Euro-Asia Centre Research Papers Vol. 26 2000 Ldzstrdnieks University of Limerick. College of Business. Dept. of Economics.

Euro-Asia Centre

Taxation and Innovation in the European Union

Bernadette Andreosso-OCallaghan*

Contents Introduction 1. Economic significance of the High tech sector in the EU 2. Innovation Policy and Taxation The case of the EU in a comparative perspective 3. Recent recommendations proffered at EU level and ensuing initiatives Concluding remarks

Introduction

Although tax policy is an important determinant of innovative behaviour, it is only one of the many factors impinging on the level of technological change and innovation. In the Handbook of Industrial Innovation (1994) the section on Key Issues Affecting Innovation contains ten chapters respectively relating innovation to each of the following factors: financial systems, supplier relationships, user/supplier links, technological collaboration, marketing, intellectual property, size of firm, organization, industrial relations and training. All these factors can be interpreted as emanating from a combination of institutional infrastructure, skills, knowledge and insight. This suggests that no one measurable factor can comprehensively explain differences in technological and innovation performance 1 . However, taxation regimes do create additional and important incentives (conversely dis-incentives) for research and innovation.

Consequently, the establishment of an environment conducive to innovation implies, inter alia, the implementation of a favourable fiscal treatment for innovation-based investments. The issue of taxation and high technology is complex in the sense that the innovative activity of firms is associated with many aspects and levels of taxation. These are: indirect taxes such as VAT rates on high tech products; direct taxes such as income taxes of researchers and scientists, and social security contributions; corporate tax rates on innovative activities, and taxes on intellectual property such as patents. By highlighting the many problems that exist in the EU taxation systems with regard to innovation, this article will provide an insight into the recent efforts made by the EU
* Professor, University of Limerick
1 According to Porter (1990), the intensity of competition and the nature of the financial and educational institutions in the domestic market have a dominant effect on innovation. Other authors argue that

Commission to redress the fiscal bias, in favour of research and innovation. A comparative analysis with the EUs main innovative competitors will enable to comprehend the extent of the fiscal and technological lags. Starting with a few definitional issues, the article will also briefly assess the economic importance of the high-technology sector for the EU as a whole.

1. Economic significance of the High tech sector in the EU 1.1. Definitional issues A high technology industry is defined by the OECD as one industry that devotes a high share of its turnover or production to R&D spending. The computation of this ratio for a country enables the classification of manufacturing industries into high-tech, medium-high, medium-low and low technology categories (OECD, 1994, Science and Technology Policy). With more than 10 per cent of their production value devoted to R&D expenditures, the Aerospace, Computers, Electronics, and Pharmaceuticals industries are typical high-technology industries. Instruments, Motor vehicles, Chemicals and Electrical Machinery are all classified as medium-high technology industries. In contrast, Wood and Furniture, Textiles&Clothing, Paper and Printing are examples of low-technology industries. 1.2. Economic significance of the high tech sector in the EU and elsewhere These high-technology industries are important for a large number of economically advanced EU countries, in that they correspond to their new areas of comparative advantage or to their new manufacturing strengths. In a large typical country of the EU (such as Germany, the UK and France), the high-technology markets capture roughly a third of total domestic turnover. These industries enjoy above average productivity and employment growth. In terms of employment, the high growth sectors (of which computers and office machinery) have made the highest contribution in terms of job growth between 1994 and 1998 (CEC, 1999). In the EU, the innovative industries, defined as those with above average R&D intensities, are also those with the highest percentage of new product sales, and with high export shares (Calvert, Ibarra, Patel and Pavitt, 1998). Moreover, because of their spillover effects, these industries command productivity gains in others industries, including industries in the services sector. These industries are therefore major determinants of economic growth in an economy.

innovation is more influenced by technology specific factors, linked to technology regimes (see Malerba and Orsenigo, 1995).

