Tuesday, 2 June 2015

Critique of Knowledge Development Box

David Jacobson and Jim Stewart: The idea of the Knowledge Development Box (KDB) is to provide tax incentives to firms to locate their R&D activities in Ireland. In a recent submission to the Government on the KDB, we argued that it is just a substitute for the “double Irish” tax loophole, which is in the process of being removed following EU and OECD pressure.

We also argued that although encouragement of innovation is indeed an important part of a rounded industrial policy, the KDB proposal is not an appropriate way of encouraging innovation.

Examples of the tax-related weakness of the KDB proposal include the following:

  • MNEs will continue to be able to use internal administrative switching of costs and revenues between fiscal regimes, especially for new product and process development.  What this means is that with little change in activity they will be able to derive the benefit of the KDB;
  • One of the elements of the KDB being offered to MNEs by the Irish government  is “increased resources for Revenue’s ‘competent authority’ function so that they can assist multinational taxpayers in transfer pricing disputes with other jurisdictions” (Department of Finance General Briefing on Corporation Tax for Budget 2015).  This appears to contradict what the OECD suggests as appropriate activity for a competent authority, in that such authorities should not take advocacy positions in relation to companies located in their own jurisdictions (OECD, 2007, Best Practice no. 3, p. 11);
  • Most firms in Ireland pay little or no tax. In 2012, 66% of firms accounted for 1.68% of corporate tax receipts.  For these firms, providing a tax incentive to undertake innovation is useless.  On the other hand, 0.9% of firms accounted for 83% of corporation tax receipts (see CSO Corporate Tax Distribution Statistics). Obviously the KDB is aimed at these few, multinational firms. This will do little to enhance the broadly defined Irish system of innovation.

The following points support our argument that the KDB is not the best way to support innovation as part of an integrated industrial policy:

  • The vast majority of R&D is undertaken by MNEs in Ireland.  Although accounting for only 55 percent of turnover, foreign owned enterprises account for over 70 percent of R&D (CSO press release, 2012).   If anything, the KDB will result in an even greater share in total R&D being accounted for by MNEs;
  • The KDB focuses on intellectual property and patents in particular.  Most innovations do not arise from patents.  Many patents, however, do not even result from R&D, but are the results of ideas generated “on the shop floor”;
  • The KDB will attempt to link the R&D expenditure in Ireland with the income from the intellectual property (IP) resulting from that expenditure. However, much expenditure on R&D never results in patents or any other IP.  The R&D may be generic and speculative in which case it may have long term objectives, or it may be specific and targeted but unsuccessful.  This will reduce any clarity about the relationship between a company’s R&D expenditure and its income from exploitation of its IP; 
  • Where exactly an idea is generated and evolves to become the IP of a company with operations in many countries may be difficult or impossible to determine.  This will further reduce the link between any R&D expenditure and the company’s IP;
  • The inherent lack of clarity will easily lead to the possibility of attachment of expenditure to result that will enable the MNE to derive the KDB tax benefit;
  • One consequence of this is likely to be “rent seeking”, with the build-up of expertise in the big accounting firms to ensure that the administrative systems of the MNEs meet the requirements for benefiting from the KDB, rather than any addition R&D skills.

Irish industrial policy has been excessively dependent on a fiscal regime to encourage foreign direct investments by MNEs into Ireland.  The KDB consultation paper itself states:
“Attracting investment that generates economic activity with real substance has been a central column of the Irish taxation system for more than 50 years and it is within this context that the introduction of the KDB is being considered.” 
It is our view that incentivising “investment that generates economic activity with real substance” should be the central column of industrial policy, not fiscal policy.

What is required for sustainable development in Ireland is an effective system of innovation.  This cannot be created by the types of policies exemplified by the KDB.

In TASC’s analysis of industrial policy we show that there is a wide variety of different policies, including the following, that must be integrated into a coherent industrial strategy:

  1. Setting up dedicated research institutes, for example Fraunhoffer Institutes in Germany 
  2. Encouraging and funding existing research institutes for example in Universities to focus on applied research and establish collaboration with industry;
  3. Using State agencies to encourage knowledge acquisition through such means as attendance at trade missions, provision of information;
  4. Subsidising and targeting lending;
  5. Providing current and capital grants for ‘qualifying’ expenditures;
  6. Providing tax incentives targeted at particular activities.
Ireland, it is clear from the foregoing, has concentrated for far too long on the last of these polices, namely fiscal policy.

David Jacobsen and Jim Stewart are members of TASC's Economists Network 

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