Absorptive capacity and R&D tax policy: Are in-house and external contract R&D substitutes or complements?

Todd A. Watkins, Lolita Anna Paff

Research output: Contribution to journalArticlepeer-review

12 Scopus citations

Abstract

Firms fund research and development (R&D) to generate commercializable innovations and to increase their ability to understand and absorb knowledge from elsewhere. This dual role and opposed incentive structure of internal R&D create a significant question for both theory and R&D policy: Is internal R&D a complement or substitute for external R&D? We develop a model and novel technique for empirically estimating R&D substitution elasticities. We focus on bio-pharmaceutical and software industries in California and Massachusetts, where tax credit rates changed differently over time for the two types of R&D, creating a natural experiment. The effective tax prices for the two R&D types differ from type to type, firm to firm, state to state, and year to year. This allows us to examine changes in the composition of firms' R&D budgets between in-house R&D and external basic research when the relative tax prices of each category of research change. We find evidence of a substitute relationship both for a sample comprising exclusively small firms as well as for a more general distribution of firm sizes.

Original languageEnglish (US)
Pages (from-to)207-227
Number of pages21
JournalSmall Business Economics
Volume33
Issue number2
DOIs
StatePublished - Jan 1 2009

All Science Journal Classification (ASJC) codes

  • Business, Management and Accounting(all)
  • Economics and Econometrics

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