ZEW Workshop: Germany Needs to Provide More Tax Incentives for Research and Development

The German government’s main tactic to incentivise companies to invest in innovation is to directly fund research projects. However, a number of recent studies have shown that this method of encouraging innovation does not go far enough. Particularly in small and medium-sized enterprises, there has been an increasingly steep decline in the level of innovation activity in recent years. This begs the question of whether it is time to focus greater efforts on tax incentives for research and development (R&D). This issue served as the focus of a workshop which took place on 21 January 2016 at the Centre for European Economic Research (ZEW) with the cooperation of the University of Mannheim and the consulting firm PricewaterhouseCoopers (PwC).

Prominent experts from the worlds of science, business and politics were in attendance to discuss why Germany needs to provide tax incentives for R&D and what these incentives should look like. Recent ZEW studies have provided evidence that Germany is in need of tax-based R&D funding schemes. In his opening presentation, Professor Christoph Spengel, professor of taxation at the University of Mannheim and a research associate at ZEW, identified R&D, and by extension innovation, as the most important drivers of economic growth. However, in Germany the government is investing far too little in innovation. Private investors invest far more money in innovation in Germany than government agencies do. Since 1981, the percentage of total funding for R&D coming from the public sector has dropped from 41.8 per cent to just under 30 per cent. Germany is also one of only a few countries that does not provide tax incentives for either investment or innovation. All this puts Germany at a disadvantage as a business location. According to the Lisbon Strategy and its successor the Europe 2020 Strategy, EU Member States should be spending 3 per cent of their GDP on R&D. In 2014, however, only 2.85 per cent of Germany’s GDP went on R&D, while the EU average amounted to only 1.91 per cent (compared to 3.47 per cent in Japan, 3.0 per cent in Switzerland and 4.15 per cent in South Korea).

For almost 60 years, Germany has been focused on funding projects directly, and will most likely have to continue doing so in the future, as cutting direct funding would likely provoke considerable resistance. Directly funding projects has, however, been proven to be a highly selective process, which often runs the risk of creating disincentives for innovation while systematically placing small and medium-sized enterprises at a disadvantage compared to multinational corporations. Both economists and business insiders agree that growth-oriented tax policy should seriously consider supplementing direct project funding with tax incentives for R&D.

Companies’ innovative strength depends on their financial cushion

Dr. Frank Schmidt, tax partner and head of industrial production at PwC, confirmed that the scientific finding that companies’ innovation activities depends primarily on their internal financing potential also holds in practice. Accordingly, the question of whether a tax system helps or hinders R&D and innovation is first and foremost a question of how said tax system impacts the internal financing of companies. “Unfortunately, German fiscal policy has for many years consistently been moving in the wrong direction. For instance, if someone in Germany suffers a loss for taking a business risk, they receive absolutely no support from the tax system,” says Schmidt. Germany’s tax system is in need of a structural reform that will remove any obstacles to innovation. According to Schmidt, this kind of medium-term tax policy reform should begin with tax incentives targeted at R&D.

In Curetis CEO Dr. Oliver Schlacht’s view, “the prevailing form of project funding provided in Germany urgently needs to be supplemented with technologically friendly, easy to apply for tax incentives for R&D, so that Germany can stop losing ground as a location for technology and doesn’t miss the boat when it comes to future technologies.”

Dr. Georg Licht, head of the ZEW Research Department "Industrial Economics and International Management” pointed out that small and medium-sized enterprises are finding it particularly difficult to secure the necessary investments in R&D and innovation. As ZEW’s Innovation Survey shows, the percentage of total expenditure of innovation in Germany attributed to small and medium-sized enterprises has seen a considerable drop in recent years. “One of the advantages of tax incentives is that they also reach companies that don’t usually engage in R&D. Direct funding for R&D projects usually doesn’t reach this group of companies, meaning that their growth potential is not being fully exploited.”

Research and development caught between conflicting political priorities

Unfortunately, the German government is currently not pursuing any kind of policy in this direction. According to Dr. Michael Meister, State Secretary at the German Federal Ministry of Finance, “R&D incentives in Germany have thus far proved themselves to be effective,” pointing to the successful R&D activities of German companies. Meister, however, also admits that tax incentives to encourage R&D activity that are still fair are something to seriously consider. Such incentives “would have to be judged in the light of the existing direct funding methods targeted at specific types of businesses”.

