R&D Tax Credits — Atlas of Innovation

Definition

Research and development (R&D) tax credits encourage innovation by allowing companies to reduce their tax bill by claiming credits on eligible R&D expenses. Eligibility can depend on factors such as a company’s sector, size, or other characteristics.

Tax credits targeted to a specific product or service are covered in per-unit subsidies.

Why might R&D tax credits be the right funding approach?

R&D tax credits enable policymakers to broadly spur innovation without micromanaging which ideas get funded. By lowering the after-tax cost of innovation, R&D tax credits encourage companies to invest in innovation, while leaving them free to choose which projects to support. Evidence suggests tax credits have a large effect on the volume of R&D undertaken: “a 10 percent fall in the tax price of R&D results in at least a 10 percent increase in R&D in the long run.”

R&D tax credits are most effective when the innovation challenge is:

Suitable for domestic companies with tax liability: Credits are awarded only for R&D conducted within the jurisdiction offering them, and can reduce taxes only up to the company’s tax liability in that same jurisdiction.
Near commercial application: R&D tax credits work best when companies already see a plausible market path. Companies still shoulder most of the cost and naturally pursue projects with clear commercial payoffs. This makes tax credits a low-friction way to support research and development for technologies close to market, but a poor tool for incentivizing research not typically done by companies.

R&D tax credits offer policymakers several key advantages, including:

Avoiding picking winners: Any company that meets the statutory definition of qualifying R&D can claim the credit, so officials do not need to judge which specific projects or companies are best placed to succeed. This reduces administrative costs, lobbying pressure, and selection error.
Leveraging companies’ private information: Companies know their pipelines, costs, and risks better than grant panels do. An R&D tax credit lets companies act on that private information without having to disclose proprietary details in seeking public funding.
Skin in the game: Since tax credits only offset a portion of the R&D costs, innovators still have “skin in the game” and invest only when they expect sufficient commercial returns.

What can go wrong?

While R&D tax credits are a versatile tool, they are not without challenges:

Rebadging: Companies may rebadge existing expenditures as research and development to take advantage of the tax break.
Overspending: These programs often lack built-in budget caps. Total expenditures can balloon if take-up of R&D tax credits significantly exceeds projections.
Priority agnosticism: Because any qualifying expense earns the same relief, credits mainly support projects with substantial private payoffs, not the ones where the gap between social value and commercial incentive is greatest (e.g., neglected‑disease drugs). As a result, ample fiscal resources may bypass the market failures policymakers most want to fix.
Research relocation: Since credits only offset domestic tax liability, they tilt research activity toward the sponsoring jurisdiction. While some policymakers may welcome this, it can lead companies to relocate research they would have completed anyway, even without the financial incentive.

Apart from good tax credit design, policymakers can address these pitfalls by implementing stricter eligibility audits and fiscal controls, such as company-specific spending caps and sunset clauses. While rigorous audits help ensure only legitimate R&D receives support, excessive compliance requirements may deter smaller companies. Similarly, spending limits help manage costs but can leave large-scale innovation ineligible for credits.

Design and implementation details

Policymakers must decide on key design features, including scope, structure, and eligibility. Policymakers face several key choices:

Should the credits have a broad or targeted scope? General credits apply across all industries and let companies choose their own R&D projects. They are simpler to administer and less vulnerable to lobbying. Sector- or topic-specific credits target industries where research generates broader spillovers or technologies with large social benefits, such as climate technology and pandemic preparedness.

Should credits be relative to a baseline? Incremental credits reward companies for increasing their R&D spending, directing support toward new investment rather than ongoing work. However, they can also prompt companies to shift spending between years to earn larger credits. Volume-based credits avoid this by rewarding all R&D spending equally.

Should credits depend on its tax liability or the size of a company? Refundable credits benefit companies with little or no taxable income, such as early-stage companies with limited tax liability. Carry-forward provisions allow companies to claim the credit once they have sufficient tax liability. Some systems offer enhanced rates or simpler rules for small and medium-sized companies, since the implementation of refundability and incremental credits can make R&D tax credits difficult for them to navigate.

Regardless of structure, clear guidance and simple administration are critical to avoid discouraging legitimate claims.

Examples

R&D tax credits are widely used across the economy and, in some cases, targeted to specific sectors. Governments recognize that there are very common reasons that firms tend to underinvest in R&D. For example, competitors can capture the economic returns through imitation, reverse engineering, or worker mobility. The examples below illustrate both broad and sector-specific R&D tax credit programs.

Broad R&D tax credit programs:

US Research & Experimentation (R&E) Tax Credit: Implemented in 1981, the R&E tax credit supports companies investing in qualified R&D activities, ranging from pharmaceuticals to software development. The US credit is general (as opposed to sector-specific) and incremental.
UK’s R&D tax credit: The UK offers R&D tax credits to companies performing research in the UK. They offer different tax credits for small and medium enterprises relative to large enterprises, and evidence suggests that UK’s R&D tax incentives increase patenting.

Sector-specific R&D tax credit program:

Wisconsin Energy-Sector Research Credits: Wisconsin’s energy-sector-specific research credits are an example of sector-specific research credits. Wisconsin offers a baseline 5.75% tax credit for all R&D, with a higher 11.5% rate for energy-related technologies to spur further innovation in internal combustion engines, hybrid vehicle batteries, efficient lighting, building automation, and other energy technologies.

R&D tax credits often complement other innovation funding mechanisms. Their flexibility and broad targeting make them a foundational tool that can be combined with other strategies:

Research grants: Direct grants can support risky, early-stage research that lacks strong commercial applications but has significant public good potential, such as basic science. Grants stand in contrast to R&D tax credits, which boost the projects that companies already see as profitable or near profitable.
R&D contracts: Contracting research with specified development goals works well for tightly managed innovation projects, while tax credits are better suited to fostering decentralized innovation.

Definition

Why might R&D tax credits be the right funding approach?

What can go wrong?

Examples

Related funding approaches

Further reading