Proposed R&D Tax Incentive for Germany Could Be Further Improved

The federal government’s current plan to introduce tax incentives for research and development (R&D) for companies in Germany is a step in the right direction – but it could be further improved. The legislation proposed by the German Federal Ministry of Finance for a new “Forschungszulagengesetz” (“Research Allowances Act”) is right to focus on small and medium-sized enterprises. However, the incentive suffers from various weaknesses that will significantly reduce its impact: a restriction to personnel expenses, a low cap for eligible expenses, high bureaucratic costs, and a four-year lifespan. With targeted adjustments, the incentive would be much more effective in strengthening the attractiveness of Germany as a location for private-sector R&D.

These are the key findings of an assessment of the proposed R&D tax incentive that was conducted by a team of researchers at the ZEW – Leibniz Centre for European Economic Research in Mannheim. Following a review of the proposed incentive, the ZEW team has published suggestions for improvement that would help to leverage the full potential of a tax incentive for R&D in a ZEW expert brief.

The proposed R&D tax incentive would offer a 25 per cent credit on a firm’s corporate income taxes for R&D expenses on wages and salaries (excluding employers’ contributions to social insurance). Taxable costs are capped at two million euros per financial year and company group, which means that the maximum funding amount is 500,000 euros per year. The effect of the funding scheme would thus be rather negligible for companies with R&D expenditures in the tens or hundreds of millions of euros per year. However, this class of company undertakes more than 80 per cent of all private-sector R&D in Germany.

To be eligible for funding, companies also have to submit a declaration stating that the claimed R&D expenditures comply with the law’s definition of R&D. This requirement entails high bureaucratic costs. As a result, a major potential advantage of an R&D tax incentive – avoidance of red tape – is lost.

Finally, the law is set to expire after four years, a time frame that is out of alignment with the middle- to long-term nature of corporate R&D activities. According to the ZEW assessment, such a short time frame will fail to provide incentives for companies to invest in more R&D staff and infrastructure. This is especially true for small and medium-sized enterprises.

"The proposal could have much greater impact"

The German Federal Ministry of Finance has earmarked a total of 1.25 billion euros per year for the implementation of the new funding scheme. However, calculations regarding the innovation behaviour of the German economy conducted by ZEW researchers and based on the Mannheim Innovation Panel (MIP) show that the legislative proposal could have a considerably greater impact if the funding amount was higher and the attendant bureaucratic costs were lower.

First, all R&D expenses for personnel should be eligible for funding. The fact that the employers’ contributions to social insurance are not part of the eligible expenses in the current proposal does not make economic sense. In addition, the proposed ceiling is far too low. As a consequence, many medium-sized enterprises with substantial R&D potential – so-called “midrange companies”, with 250 to 3,000 employees – would only receive funding for a small share of their eligible R&D expenses, which means that there would be no incentives for these company to invest more in R&D.

The ZEW researchers therefore recommend a combination of higher eligibility caps and tiered subsidy rates – as has been implemented, for example, in the Netherlands and France. Specifically, the researchers suggest that as part of the planned reform, R&D expenses for personnel ranging between two and ten million euros should be liable for taxation, but subject to lower tax rate of around 15 per cent.

"The federal government’s proposal should be welcomed"

The ZEW researchers note that while lifting the ceiling would result in additional costs of around one billion euros per year, part of this additional cost can be saved by abstaining from the planned declaration process. Finally, the researchers call for completely eliminating the four-year time limit, since companies need a reliable basis for mid- to long-term strategic decisions such as R&D.

“Although the proposal of the German Federal Ministry of Finance features a relatively high funding rate compared to other countries, it’s effectiveness is undermined by its narrow range of applicability and the low funding cap on the amount allocated to each company. At the same time, companies have to bear relatively high application and bureaucratic costs. Particularly in the case of small companies, it is likely that these costs will exceed the funding amount granted by the government. This will discourage many companies – particularly smaller firms – from using the tax incentive, which, in turn, will render this instrument ineffective for a segment of the private sector that is highly important from an innovation policy perspective,” concludes Dr. Georg Licht, head of the ZEW Research Department “Innovation and Industrial Dynamics”, and one of the authors of the ZEW expert brief.

“In contrast to many other countries, Germany still lacks tax incentives for private-sector R&D. The proposal of the federal government is therefore very welcomed, since this will provide German companies with the necessary impetus to invest more in new knowledge and new technologies, and help Germany maintain its competitiveness. Our analyses show, however, that the legislative proposal currently falls short of its objectives,” adds ZEW President Professor Achim Wambach.