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Absorptive Capacity And R&D Tax Policy: Are In-house And External Contract R&D Substitutes Or Complements?

T. Arwyn Watkins, Lolita Anna Paff
Published 2009 · Economics

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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.
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