Annex 1 The effect of R&D tax incentives on location of R&D investment Chiara Criscuolo Centre for Economic Performance, London School of Economics and OECD c.criscuolo@lse.ac.uk and chiara.criscuolo@oecd.org Introduction Governments across developed and developing economies try to encourage firms to invest in Research and Development (R&D) using financial and fiscal incentives. The reason is that the returns to investment in knowledge and innovation cannot be fully appropriated by innovating firms as knowledge is a public good that can ‘spill over’ to others. Due to these externalities, the level of private R&D investment will be below what would be socially optimal. Spillovers are generated from private firms’ R&D and firms can therefore benefit from the presence of more innovative and more productive firms. There is now widespread evidence that multinationals are both more innovative and more productive than the average domestic firm. This is the rationale for policies to be aimed at attracting foreign firms. In a world where multinational enterprises (MNEs) are increasingly internationalising their R&D activities, governments also compete in attracting R&D activities of multinational corporations which would have a high value added content and a strong knowledge spillover potential. The rationale is that generous incentives (e.g. a generous R&D tax incentive system) might make a country a relatively more attractive location for R&D investments than its competitors and that the forgone tax revenues would be compensated by the benefits accruing to the local and national economy from receiving the Foreign Direct Investment (FDI) both through increased employment, value added and localized knowledge flows. 1 Understanding whether these policy measures have a significant impact on the location of multinationals’ R&D investment is therefore becoming increasingly important since (national or local) governments’ decisions on the introduction or modification of innovation support programs have the additional aim of attracting the increasingly mobile R&D investment projects by multinational corporations. Recently, several countries have made their R&D tax incentives more generous to be more attractive to foreign firms. For example, in Europe, France has recently changed 1 The economic geography literature has stressed the importance of localized knowledge spillovers (LKS). Some researchers (e.g. Breschi and Lissoni, 2001) have stressed that more than pure externalities, local knowledge flows are actually mediated by economic mechanisms, .local markets, but do not dispute that knowledge flows are an important agglomeration force.