1.3. The EU innovative capability and performance Technological capabilities are defined by Bell and Pavitt (1997, p.89) as the resources needed to generate and manage technical change, including skills, knowledge and experience and institutional structures and linkages.2 Being an input into technological effort, R&D is clearly a first indicator in Science and Technology performance. In 1997, gross expenditure on R&D (GERD) as a percentage of GDP in the EU was 2.35 per cent, compared with 2.64 per cent in the USA and 2.83 per cent in Japan (Table 1).3 Table 1: Gross Domestic Expenditure on R&D (GERD) as a percentage of GDP 1992 1995 1997 ___________________________________________________________ Japan 2.8 3.00 2.83 (*) USA 2.7 2.58 2.64 Germany 2.5 2.28 2.39 France 2.4 2.34 2.26 UK 2.1 1.94 (*) Italy 1.4 1.14 1.05 EC/EU (#) 1.9 1.84 2.35 (*) ___________________________________________________________
Source: OECD (1994) Science and Technology Policy; OECD (1997 and 1999) Main Science and Technology Indicators (Paris). (*) Data for 1996. (#) EC-12 for 1992; EU-15 for subsequent years.

The level of skill, knowledge and insight is another factor influencing innovation. According to some writers, it is the main one. Reich (1992: 137), for example, argues that the important question... is not which nations citizens own what, but which nations citizens learn how to do what. Table 2 shows that the EU ratio of highly qualified personnel (HQP) to the labour force (4.9% in 1995) compares quite poorly with that of either Japan (10.1%), or the USA (7.4% in 1993). As for GERD, so for HQP, there are wide discrepancies within the EU. The ratio is higher for France, Germany and some of the Nordic countries like Finland and Sweden than for the
2 For a synthetic discussion on technological and social capability at both individual and institutional levels, see Jang-Sup Shin, 1996, chapter 2. 3 It should be noted that this low figure for the EU conceals substantial imbalances in GERD levels among the various member states. While Swedens R&D levels are higher than those of Japan and the USA, the figures for the other best performing EU economies are well below: 2.73% for Finland, another new EU member, 2.39% for the reunited Germany, 2.26% for France, 1.94% for the UK, and 2.09% for the Netherlands. The other large EU member countries devote much less of their GDPs to GERD, the figure being only 1.05% in Italy and an even lower figure of less than 1% in Spain. When the four poorest member states of the EU, the so-called cohesion countries, are excluded (i.e. Greece, Portugal, Spain and Ireland), the GERD to GDP ratio for the EU-11 rises slightly to 2.05% (CEC, 1998). The four cohesion countries devote, on average, only 0.82% of their GDP to GERD, a

other EU countries. Note that in Europe the ratio is the highest for Norway, a non-EU member that participates in EU-funded research programmes.

Table 2: Total R&D scientists and engineers, or university graduates per thousand labour force. Country EU-15 Nordic Countries Japan USA 1991 4.4 5.4 7.5 7.6 1995 4.9 7.0 10.1 7.4 (*)

Source: OECD, various issues, Main Science and Technology Indicators. (*) Figure for 1993.

Table 3. EU trade in high-tech products (in billion Ecus) Extra-EU exports 35.413 72.509 61.6 Extra-EU imports 30.345 95.794 72.0 Balance + 5.068 - 23.285 - 10.4

1980 1990 1997

Source: adapted from European Economy (1993b, p.213). For 1997, Bulletin of Economic Trends in Europe and Summaries 1/99, Dossier of the month, Brussels.

