Preliminary hint

From the 1st of January 2016 officially entering into the force of the 17 goals and 169 targets [1] sustainable development followed the historic summit of the UN which took place in September of 2015.  The implementation of these goals is not legally binding, however, providing appropriate events and program development, implementation and monitoring are expected by UN member countries.

The 9th [2] of 17 goals of sustainable development is: “To create comfortable infrastructures, to contribute to the inclusive and stable development of the industry and foster innovation”.  Innovation is being presented like this: “To expand research works,  make relevant the technological opportunities in the branches of industry in all the countries, especially in developing ones, which includes  encouraging innovations until 2030 and significantly increasing research and development staff  per 1 million people, increasing public and private costs on research and development”. Let’s choose 2 keywords from here with which we will discuss on the next parts: Innovation, Research and Development (R&D).

R&D: commenting and connection with innovation.

In 1980s, when the approaches of the traditional economics were gradually being criticized, discussions over definitions and approaches of prominent Austrian economist Joseph Schumpeter, where the main accents are strived to innovation, entrepreneurship, their mutual connection and to Schumpeterian model of economic growth, were widely spreaded. In the context of innovation, which is a cornerstone in the Schumpeterian model of economic growth, the R&D examination’s emphasis in innovation stands out. In the vision set by the UN, the innovation and R&D are percepted as the way of reaching stable goals of development, demanding the countries increase the number of employees in that sphere and also the ratio between R&D costs and GDP.

Investopedia defines R&D as costs, which are “connected with the research and development of the products and services of the company. The company, in general, makes R&D costs while finding and creating new products or services” [3]

The Organisation for economic Co-operation and development (OECD) notes that this process should be new, creative, uncertain of its result, systematic and transmissible or reproductive [4]. I. e.  these are costs that incur in the the business (also the government, the universities, research centres, not commercial organisations, but, based on the purpose of the article, let’s emphasize the business sphere) expecting bigger results, which on his hand,  in addition to, for instance, the growth of the profitability, is creating also other favorable conditions, which we will discuss afterwards. 

To this day, the ratio between R&D expenditures and GDP, a number of expenditures per capita, as well as the impact of the tax factor on expenditures and amount invested by the state are still key to the analysis of economists.

As the innovation and R&D investments are being discussed together, it will be difficult to imagine the discussion without the startup ecosystem and without the discussion of possible proposals in this direction. Startups, as  the innovative fundamental basis, have been growing in the last decade in RA. This is especially connected with the development of the venture financing (the state investments greatly fostered the development of this branch too) with the positioning of Armenian companies in international market, with the growth of sizes of alternative financing (based on the results come from the Cambridge Centre for Alternative Finance [5] RA is the 9th in the world with the size of alternative financing per capita) and also with the application of the legislative regulations and tax incentives. This attitude related to newcomers in the market is attributed to different empirical researches. For example,  the economist David Resenberg, based on historical and practical experience, notes that due to market newcomers, technological innovation has developed much more in the different industries. Perhaps, this is one of the reasons why the entrepreneurship plays a crucial role in the world. 

Many economists like Kent Daniel and Sheriden Titman note in their “Market Reactions to tangible and Intangible Information” [6] that companies which are active regarding R&D investments,  are more likely to benefit from the technical innovations, which will have a positive impact on the market price of the company.

As a result of  that, governments are beginning to invest much more money in the R&D sphere and make it much more attractive for companies, investing in different legislative projects, to foster innovation. 

Relevant issues regarding R&D

The approaches of countries to design, foster and understand R&D are different, which brings several problems or ineffective choice of alternative options. The one of the relevant problems is that small companies keep being in the centre of the attention of the governments based on the technological innovation and point of view of R&D. The touch upon this issue of “Harvard business review” is worth mentioning. Let’s highlight two foremost issues of Anne Marie Knott’s research [7]:

  • The author claims that big companies invest in R&D 5.75 times more than small companies. Perhaps, this is due to several circumstances, especially the presence of the financial resources, experience, a high productivity of human capital which reflects the emphasis of government policies on small companies. But it is interesting that the research quotient of big companies (it is considered as the ability to generate income from R&D investments) is 13% higher in comparison to little companies. 
  • The author also refers to “Inc. 500 companies [8] research from an authoritative  Inc. newspaper where it is mentioned that more than 50% of startup founders made up their business idea from the sphere where they had  worked. I. e. the big business are the sources of innovative ideas which, in essence, are mostly omitted from the circle of privileges.

