive scheme in Indonesia. However, under the tax law, expenses from conducting R&D
activities in Indonesia may be claimed as a tax deduction in calculating taxable income. In addition, under the Tax Allowance Incentive
Scheme, which is available for new investments or investments for the purpose of expansion, businesses conducting eligible R&D may
qualify to carry forward and claim tax losses for an additional year (following the standard 5 years) if the proportion of the R&D investment
is at least 5% of the total investment within 5 years. This scheme also allows for accelerated depreciation and amortization of capital assets.
 Indonesia does provide grants for R&D; however, the funding is limited and often short-term only.

Japan  R&D Tax Credit: A tax credit of 8-10% of total qualifying R&D expenses is available for large companies, while a tax credit of 12% of
total qualifying R&D expenses is available for SMEs (defined as companies whose capital does not exceed JPY 100 million). The tax credit
30 Innovation, Competitiveness and the Role of Fiscal Policies

Economy Fiscal and taxation policies relating to R&D

is limited to 20% of the company’s corporate income tax liability amount, with the excess portion allowed to be carried forward for 1 year.
For fiscal years beginning 1 April 2013 through 31 March 2015, the tax credit limit is increased to 30% of the company’s corporate income
tax liability amount.
 Additional R&D Tax Credit: When a company’s qualifying R&D expenses exceed certain benchmarks set in previous years, an additional
tax credit of up to 10% of the company’s corporate income tax liability is available. Companies may be able to claim either the Incremental
R&D Tax Credit (5% of incremental qualifying R&D expenses) or the Excess R&D Tax Credit (qualifying R&D expenses in excess of an
amount equivalent to 10% of average sales, multiplied by a certain percentage).
 Asian Business Location Law: Japanese subsidiaries of qualifying multinational companies which start R&D operations in Japan can
deduct up to 20% of income that is attributable to its R&D activities for the first 5 years. (Companies are required to submit an R&D
business plan and obtain pre-approval before claiming the incentive. This incentive cannot be claimed in conjunction with the R&D Tax
Credit.)

Korea  R&D Tax Credit: For large corporations, the credit equals the greater of either (1) 40% of eligible current-year R&D expenses exceeding
the average of R&D expenditures in the 2 prior years, or (2) 3% of eligible current-year R&D expenses plus an additional rate defined as
50% of the R&D expense ratio (capped at 6%). For SMEs, the credit equals the greater of either (1) 50% of eligible current-year R&D
expenses exceeding the average of R&D expenditures in the 2 prior years, or (2) 25% of eligible current-year R&D expenses. For R&D
current-year expenditure incurred by new, high growth companies with original technology, the credit is increased to 20% for large
corporations and 30% for SMEs. Unutilized R&D tax credits can be carried forward for up to 5 years.
 R&D Facility Tax Credit: An additional tax credit of 10% of the cost of developing a new R&D facility may also be available in the year
that the facility is completed.
 Korea also has a number of incentives available in order to promote domestic R&D centers as well as foreign investment in R&D in Korea,
including additional tax credits, tax exemptions, and subsidies and cash grants. For instance, an R&D center registered in a designated R&D
special zone and performing specified R&D activities is fully exempted from corporate tax for the first three years with a 50% exemption
granted for the subsequent two years.

Malaysia  Investment Tax Allowance (ITA): Companies performing in-house R&D may qualify for an ITA of 50% on the qualifying capital
expenditure incurred within 10 years, while R&D service providers may qualify for an ITA of 100% on the qualifying capital expenditure
incurred within 10 years. The company can offset the ITA against 70% of its statutory income for each year of assessment, with any
 Innovation, Competitiveness and the Role of Fiscal Policies 31

Economy Fiscal and taxation policies relating to R&D

unutilized allowances carried forward to subsequent years until fully realized.

 Super deduction: Companies performing in-house R&D may be eligible for a 200% super deduction for qualifying non-capital expenditures
incurred in qualifying R&D, subject to approval. This super deduction can also be claimed for cash contributions or donations made to
approved research institutes and for payments for the use of services of approved research institutes, approved research companies, R&D
companies, or contract R&D companies.
 Pioneer Status Income Tax Exemption: The Ministry of Finance may grant “Pioneer Status” to companies deriving income from certain
activities and products that benefit the Malaysian economy such as R&D companies, high-tech companies, software development
companies, and manufacturing companies producing world-class products. Statutory income earned by an R&D company granted Pioneer
Status is eligible for a 70% to 100% income tax exemption for a period of 5years, which can be extended for another 5 years upon approval.
 Under the Special Incentive Package, R&D grants are made available on a reimbursement basis for qualifying R&D expenditures under
approved projects. Applicants may also be able to negotiate income tax exemptions for a specific period and and/or an ITA on qualifying
capital expenditures incurred for a specific period.