The continuous fragility of the EU high technology sector appears clearly from the reading of table 3, and figures 1 and 2. The deficit in high-tech products is particularly noticeable in 1990. A closer look at import and export structures would show that the EU high-tech imports are highly concentrated in computers and office machinery, followed by general electronics, the weak areas of EU industrial specialisation. In terms of trade partners, the EU had in 1995 a negative trade balance in high technology products with the USA (-Ecus 13.7 bn), Japan (-Ecu 10.1 bn), and with the six newly industrialised countries of Asia (- Ecus 8.9 bn) 4 (CEC, 1997). However, the trade deficit in hightechnology products has decreased during the 1990s. The deficit came down to approximately ECU 10 billion in 1997. The EU deficit in high-tech products nearly halved between 1995 and 1997. This relatively encouraging performance is explained by remarkable results achieved on world markets in some specific industries (aerospace), and by the closing of the gap in the electronics area5. Figure 1 gives an insight into the relative performance of the major high-tech industries in 1997. In the European Union,
performance that substantiates the fact that the technology gap between the four cohesion countries and the other member states is still significant. 4 The 6 NICs mentioned here are: Hong Kong, Malaysia, Singapore, Taiwan, Thailand and South Korea. 5 For the French economy alone, the cover rate (defined as X/M) in the computers industry increased from 72% in 1993 to 89% in 1997 (CGP, 1999).

cover rates have traditionally been particularly low in Computers and Office Machinery and in the Electronics industry. In comparative terms, the Japanese selective Industrial Policy has resulted in strong positions in Electronics and in Office Machinery, two industries where the Japanese cover rates are still high, although declining (3.07 and 1.97 respectively in 1995). The USA display high cover rates in Aerospace and Pharmaceuticals.

FIGURE 1: EU Trade in Selected High Technology Products - Export: Import Ratio (1997)

1.4 1.2 1 0.8 0.6 0.4 0.2 0

M ac hi ne ry cs ce ro ni C O E Ae ro sp a SM O I

Source: Eurostat. Bulletin of Economic Trends in Europe and Summaries, 1/1999. Key: COE: Computers and Office Equipment; SMOI: Scientific, Medical, Optical Instruments.

The weak position of the EU in the computers and electronics industries, two fast growing industries at the world level, has resulted in declining world market shares of EU high-tech products. While Japanese shares increased over the 1980s, European shares of the world high-tech markets declined continuously. In 1994, the world export shares of high technology products reached 20.6 per cent for the USA, 16.5 per cent for the EU and 15 per cent for Japan (Sharp, 1999). Since the identification of the technological gap in the 1960s, it became increasingly clear that the integration of European research and innovation policy was required to help the EU realise its scientific potential. Although tax harmonisation has been on the agenda of ministerial meetings for many years, it is only in recent years that a co-ordinated tax policy has been seen as a central element of a new co-ordinated innovation policy at EU level.

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2. Innovation Policy and Taxation The case of the EU in a comparative perspective

Different EU countries, with an equal scientific and technological potential, or with equal technological and scientific capabilities, display different degrees of innovative attractiveness, depending on their fiscal (and also regulatory) regime. Placed in a comparative framework, this section will (1) review the major types of fiscal instruments available for the stimulation of innovation, (2) examine briefly the link between fiscal incentives and R&D, and (3) highlight the major taxation issues to be addressed in the EU.

2.1. Major types of fiscal support to innovation

Government fiscal support to corporate innovative activity refers to three major classes. One first type of support consists in treating R&D costs as current expenditure and in writing off these costs against profits in the current year. A second possibility is to offer special fiscal incentives (tax credits) to domestic R&D activities. Finally, a third option consists in relying on imported high technology and in attracting high-tech based FDI through a number of incentives. To these three types we now turn. 2.1.a. Minimising the corporation tax rates of innovative firms. Treating R&D costs as current costs would enable to adjust the basis for the assessment of corporation tax in one given fiscal year. However, investment in R&D is traditionally capitalised as a long-term asset, in spite of the uncertainty surrounding the return on such investment.