The next issue is the capitalization of R&D expenses. Capital expenses, are the expenses of the organisation with which new values are created and in the end, that expenses are reflected in the accounting balance sheet as an asset. This supposes that this kind of expenses, unlike, for example, marketing expenses, are not recognized as expenses when incurred, but are capitalized. I. e. they are added to any value of asset of the company or indicate the initial value of the resulting asset, then they are beginning to amortize those expenses during the certain period. 

The thing is that as a result of R&D expenses, sometimes intangible assets are created, which the organisation can use and gain the growth of economic benefits. Meanwhile, when the thing comes to the comparison of IFRS (International Financial Reporting Standards) and US GAAP (Generally Accepted Accounting Principles) with which the companies run the accounting (it is about the US reality) real differences are accrued. IFRSes, which are principle-based, enable capitalize R&D expenses if they satisfy defined criteria and it is supposed that a new asset is imported as a result. Meanwhile, US GAAP, which is regulation-based, define that these expenses should be recognized as expenditures during the reporting period to which they are attributed. The main issues that make us think are. 

  • GAAP defines transactions of R&D expenses and identification of those expenses at the same reporting time, meanwhile, the incomes of those expenses mainly come in different periods. From the point of view of administrative accounting, also based on the coinciding principles of accounting and terms of accounting method, this causes some contradiction.
  • If those are aimed at the creation of assets, the companies are more keen to implement capitalisation and amortisation of R&D expenses. I. e. the reflection of these expenses are efficient for companies not in the statement of comprehensive income, but in the statement of financial state(the statement for damage or income). For example, the company produces X type of product, a part of which is plastic in any kind and the company wants to increase the product durability. For that purpose it can make R&D expenses in a plastic sphere and find a new kind of plastic or any substance, which will be more durable. As the quality and features of the product have been changed because of R&D expenses, the capitalisation of that research expense is principally justified.

This also causes a problem from the base of financial analysis of the company. For example, when we compare the indicators of profitability in the similar industrial branches, we will notice that as a result of that, one of them, making R&D expenses and reducing them from the gross income, has gained a less income than other similar companies, which have not made that kind of expenses, however, for example, in terms of M&A (Margines & Acquisitions) the existence of R&D will make a sense.

Perhaps, there are quite many contradictions, discussions, and specialists that have not come to some consensus yet. However, we had better refer to these expenses in terms of accounting. In essence, companies are submitted to IFRS in terms of financial accounting, meanwhile, the “game rules” of accounting are generally settled by the government, and the international experience, if necessary, is used here to implement projects and to keep financial policies in monitoring. The peculiarity of tax policy and methodology is that it was historically regarded as a “monopoly” of the independence of the government. Perhaps this is one of the reasons that the UN applies coordination of tax policy but not harmonization approach.

The tax policies aimed for promoting R&D. World and Armenia 

It has already been several decades that the technological and globalizing world continues to adopt and develop an idea and application of tax credits (from now on tax credit). Formerly let’s try to understand which are regarded as tax credits and let’s speak about R&D credits (there are tax credits in either businesses or for physical persons, but we will discuss in terms of business). 

In terms of taxation, tax credits are considered as the expenses which are being reduced not from gross income but from tax liability amount (mainly are used in the USA, in the UK and in some countries of the UN). For example, in the USA if the company made $10000 expense for R&D and gross income was $100000 then to decide tax liability, we should not reduce $10000 from $100000 and we will calculate 18% profit tax rate on the basis of the received tax (credit is applied to the liability arising from different types of taxes. Profit tax example is used to streamline) and we will get $16200, but we will apply the profit tax rate on $100000 receiving $18000, then we will deduct $10000 from R&D tax on $8000, which is the amount of the company’s final tax liability. It turns out that the company paid $8200 less tax with R&D tax credit, which is, of course, profitable for the business. This, perhaps, refers to software, engineering, environmental and biological, manufacturing and design companies, whose gross revenue of that tax year does not exceed $5 million. Companies can reduce $25000 R&D amount from tax liability amount during one tax year [9]. The main goal of this is the development of scientific research thought and preservation inside the country as well as promotion of innovation. 

