Hot! Intangible taxes – business/ – It’s time for a close look at fiscal support for R&D, exploration spending
Jun 28, 2011.   Jack M. Mintz

Recently, I was asked to speak at the National Tax Association conference in Washington on U.S. corporate tax reform, pitching the well-known policy of lower tax rates and a more level playing field among businesses. One of the participants asked a rather important question: Why does intangible capital spending, such as research and development, exploration and development, advertising and labour training, get better treatment under the tax system than other capital investments? No simple answer comes to mind.

We know that intangible capital spending is large. For Canada, 2009 private spending on research and development was $16-billion. Exploration and development spending by the non-renewable resource sector was about $25-billion, with about two-thirds in the oil and gas sector. Advertising expenditure was somewhat less than $10-billion. Investment expenditure in construction of real estate is about $15-billion. In total, this private intangible spending amounts to about 3.2% of GDP.

We often link GDP growth with intangible spending, especially R&D. Yet, GDP accounting is distorted by such expenditures for several reasons. Intangible spending creates “capital” in the form of new ideas, goodwill or reserves in the ground. Unlike buildings that are typically sold, the value of this “capital” is not measured as part of GDP, so Canada looks as though it is spending money without generating any output. For example, typical analysis has suggested Alberta has poor productivity, but if we valued such created capital (reserves in the ground), we would see productivity zooming through the roof. When capital from intangible expenditures is built, they contribute to production, which is then added to GDP. The longer it takes to earn income from intangible investments, the longer it shows up in our growth rates over time. This helps explain in part why countries with large intangible spending have low productivity, since it takes time to use the capital that is not valued in GDP measures.

Governments fall over themselves to support certain types of intangibles. Under the corporate income tax, intangible expenditures are often written off fully, enabling companies to claim deductions before they realize income from such expenditures. In the case of R&D, companies claim federal and provincial investment tax credits that total up to 27% of R&D spending in the case of large companies and roughly 44% of costs for small businesses. Investment tax credits are also given for mining exploration. Grant and other fiscal support is also given to these activities.

Provincial royalties for mining, oil and gas either offset or add to the preferential treatment provided to these investments under the corporate tax system, depending on the type of expenditure. Mining royalty systems, such as for potash or metallic ore, provide fast write-offs for intangible expenditures as well. Oil and gas royalties in Nova Scotia and Newfoundland and Labrador provide excessive write-offs for successful exploration and development expenditures although they unfairly disallow the deduction of unsuccessful exploration expenditures. Royalties on conventional oil and gas impose fiscal costs on new exploration and development projects since costs are not deductible, while the oil sand royalties are more appropriately framed as rent levies.

Overall, the Canadian fiscal system provides significant fiscal benefits to most intangible expenditures, except for certain oil and gas spending. What rationale can be given for the preferential treatment of intangible expenditures?

A typical argument is that intangible expenditures on research is insufficient without government grant or tax support due to economic “spillovers.” Innovators cannot fully appropriate the economic returns on research investments since they cannot charge other businesses for the use of the knowledge without paying for its costs. If they could be rewarded for all economic returns, they would invest more in research projects.

This so-called “spillover” argument makes sense especially for R&D and E&D, but less so for advertising. Innovation by one firm provides significant benefits to other companies who could use the idea without paying for it. Finding a pool of oil or ore deposit in one part of Canada provides new information to competitors (who also get higher values for contiguous leases). Advertising provides few economic benefits to other firms, except perhaps to draw attention to the industry’s product, rather than the advertiser.

By implication, the tax support given to intangibles should therefore vary by the size of spillovers. They do not. Clearly, businesses such as drug companies are able to capture better the economic returns on patented compared with non-patented R&D, yet we provide the same tax credit in both instances. Similarly, we provide more support to small business research, but do not know whether the spillovers are more important in this case compared with large business research. And, mining exploration is given more tax support compared with oil and gas exploration, but less so than development expenditures for research projects.

None of this really makes sense. The R&D lobby is able to garner public support by pointing out Canada’s low R&D intensity — the heavy tax and grant support reflects this successful plea. Mining is typically favoured since it generates jobs in rural areas. Conventional oil and gas intangibles are treated less favourably given their size and costs, but also in part for historical reasons.

With the federal and provincial governments looking to improve productivity, it is time for us to have a close look at the current fiscal support given for intangible spending to make it more effective. The principle underlying our tax systems is that we should keep rates low and as neutral as possible among businesses, a principle that has served Canada well in the past 15 years. The only exception is to encourage more research or exploratory activity. It is also a principle that the United States should learn from Canadian tax reform experience.

Financial Post
Jack M. Mintz is the Palmer chair in public policy, School of Public Policy, University of Calgary.

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1 Comment

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