2.1.b. Fiscal incentives designed for the high-tech based domestic firms The fiscal incentives designed for the high-tech sector in general can be conveniently divided into tax rebates or incentives for the producers of high technology 6 , and tax incentives for the users of technology. Whereas many different schemes exist in different EU countries to stimulate the absorption of high technology (indigenous or foreign), little can be said in comparison with regard to tax incentives offered to the creators or producers of high technology. Tax credits are a major fiscal tool designed with the view of stimulating the level of R&D. They can include the salary costs of research staff. They are deducted from the corporate income tax, and can be based either on the actual level of R&D expenditure or
6 I.e. for Inventors and Innovators.

on increases in spending with respect to a given base year (Gullec, 1999). In the case of the European Union, countries such as Spain, the Netherlands, France, the UK and Italy have all introduced tax credits measures in their legislation (ESN, 2000). Capital allowances, and in particular, allowances for expenditure incurred on hightechnology investment are another important fiscal tool designed to help domestically produced high technologies diffuse into the industrial structure of EU countries. Clause 69 of the recent UK Finance Bill (March 2000) introduced a 100 per cent first year allowance for expenditure incurred by SMEs on information and communications technology (ICT) between April 2000 and March 2003 (Taxation, 2000)7. By making investment in such equipment more attractive tax-wise, these incentives are designed to help SMEs bridge the technological gap with larger firms, and hence to boost productivity and growth. The 2000 Austrian Tax Reform places also some emphasis on entrepreneurship and innovativeness through the granting of exemptions from capital transfer taxes, stamp duties and social security contributions (Tax Planning, 2000). The taxation of property rights, and in particular of royalties, is another example of how fiscal systems can impact on the diffusion of high technology from firm A to firm B, through licensing agreements. In order to eradicate possible double taxation of such payments in the case of cross-border co-operation between companies of different Member States, the EU Commission has recently produced a Proposal for a Council Directive on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States (CEC, 1998).8 Figure 2 below represents the extent to which R&D is subsidised through tax breaks in major OECD countries. The figure shows clearly the diversity of fiscal treatment accorded to innovativeness in the European Union. In their quest to catch up rapidly with the most technologically advanced countries of the EU, three of the peripheral countries, namely Spain, Portugal and Ireland subsidise R&D rather heavily. Tax subsidies represented more than 30 per cent of all R&D expenditure in Spain in 1998. The Netherlands, France and Austria are three other EU countries that use fiscal incentives, albeit to a lesser extent, in order to stimulate invention and innovation. This is in line with practices prevalent in other OECD countries such as Japan, South Korea and the USA. On the other hand, R&D in the Nordic countries (Finland, Sweden and Denmark), as well as in Belgium, Greece, Italy and Germany is penalised rather than favoured by taxation regimes.

7 ICT include, inter alia, computers, electrical systems for computers, and third generation mobile phones. 8 See also CEC (1998a).

Figure 2. Amount of tax subsidies per US dollar of R&D expenditure, large firms, 1998 Source: OECD
Spain Canada Portugal Australia Japan Netherlands Korea France Austria United States Ireland Mexico United Kingdom Finland Belgium Sweden Greece Switzerland Norway Denmark Italy Iceland Germany New Zealand -0.15 -0.1 -0.05 0 0.05 0.1 $ 0.15 0.2 0.25 0.3 0.35

The findings depicted in figure 2 are close to the results obtained by Warda (1996) in an earlier study on the same issue. Warda was able to rank the main OECD countries along a scale defined as an index of tax generosity. This index is equal to the after-tax cost of a $ expenditure on R&D, divided by 1 minus the corporate income tax9. According to this methodology, the most tax generous countries in 1996 were Spain, Australia, Canada, Denmark, the Netherlands, France and the USA. At the other end of the spectrum, Germany, Norway and Italy were the least tax generous. The relatively favourable tax treatment of R&D in the peripheral countries of the EU (i.e. Spain, Portugal and Ireland) may be explained by their emphasis on the attraction of R&D projects form abroad rather than on the domestic creation of same.