The application of the 10% rate of income tax gives reasons to think. In essence, the need of tax liability is connected to the development of IT companies and 0% of income tax surely is aimed at that and boosts development. However, the deduction of the income tax rate is not aimed at the companies, but at individuals, because the salary is, in essence, regarded as a wholly expense for the company and the company is just tax agent for individuals for paying income tax instead of, and, in essence, it is not so important for employer how much tax that employee will pay from that amount. It can also bring an artificial movement of employers from one sphere to another. We think it will be advisable to apply tax credits instead of this. Let’s substantiate why:

  • A monthly average nominal salary has made 186410.0 dram in RA in 2020 [10], according to unofficial data [11], the average salary of IT  sphere staff is estimated between borders of 400-480 thousand dram, meanwhile the salaries of educational sphere is the lowest. Hence, the privileges of income tax are much more needed in the educational sphere. Moreover, as it is mentioned above, a part of R&D is provided by scientific research centres and universities.
  • The advantages and disadvantages of the tax credits are widely discussed by specialists. Especially, the R&D credit is partially regarded as a benefit for staff again. The thing is that a big part of expenses of the R&D sphere is addressed to engineers’ and scientists’ salaries. The economist Osman Goolsby [12] refers to this issue and notes that up to 50% of that expenses are addressed to just reward,  while mentioning that “In this sense, R&D policy does not refer to innovative development as much as the reward of scientists’ human capital”.

Agreeing with this term, let’s mention that growth of scientific potential and rapid development of applied sciences in RA show a big importance especially in the corporate sphere. In the 2017 report of “Enterprise Incubator Foundation” states that 77% of inquired companies noted the lack of highly qualified employees as the main stymie of ICT activity. Based on the results of the UN Armenian office [13], R&D is only 0.24% of GDP in RA and a number of R&D specialists per one million population is only 1231 people, the state accounts for the largest share of these accounts for the largest share of these expenses. If we compare with our neighbor Georgia [14], then the difference between countries are not large based on the ratio of the male and female specialists, the number of specialists per one million population and the ratio of GDP, while the main difference is that the largest sector in Georgia, which makes this expense, is universities.

Considering above mentioned observations and discussions as well as the need of continued innovation in the economy and the efficiency of importing tax various mechanisms, we think that investment of tax credits and the development and implementation of other economic and tax policy will give the RA the opportunity to implement international “responsibilities”, foster scientific research mind development and the continuous growth of startup ecosystem, making RA not only post-Soviet but also European “Silk Valley” as a result.

  1. ՀՀ հարկային օրենսգիրք
  2. Ձեռնարկությունների ինկուբատոր հիմնադրամ: «ՏՀՏ ոլորտը Հայաստանում», 2017, 2018
  3. European Commision: A Study on R&D Tax Incentives Annex: Country fiches, 2014
    https://ec.europa.eu/taxation_customs/sites/taxation/files/resources/documents/taxation/gen_info/economic_analysis/tax_papers/country_fiches.pdf
  4. Rachel Griffith:How important is business r&d for economic growth and should the government subsidise it?, 2000
    https://www.ifs.org.uk/bns/bn12.pdf
  5. Pierre Mohnen: The effectiveness of R&D tax incentives, 2013
    https://ec.europa.eu/competition/state_aid/legislation/workshop_rdi_pm_en.pdf
  6. OECD library: Productivity Measurement and Analysis, 2008 https://www.oecd-ilibrary.org/economics/productivity-measurement-and-analysis/empirical-analysis-of-the-effects-of-r-d-on-productivity_9789264044616-17-en;jsessionid=Ti755NEtvH7vSHZRb5_4NzbA.ip-10-240-5-87
  7. Nirupama Rao: Do tax credits stimulate R&D spending? The effect of the R&D tax credit in its first decade, 2016
    https://www.sciencedirect.com/science/article/abs/pii/S0047272716300482
  8. Andi Duqi, Riccardo Mirti, Giuseppe Torluccio:  An analysis of the RD effect on stock returns for European listed firms, 2011
    https://mpra.ub.uni-muenchen.de/40012/1/MPRA_paper_40012.pdf
  9. Alexander Klemm: Causes, Benefits, and Risks of Business Tax Incentives, 2009
    https://asean.elibrary.imf.org/view/IMF001/09873-9781451871685/09873-9781451871685/09873-9781451871685_A001.xml?redirect=true&redirect=true


Author: Hayk Khalantaryan  © All rights reserved.

Translator: Aram Sanamyan