Risky business? Why firms should be aware of the consequences of tax benefits for R&D 

By Professor Christos Tsinopoulos, August 2022

Do firms that secure tax benefits for Research and Development risk hindering innovation thanks to heavy political intervention? Professor Christos Tsinopoulos explains. 

It’s hardly a groundbreaking statement to say that, in order to stay competitive in any industry, it’s vital for a business to keep innovating. However, this statement has never been truer than it is now. With the many and varied rapid advancements in digital technologies and their growing impact on the way we live and work, it’s essential that companies are able to take advantage of the latest capabilities they offer.  

By refusing to settle for the status quo of day-to-day operations and committing to consistently investing in research and development (R&D), companies are often reassured they’ll be able to stay ahead of the competition. Yet, this can be easier said than done – especially for smaller firms. R&D is often an extremely costly exercise which can amount to very little in the way of outcomes unless done correctly. 

Thankfully organisations don’t always have to go it alone — there are often benefits and support schemes on offer to encourage companies to commit to their R&D efforts. Many such schemes are provided by local and national governments. 

Of course, firms innovating and becoming more and more competitive provides a bonus for government too. After all — if the businesses and industries in their locales are providing the most innovative product or service on the market, then not only will these companies’ profits increase, but the government also stands to profit too through tax revenues. Therefore, it seems to make perfect sense for governments to do all they can to help firms become more innovative, such as offering tax benefits for those which agree to invest in R&D.  

Or does it? While on the surface it seems such schemes provide a win-win for business and government, my research together with PhD candidate Chris Yao, reveals there is a negative to these seemingly rosy partnerships.  

We found firms that seek out tax benefits for R&D through institutional intermediaries, like professional and membership associations, can risk a lack of innovation because of the large level of political intervention that typically comes with such support. 

These intermediaries are frequently seen by businesses as a way to gain greater financial support for their projects. Membership to such associations can also help to create legitimacy and firm credibility, something which can be hard to come by when starting R&D from scratch. Moreover, they help those seeking buy-in by potentially unlocking new resources including access to investment funds, which can help provide a bed for innovation to grow from.  

However, the conflicting demands that can be imposed on R&D by government links can blur a firm’s strategy, impact their vision and, as a result, restrict their ability to experiment and innovate rather than enhance it. 

Our findings were discovered through interviewing the CEOs of nine separate firms in China and analysing data from a survey of 548 firms on their links to government funding. We then used the successful or failed patenting by these companies as a proxy to determine the extent of each firm’s innovativeness over a specific period. 

We found that, while government funding of R&D initiatives could make a firm more innovative initially, such schemes also had a negative effect on innovation by making projects less autonomous or flexible. These limitations meant companies were unable to experiment as much as they would like. 

Unfortunately, despite the limitations that using intermediaries can have, this is often the only way for small firms to gain vital support to develop and grow. Committing to such schemes is often, therefore, a double-edged sword. The decision between exploring R&D freely with little financial backing or accepting support and benefitting from tax breaks with a caveat or R&D boundaries, makes it incredibly difficult for smaller firms to navigate R&D effectively and commit the necessary funds to do so.  

The very real risk, if the wrong decision is made, is that a company may either become less competitive and therefore less profitable if their R&D activities are ringfenced or go out of business entirely if they simply cannot keep up with the rate at which the market is evolving.  

So what should smaller firms do when finding themselves at such crossroads? Our findings provide several important insights for both managers of small firms and for policymakers aiming to cultivate an ecosystem of innovation.  

Smaller firms certainly need to lean on both the expertise and the funding of policymakers to help them to innovate and grow. However, membership associations that function as intermediaries must raise greater awareness of how their supportive policies operate, in order for small firms to fully understand and benefit from them. There must also be room for flexibility. Such intermediaries should seek to seamlessly bridge the link between small firms and the state, providing better access to policy information and institutional support without limiting opportunity.  

After all, as with any effective service, it must be developed with the user’s key needs in mind and reviewed and updated regularly. The business landscape is continually evolving. It stands to reason that the support schemes dedicated to helping businesses navigate such unpredictable futures should evolve too.  

More information about Professor Tsinopoulos's research interests.