9 The after tax cost is the net cost in investing in R&D; it takes into account all available tax incentives in the country. This index of tax generosity can thus be written as

i=

(1 A)
(1 )

, where A is the discounted net

present value of depreciation allowances, tax credits and special allowances on R&D assets (Warda, 1996).

2.1.c. Tax incentives for the attraction of high-tech foreign direct investment Inward investment, and the particular targeting of high-tech industries, is a popular way to soak foreign-produced technology into the domestic industrial structure. The Republic of Ireland is a well-known case of an economy that has succeeded in attracting a certain type of manufacturing activities (high-tech activities such as computers, electronics and pharmaceuticals) through its very generous corporation tax regime (10 per cent rate) combined with a selective industrialisation-by-invitation policy. Although there are clearly other determinants of FDI in Ireland, such as low labour costs, EU membership, and the importance of the Irish diaspora in the USA the main source of direct investment into the country -, the low corporate tax rate is undoubtedly the variable with the greatest explanatory power (Telesis, 1982; Ruane and Georg, 1996; Bank of Ireland, 1999). Other cohesion countries, such as Portugal and Spain, provide also tax credits to R&D activities with the aim of attracting technology-based inward investment (Dictionnaire Permanent Fiscal, 2000). The treatment of (foreign) high technology in some EU countries is therefore close to the case of some of the newly industrialised countries. Although in most countries of the developed world, with perhaps the notable exception of the USA, the tax treatment of technology has been lagging behind the times, the newly industrialised countries provide good examples of countries that have quasisystematically given priority to technology upgrading through fiscal measures. For example, with its complex system of 14 separate tax laws levied at three governmental levels, Taiwan has been allowing numerous tax breaks and fiscal incentives to foreign investment and high-technology industries (Koo and Wilson, 1993). The important technological industries, which include telecommunications, information and consumer electronics, aircraft, chemicals and precision machinery, have been accorded the most favourable incentives. Other tax aspects refer to accelerated depreciation of new machinery and equipment, investment tax credits, tax exemptions or deferral on mergers, deferred payment of income tax on stock dividends, and tax exemption of 80 per cent of investment returns from venture capital investment enterprises (Koo and Wilson, 1993: 224). In India, both foreign and Indian businesses can profit from various tax benefits and incentives implemented to help the economy grow (Raghavan, 1995). In particular, residents earning royalties can deduct 50 per cent of their income derived from the use outside India of any patent, model, design, secret formula, and other property rights. China is another country where tax exemptions are given to technologically advanced foreign investment, and to high technology development zones (Stricker-Kellerer, 1998; Andreosso-OCallaghan and Qian 1999; Zeng, 2000). Most of the PRCs tax treaties with

other countries allow for substantial tax reductions on income earned from licensing high technology or technically advanced technology (Stricker-Kelleher, 1998)10. Finally, in some of the East Asian countries, the 1997 Asian currency crisis has made the need to resort to tax incentives to attract high-tech investment even more urgent. For example, in spite of setbacks due to the crisis, Malaysia continues to introduce new tax incentives and to promote technological development (Wong, Olesnicky, and Peterson 1999). The high-tech companies fulfilling a number of criteria can be eligible for full tax exemption for five years. R&D activities are promoted by a number of fiscal incentives, of which a tax exemption for five years for engaging in R&D activities; a tax exemption on dividends derived from such activities; and an investment tax allowance of 100 per cent of capital expenditure incurred within a ten year period for carrying out R&D activities for other companies.