Mexico  High Added Value Technological Innovation for Technological Research, Development, and Innovation (INNOVAPYME): Provides cash
grants to technologically innovative Mexican SMEs that provide high levels of added value of up to USD 1.6 million per company for
eligible R&D expenses paid by the company. Benefits include (1) 30% of the current year's R&D expenditure on an individual project and
(2) 35% of the current year's expenditure and 75% of research centers' and universities' expenditure on linked projects incurred during the
current year.
 Development and Innovation of Precursor Technologies for Technological Research, Development, and Innovation (PROINNOVA):
Provides cash grants to Mexican companies engaged in the development and innovation of initial technologies of up to USD 2.08 million
per company for eligible R&D expenses paid by the company. Benefits include 35% of the current year's expenditures (increased to 50%
for SMEs) and 75% of the research centers' and universities' expenditure incurred in the current year.
 Technological Innovation to Enhance Competitiveness for Technological Research, Development, and Innovation (INNOVATEC):
Provides cash grants to Mexican companies engaged in technological innovation for competitiveness of up to USD 2.77 million per
company for eligible R&D expenses paid by the company. Benefits include: (1) 25% of the current year's R&D expenditure on an
individual project and (2) 30% of the current year's expenditure and 75% of research centers' and universities' expenditure on linked
projects incurred during the current year.
32 Innovation, Competitiveness and the Role of Fiscal Policies

Economy Fiscal and taxation policies relating to R&D

New Zealand  New Zealand has various grant funding initiatives to support the creation and commercialization of innovative technologies. For instance,
the R&D Growth Grant provides funding equal to 20% of the qualifying firm's eligible R&D expenditure for a period of 3 years, up to a
maximum of NZD 5 million per year. (After 2 years of funding, firms can apply for a 2-year extension.) For smaller firms, the government
offers an R&D Project Grant, which typically provide support of 30% to 50% of eligible R&D costs.

Papua New  A 150% tax deduction is available for scientific R&D expenditure carried out under an R&D plan that has been approved by a committee
Guinea chaired by the Internal Revenue Commission (IRC).

Peru  Qualifying expenditure incurred to undertake R&D activities in Peru is deductible subject to a limit of 10% of net revenue per year, with a
maximum limit of 300 UIT (approximately PEN 1.14 million).
 Funding for Innovation Projects (FINCyT): Peru, together with the Inter-American Development Bank (IDB), has made USD 100 million
available for the financing of innovation projects, scientific research, and postgraduate scholarships.

The  Companies can deduct 100% of current R&D expenditures from gross income (as ordinary and necessary expenses) and can also chose to
Philippines defer qualifying R&D expenditures on capital over a period of at least 60 months.
 Investment Priorities Plan (IPP): Enterprises engaged in R&D activities such as the establishment of research or testing laboratories may
apply to the Board of Investments (BOI) to be entitled to a four-year income tax holiday on income derived from the registered R&D
activity as well as other fiscal and non-fiscal incentives.
 IT Zones: An enterprise engaged in IT service activities such as IT R&D and located inside a registered IT zone may register with the
Philippine Economic Zone Authority (PEZA) to be eligible for various incentives, including an extended income tax holiday and an
exemption from import duties and taxes on imported machinery and equipment and raw materials.
 Cash gifts or donations made to an accredited research institution or organization shall be exempt from the donor's tax provided that no
more than 30% of the gift is used for administration purposes. Donations made to an accredited NGO operating exclusively for scientific,
research and educational purposes shall be deductible in full from the taxable business income of the donor provided that no more than 30%
of the gift is used for administration purposes.

