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State-level R&D tax credits create startups, but don’t help them succeed

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Research and development tax benefits are touted as a way to encourage economic development and innovation, but new research from MIT Sloan entrepreneurship and strategy professor Scott Stern suggests these benefits don’t guarantee rapid, high-entrepreneurial growth.

In their working paper “The Impact of State-Level R&D Tax Credits on the Quantity and Quality of Entrepreneurship,” Stern and his co-authors write that while local R&D tax credits encourage the type of entrepreneurship needed for economic growth, they “offer no universal salve for accelerating entrepreneurial ecosystems.”

State-level R&D tax credits were linked to a 7% increase in the rate of net new businesses.

“Counties with R&D credits are no more effective at helping startups to realize growth outcomes than those without,” the researchers write. “Thus, while R&D tax credits will lead to creation of more growth-oriented startups, policymakers cannot also count on R&D tax credits to improve those startups’ performances.”

Stern’s co-authors are Jorge Guzman, an MIT Innovation Initiative research affiliate and Columbia Business School assistant professor, and Catherine Fazio, managing director of the Laboratory for Innovation Science and Policy at the MIT Innovation Initiative.

The authors analyzed all new business registrations from 34 U.S. states between 1988 and 2012 (more than 18.9 million businesses), combined with information from the Panel Database on Incentives and Taxes, which lists taxes and business incentives for 42 cities across 33 states from 1990-2015.

R&D credits are slow and steady

According to the study, R&D tax credits were linked to a 7% increase in the rate of net new businesses.

Counties with R&D credits also had a 7.5% higher number of new businesses than counties without those credits, as well as a higher “quality-adjusted quantity of entrepreneurship,” essentially more businesses that are more likely to grow.

And the increase in new startups won’t be immediate. The researchers observed a 2% rise in the rate of new startups each year throughout a 10-year period — a 20% total increase.

“Our results provide evidence showing that there is a significant effect of state R&D tax credits on the rate of entrepreneurship, but that this effect only accumulates through time,” the researchers write. “Counties should expect to wait a few years following the introduction of a credit to see any initial effects and up to a decade to see effects that are substantial.”

Investment benefits can crowd out newcomers

R&D tax credits aren’t the only economic development options for counties, but the researchers found that not all benefits are created equal — at least in terms of helping or harming early-stage startups.

State-level investment tax credits have been used for the past few decades by larger, more established companies purchasing machinery and buildings, the paper stated.

These credits are linked to a 5% drop in the number of new businesses in a county and a 9% decrease in the regional entrepreneurial potential, meaning less potential high-growth businesses.

And while R&D credits are linked to a 20% rise in the rate of new startups throughout a 10-year period, for that same timeframe, investment credits drop expected growth outcomes by 1.2% per year and 12% in total.

“Generally, we concluded the effects of the investment tax credit are negative on entrepreneurship, and more specifically high growth potential firms, suggesting a ‘crowding out’ effect on investment in the region as the investment tax credit is taken advantage of by large companies,” the researchers write.

Tax credit takeaways

So what can counties do to promote innovation and entrepreneurship for their new and established businesses?

Stern and his co-authors recommended patience as well as a mix of incentives to avoid ending up with benefits that are at odds with one another.

“Overall,” the researchers write, “our findings counsel in favor of ‘patient’ and targeted policy — offering longstanding tax incentives tailored towards the revenue trajectories of high-potential growth startups and encouraging investment in initiatives, including public-private partnerships, that support this important category of newly-founded firms.”

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