Certain state governments, however, are more open to the idea of R&D tax incentives. The Minister of Finance and Economic Affairs for Baden-Württemberg, Dr. Nils Schmid, said unequivocally, “I see increased tax incentives for research activities with a particular focus on small and medium-sized enterprises as essential. These incentives should take the form of a research allowance so that companies can still see the benefits even when they are going through a period of losses and must be based on companies’ R&D expenditure.”

Tax subsidies for innovation activity can be calculated based on either R&D activity directly (input), as has traditionally been the case, or, as is increasingly common, on successfully realised innovations (output). “Spillovers” is the term used by economists to categorise R&D incentives. In the case of R&D, positive spillovers are observed, since companies benefit from the R&D activities of other companies without bearing any of the costs. This is one reason why not enough money is being invested in R&D and why R&D input should serve as the basis for R&D tax incentives, which should ideally take the form of tax credits. Tax credits for R&D expenses are widely recognised in both scientific research and practice.

Tax credits as a possible catalyst

Alongside direct funding of projects, a recoverable 10% tax credit for R&D expenses could help Germany to raise its total R&D expenditure to 3 per cent of its GDP as prescribed by the Europe 2020 Strategy. According to calculations conducted by ZEW, such a tax credit would create an annual tax deficit of around five billion euros. At the same time, however, the study predicts overall income gains of roughly 750 million euros as well as an increase of 0.1 per cent in the aggregate GDP growth rate. “In the long run, the additional tax revenue resulting from this growth will more than compensate for the anticipated tax deficit these tax credits would bring,” said tax expert Spengel.

One instrument for subsidising innovation activity based on R&D output are what are known as patent or intellectual property (IP) boxes. The primary goal of patent boxes is to increase the appeal of patents and thus the income they generate in individual countries. As a result, returns made on the use of successful research (primarily income from license agreements for the use of patents) are subject to an extremely low tax rate (between 0 and 15 per cent), with the effective tax burden often even being negative. Patent boxes are difficult to justify from a political perspective since they are connected to R&D output. Despite this, the popularity of patent boxes has been unabated, with 14 European countries now having introduced them. “This is putting German companies at a competitive disadvantage. They will be left with far less cash flow after tax if licensing revenue is taxed at a considerably higher rate here than in many other countries. This will restrict growth in dynamic markets,” warned Ina Schlie, head of the corporate tax department at SAP.

Patent boxes put German companies at a competitive disadvantage

Schlie called for tax harmonisation within the EU in light of the fact that German companies are at a competitive disadvantage because some European countries offer far more attractive conditions with respect to tax incentives for R&D than Germany does. “Germany is in desperate need of tax incentives for R&D. As far as innovation policy is concerned, it would also be ideal if certain obstacles to innovation in the current German tax system were relaxed or lifted. These include interest caps, minimum taxation, double collection of trade tax due to additions for interest and license payments, forfeiture of losses according to Paragraph 8c of the Corporation Tax Act particularly for start-ups, as well as function relocation regulations. Germany should under no circumstances introduce any more unilateral tax restrictions similar to the interest caps.”

The study on the effect of taxation on innovation activity in companiespresented at the workshop by Frank Schmidt and based on a survey of 500 global companies came to the conclusion that taxes can have considerable influence over the location of patents. By comparison, R&D activities as such seem to be fairly immobile. If the government wants to target such activity with tax incentives, they need to be drafted in such a way that they have an immediate effect on liquidity, provide as great a safety net as possible for firms in the planning stage and are as straightforward as possible.

Patent boxes thus contribute to the creation of a level playing field with respect to taxation. According to Schmid and Spengel, lawmakers would be well advised not to introduce patent boxes in Germany. “Patent boxes distort competition, are implemented highly selectively, destroy the entire system of tax law and conflict with EU rules on state aid. And, above all, they make it easier for companies to engage in profit shifting.”

In light of all this, it is best for Germany to hold tight. If Germany wants to pursue a growth-oriented tax policy, lawmakers seriously need to consider introducing tax incentives for R&D, ideally in the form of tax credits based on R&D input.

For further information please contact

Prof. Dr. Christoph Spengel, Phone +49(0)621/1235-149, E-mail spengel@zew.de