Russia  Companies can apply for a 150% super deduction of qualifying R&D expenses incurred for eligible activities to reduce profit tax.
Unutilized expenses may be carried forward for up to 10 years.
 Innovation, Competitiveness and the Role of Fiscal Policies 33

Economy Fiscal and taxation policies relating to R&D

 Special Economic Zones (SEZs): There are currently 26 SEZs established across Russia under one of four categories: Manufacturing,
Technology & Innovation, Tourism, and Port. Companies registered within one of the four Technology & Innovation SEZs can benefit
from a profit tax exemption, a property tax exemption (normally 2.2%), a free customs zone, reduced social security rate of 14% (normally
30%) on annual remuneration up to a cap of RUB 568,000 with remuneration exceeding the cap exempt.
 Skolkovo Innovation Centre: Companies resident in the Skolkovo Innovation Centre receive a profit tax exemption, a VAT exemption
(normally 18%), a property tax exemption, and a reduced social security contribution rate of 14% on annual remuneration up to a cap of
RUB 568,000 with remuneration exceeding the cap exempt, as well as cash grants.
 Russia also has a number of other R&D tax incentives available, including accelerated depreciation that can be applied to fixed assets used
in R&D activities; reduced social security contributions for companies involved in developing software; an import VAT exemption for
qualifying technological equipment that has no equivalent produced in Russia; direct grants of USD 1-5 million for a qualifying R&D
project in a strategic area such as energy efficiency; as well as a wide range of regional tax incentives.

Singapore  A 100% deduction is available for qualifying R&D project, regardless of whether the R&D activities are conducted in Singapore or
overseas. Unutilized losses may be carried forward indefinitely.
 An additional 50% deduction is available on certain expenditure on R&D activities performed in Singapore.
 To encourage businesses to invest in innovation and productivity, the additional deduction has been increased to 300% on the first SGD
400,000 of eligible R&D expenditure for the years of assessment (“YA”) 2011 to 2018, with a combined expenditure cap of SGD 800,000
for the YAs 2011 to 2012, SGD 1.2 million for the YAs 2013 to 2015, and SGD 1.2 million for the YAs 2015 to 2018. This additional
deduction also applies to eligible R&D expenditure incurred overseas.
 Eligible businesses also have the option to convert up to SGD 100,000 of qualifying expenses into cash in each year of assessment, at a
60% conversion rate for the YAs 2013 to 2018.
 An additional 100% deduction (capped at a maximum of 200%) is available on R&D expenditure incurred on projects approved by the
Economic Development Board (EDB) on and before 31 March 2015. Unutilized losses may be carried forward indefinitely.
 Research Incentive Scheme for Companies (RISC): Cash grants are available for approved R&D projects to assist companies in setting up
R&D centers in Singapore and to develop their R&D capabilities. Qualifying manpower-related costs receive 50% support, while
qualifying equipment, materials/consumables and software costs, professional services, and intellectual property rights receive 30%
support.
34 Innovation, Competitiveness and the Role of Fiscal Policies

Economy Fiscal and taxation policies relating to R&D

Chinese  Statute for Industry Innovation: A tax credit of 15% of total R&D expenditure can be claimed against total corporate tax payable in the year
Taipei it is incurred. The credit amount is capped at 30% of the total corporate tax payable and cannot be carried forward. Businesses in all
industry sectors conducting qualifying R&D must seek approval in order to claim the credit. Currently, it is unclear whether offshore R&D
expenditure is eligible for the tax credit.
 There are also various tax incentives available for businesses conducting qualifying R&D activities in specific industries. For instance,
companies operating in the biotechnology and new pharmaceutical industry are entitled to a tax credit of 35% on qualifying R&D activities,
which may be carried forward for up to 5 years.
 Chinese Taipei also has a number of grant programs available to encourage innovation. For instance, SMEs can apply to the Small Business
Innovation Research (SBIR) program for subsidies covering up to 50% of the total cost of R&D.

Thailand  Revenue Department Incentives: A 200% deduction is available for eligible expenditure incurred on R&D activities carried out in Thailand
by R&D Service Providers (companies or government entities that have been approved by the Revenue Department). In addition, there is an
accelerated depreciation rate of 40% available for qualifying machinery and equipment used in R&D.
 Board of Investment (BOI) Incentives: Companies which have been granted an investment incentive by the BOI to conduct R&D are
entitled to a corporate income tax exemption on the net profit derived from the R&D activity for 8 years (biotechnology companies located
in a science and technology park are entitled to a 50% reduction of corporate income tax for an additional 5 years), and an import duty
exemption on machinery for use in R&D. Tax losses during the exemption period can be used to offset net taxable profit for up to 5 years
after the exemption period.

