Endless innovating when it comes to R&D policy can only be unhelpful

We know Rishi Sunak likes innovation. The Silicon Valley premier created a new department for science, innovation and technology as part of the modest ambition of making the UK “the most innovative economy in the world”. 

In his Mais lecture last year — which showed the thinking behind the welcome tax breaks for business investment announced by Chancellor Jeremy Hunt in Wednesday’s Budget — Sunak laid out how important innovation is for growth, and bemoaned the UK’s record in stimulating business research and development. Policy to address this, alas, has been a mess.

The latest change was an “enhanced” tax credit for small, loss-making businesses that spend more than 40 per cent of their costs on R&D. This is really a tweaking of the hatchet job of last autumn.

Hunt then slashed the generosity of the R&D tax relief for small and medium sized businesses, boosted the rate for larger companies and launched a consultation on a new combined scheme. There had been concern — notably in the work of David Connell at Cambridge’s Judge Business School — about the cost of R&D tax credits, approaching £8bn. There were also questions about value for money in the more costly small business scheme.

The cuts — which prompted a furious reaction from small businesses and high-tech industries alike — were based on at least two confusions. First, there had been rumblings about fraudulent or spurious activity, including the now infamous claim for a blueberry croissant recipe. HMRC’s oversight had been laissez-faire: it couldn’t explain the growth in the cost of R&D credits, or reliably estimate fraud or error. Upping enforcement — and cracking down on the unregulated no win, no fee-style tax advisers in this area — would have been the logical response.

Second, angst about fraud had been exacerbated by the £15bn gulf between R&D as measured by tax returns and lower figures from the Office for National Statistics. This vanished last October when the ONS revised its numbers, saying its survey had hugely understated the activity happening in smaller companies — the businesses that were then penalised in the autumn Budget.

Big companies that do lots of R&D, like Rolls-Royce or GSK, are just easier for the government to deal with. But research by the London School of Economics has suggested, looking at a 2008 change in the definition of SMEs, that tax credits were successful in stimulating R&D spending and patent registrations among that cohort. This was particularly true of younger firms, more likely to face cash constraints.

Either way, last autumn’s changes, according to the Federation of Small Businesses, had already had a dulling effect on willingness to invest or undertake riskier projects. An impressive 97 per cent of respondents to a survey by start-up body Coadec said the cuts would “severely impact” them.

This latest tweak won’t help much. The prime minister in his Mais lecture decried the idea that “the government should decide which sectors will be important in the future” but the R&D tax credit scheme, fundamentally a market-led mechanism, is being reshaped in that direction.

The 40 per cent threshold is set so high as to exclude many innovative companies beyond the world of biotech start-ups. A similar test for R&D intensity in the Australian scheme is set at 2 per cent. The incentive and support for most small companies to innovate is still being drastically reduced. The new enhanced credit will favour nascent research in science and academia, rather than operational businesses in manufacturing, engineering, communications or IT.

Meanwhile, the man credited with inspiring Sunak’s R&D approach argues that the government isn’t addressing the underlying issue of the failure to turn “promising new STEM companies into significant, global players”, in part because many are acquired by overseas buyers. “R&D tax credits don’t help here,” says Connell. “We need other policies, including US-style government R&D contracts, to address this problem.”

The government is still considering a new merged tax credit scheme, and has delayed restrictions on overseas expenditure in R&D relief to next year. For companies trying to plan long-term projects, this endless innovating when it comes to R&D policy can only be unhelpful.

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