The effects of public support schemes on small and medium enterprises Sonja Radas a,n , Ivan-Damir Anic ́ a , Azra Tafro b , Vanja Wagner b a Institute of Economics, Zagreb, Trg J. F. Kennedy 7, 10000 Zagreb, Croatia b Department of Mathematics, University of Zagreb, Bijenicka 30, 10000 Zagreb, Croatia article info Keywords: Tax incentive Subsidy Direct grant R&D SME Innovation Absorptive capacity Developing country abstract In this paper we will investigate the effects of direct grants and tax incentives on recipient small and medium enterprises (SMEs). Direct grants and tax incentives are two different public instruments used to correct market failure and facilitate innovation through lowering the cost of R&D. Although large and small firms innovate in different ways, so far limited empirical evidence has been reported with respect to the effectiveness of public R&D instruments for SMEs. Our data suggests that direct subsidies used alone or with tax incentives strengthen the R&D orientation of the SME as well as some aspects of innovation output and absorptive capacity. Although the effects of policy measures are significant when comparison is made to firms that did not use any of the two instruments, not much difference is found when users of direct grants are compared to those who used both the grants and the tax incentives. This result indicates the existence of limitations in the use of tax incentives by SMEs, and thus suggests that subsidies may be the primary instrument in SMEs. & 2014 Elsevier Ltd. All rights reserved. 1. Introduction In this paper we investigate the effects of direct grants and tax incentives, two different public instruments used to correct market failure and facilitate innovation. (The terms direct grant and direct subsidy are used interchangeably to denote a payment made usually by government agencies or local authorities to companies in order to subsidize the cost of a specific R&D or innovation project). While direct subsidy programs are generally intended to support commercial R&D projects with large expected social benefits but inadequate expected returns for private inves- tors (Klette et al., 2000), a tax incentive is a tool for encouraging private R&D expenditure in companies. Traditionally, the majority of studies have focused on determining the impact of public instruments on R&D expenditures. As it was recognized that this aspect by itself does not sufficiently explain the effect of public instruments on innovation in firms, the focus shifted to include the impact of public instruments on innovation output, and changes in firms’ innovation-related behavior (Clarysse et al., 2009). However, studies that deal with alterations in firms’ innovation output and behavior remain scarce. Existing literature presents evidence of the usefulness of both tax incentives and direct grants, but the overwhelming majority of these studies focus on only a single instrument as opposed to both. Studies that consider the joint use of these instruments are very scarce (Busom et al., 2014; Bérubé and Mohnen, 2009). The effectiveness of these public policy measures is of particular relevance for small and medium enterprises (SMEs), which rely on innovation to an even greater extent than large firms and are less able to appropriate rents associated with innovation (Fritz, 1989; Sweeney, 1983). This paper adopts the European Commis- sion definition of SME as a company that employs less than 250 employees and has a turnover of less than 50 million Euros. Taking into account that SMEs comprise a large part of most economies, it is fair to state that the impact of public instruments on SMEs requires special consideration. In this paper we seek to contribute to the literature on public support schemes in four ways. First, we focus purely on SMEs seeking to contribute to the understanding of how public instru- ments affect these companies. We also consider the effects of subsidies (alone or used jointly in combination with tax incen- tives) on a number of R&D and innovation variables compared to firms which underwent no treatment. Thus far not much empirical evidence has been provided with respect to the effectiveness of R&D instruments on small and medium-sized firms (Romero-Jordán et al., 2014; Czarnitzki and Lopes-Bento, 2013; Reinkowski et al., 2010; Herrera et al., 2010). The closest to our paper is the study by Hottenrott and Lopes-Bento (2014), which demonstrates that R&D subsidies aimed at incentivizing collaboration in SMEs improve innovation performance. As compared to Hottenrott and Contents lists available at ScienceDirect journal homepage: www.elsevier.com/locate/technovation Technovation http://dx.doi.org/10.1016/j.technovation.2014.08.002 0166-4972/& 2014 Elsevier Ltd. All rights reserved. n Corresponding author. Tel.: þ385 1 2362 283. E-mail address: sradas@eizg.hr (S. Radas). Please cite this article as: Radas, S., et al., The effects of public support schemes on small and medium enterprises. Technovation (2014), http://dx.doi.org/10.1016/j.technovation.2014.08.002i Technovation ∎ (∎∎∎∎) ∎∎∎–∎∎∎