United States  Tax Credit: A non-refundable tax credit to reduce a business's federal tax liability is available for qualified research expenses incurred in the
US that exceed one of two computed base amounts. In general, the credit is limited to a maximum of 25% of the regular tax liability and
unutilized credit may be carried back for one year (five years for SMEs) and carried forward for 20 years. The Regular Credit is computed
by measuring R&D spending as a percentage of the business's gross receipts; a business will likely be eligible for this credit if it is
increasing its qualified research expenses as a percentage of gross receipts measured against a historical period. After computational
adjustments, including a minimum base amount equal to 50% of current qualified research expenses, the maximum value of the Regular
Credit is 6.5% of the business's qualified research expenses. The Alternative Simplified Credit is equal to 9.1% of the business's increase in
qualified research expenses in the current year over 50% of the average qualified research expenses for the prior three years. If there are no
qualified research expenses in the prior three years, then the credit is equal to 6% of qualified research expenses in the current tax period.
 Innovation, Competitiveness and the Role of Fiscal Policies 35

Economy Fiscal and taxation policies relating to R&D

 Tax Deduction: A 100% deduction of direct costs of R&D is allowed and can be claimed retroactively for three years. (Costs associated
with overhead and the acquisition of depreciable property are excluded.) However, taxpayers must reduce the current deduction by the
amount of the tax credit; otherwise, they can elect to take the Regular Credit at a reduced rate of 13% or 9.1% for the Alternative Simplified
Credit.

Viet Nam  High Technology Incentives: Qualifying enterprises conducting high-tech R&D are entitled to the following incentives: (1) corporate
income tax rate reduction to 10% applicable for 15 years (receiving a 4-year exemption and a 50% deduction on the applicable tax rate for 9
years), which can be extended to 30 years subject to approval; (2) VAT exemption on transfers of technology; (3) a 5-year exemption from
import duties on imported goods that are not yet able to be produced domestically to create fixed assets used in a qualifying R&D project,
including raw materials, materials and component parts; (4) preferential land lease fees; and (5) funding schemes through the federal high-
tech development program are available for training, R&D, or pilot production costs. Tax losses can be carried forward for up to 5 years.
 Science Research and Technology Development Incentives: Qualifying enterprises conducting R&D in scientific research and technology
development are entitled to the following incentives: (1) corporate income tax rate reduction to 10% applicable for 15 years (receiving a 4-
year exemption and a 50% deduction on the applicable tax rate for 9 years), which can be extended to 30 years subject to approval; (2) 1-
year corporate income tax exemption on income earned from the performance of contracts for scientific research and technological
development, from the sale of products during their test production, and from products made from new technology applied for the first time
in Viet Nam; (3) profits before tax may be used to establish a fund for scientific and technology development within the enterprise, subject
to a limit of 10% of total taxable income; (4) a reduced 5% VAT rate may be applied to eligible activities and services, while machinery,
equipment and material imported for scientific research and technology development are exempt from VAT at the import stage; and (5)
various import duty exemptions, including an exemption on imported goods directly used for scientific research and technology
development and a 5 year exemption on imported goods that are not yet able to be produced domestically to create fixed assets used in a
qualifying R&D project. Tax losses can be carried forward for up to 5 years.
Source: Compiled by the APEC Policy Support Unit (PSU) using publicly available sources, including domestic tax authorities and other government agencies as well as
information made publicly available by Deloitte, EY, and KPMG.
36 Innovation, Competitiveness and the Role of Fiscal Policies

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Tax Authorities in the APEC Region

Australia: Australian Taxation Office

Brunei Darussalam: Ministry of Finance, Revenue Division

Canada: Canada Revenue Agency

Chile: Chilean Tax Administration (Servicio de Impuestos Internos)

China: State Administration of Taxation

Hong Kong, China: Inland Revenue Department

Indonesia: Indonesia Tax Office (Direktorat Jenderal Pajak)

Japan: National Tax Agency

Korea: National Tax Service

Malaysia: Inland Revenue Board of Malaysia (Lembaga Hasil Dalam Negeri Malaysia)

Mexico: Tax Administration Service (Servicio de Administración Tributaria)

New Zealand: Inland Revenue Department

Papua New Guinea: Internal Revenue Commission

Peru: Superintendencia Nacional de Administración Tributaria (SUNAT)

Philippines: Bureau of Internal Revenue

Russia: Federal Tax Service of Russia

Singapore: Inland Revenue Authority of Singapore

Chinese Taipei: Taxation Administration

Thailand: Revenue Department

United States: Internal Revenue Service

Viet Nam: General Department of Taxation