A Model of R&D Tax Incentives

This paper examines R&D tax incentives in oligopolistic markets. It is generally agreed that R&D has some characteristics of a public good. Therefore, the market will fail to provide a sufficient amount of R&D. A tax incentive for R&D can be implemented by the government to fix this market failure. However, the controversy over the effectiveness of R&D tax incentives is still considerable. In this paper, we set up a simple game-theoretical model to identify the conditions under which the tax incentives serve as a tool to reach the socially desirable level of firm-financed R&D spending. It is shown that the government might want to tax R&D when the sector spillover is sufficiently low. This is more likely to happen if the industry is highly concentrated. Moreover, the government’s policy works only if the sector is reasonably concentrated. The optimal R&D subsidy (or tax ) is independent of demand characteristics, initial marginal cost, and the cost effectiveness of R&D. It depends only on the sector spillovers and the number of firms in the industry.