2.2. The effectiveness of tax incentives Beneficial effects of taxation on business activity of US innovative firms (and also of non-innovative firms) have been empirically simulated by Lin and Russo (1999). The beneficial impact of taxation on innovation is particularly strong in the case where R&D receives tax credits. The USA is indeed a country where tax credits for investment in research and development have been in place since 1981. Using data from 17 OECD countries, Gullec (1999) finds that Government R&D and tax incentives have a significant effect on corporate R&D11. The study warns against the fact that the effects of fiscal incentives and of direct subsidies on business R&D are significant indeed, albeit with a one year lag. In other words, the beneficial impact of tax concessions and incentives should not be expected during the year in which R&D expenditures have been incurred. Another interesting finding of the study is that fiscal incentives have a relatively weak impact on R&D in the long term, and that subsidies are more effective than fiscal incentives in the long run. Although the strength of the link between fiscal incentives and innovation, as empirically tested, falls below expectations, the fiscal regimes in the EU countries are nevertheless perceived as being less conducive to an R&D culture than that of the USA. In contrast with the USA, there is still a large number of fiscal barriers that inhibit innovativeness, risk taking and entrepreneurship in the EU. To these barriers we now turn.
10 It should be noted that since January 1998, these tax reductions have decreased and that total tax exemptions are not possible any more. 11 Austria, Greece and Luxembourg were the only three EU countries not included in this study.

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2.3. Taxation issues to be addressed in the EU

The disadvantages faced by innovative firms in the EU can be analysed at the level of two specific areas: indirect taxation and direct taxation. Indirect taxation VAT rates. Obviously, VAT rules in the EU did not address the problem of supply of services from EU to non EU countries delivered by digital means. A discrimination arises in that the supply of services to non EU countries delivered non electronically is not subject to VAT, whereas electronically delivered services originating within the EU are always subject to VAT irrespective of the place of consumption. This places EU service providers at a serious disadvantage relative to non-EU service providers. However, a perceptible change is being infused at the moment, as electronically delivered services are becoming subject to a new VAT treatment. In line with the basic principle which is that taxation should take place in the country where consumption occurs, the idea is to create a level playing field for the taxation of digital E-commerce (CEC, 2000). The proposal mainly concerns the supply over electronic networks of software and computer services generally, plus information and cultural, artistic, sporting, scientific, educational, entertainment or similar services.

Direct taxation Personal Income Tax It is a well known fact that stock option schemes offer a proven means of providing incentives for entrepeneurialism and in particular for innovation activity12. Stock options are seen as an important means to attract researchers; in particular, they are an important source of funding for research activity in SMEs, firms that, due to their size, are normally not able to attract researchers by way of high wages. Although venture capital has grown immensely in Europe in the past few years, there are still constraints inhibiting the development of this type of financing, compared with the USA, given that the personal tax laws of most Member States penalise the stock option schemes. Indeed, venture capital works best when everyone involved shares the rewards of success and the costs of failure. Stock option schemes articulate this approach perfectly. But under most European tax regimes, members of the management team are taxed on the options as soon as they are granted, not when they are realised. If the firm has significant assets, this constitutes a
12 Stock option schemes are financial incentives given to selected managers and employees in companies, whereby they are given the option of buying the companys shares at preferential rates.

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strong disincentive (ITT, 2000: 18). For example in the case of France, a favourable fiscal treatment of stock options disappeared ironically in the mid-1990s, due to the excesses of some large companies (Commissariat Gnral du Plan, 1999). The tax rate on French stock options has been raised to 30 per cent; their treatment as wage complements makes them subject to social contributions. This had an obvious detrimental impact on innovation and entrepreneurialism in general, and in particular on the population of SMEs that could not afford to attract the key researchers by offering stock options as a compensation for their lower wages. 13 This is a regime that is far less advantageous than that in the USA and also in other EU countries such as the UK and Italy.

3. Recent recommendations proffered at EU level and ensuing initiatives

The technology lag (or innovation deficit) highlighted above has led the Commission to initiate a number of corrective initiatives. In particular, the launch of the first ESPRIT programme in the early 1980s, and the following framework programmes, have adequately addressed the problems of critical size, duplication of research efforts and capital constraints in the EU. Although highly beneficial, in particular in the area of semiconductors, these initiatives have been implemented without the design of a proper and all-encompassing innovation policy in the EU14. Indeed, it is only in the last few years that the taxation regimes, as potential sources of obstacles to innovation and to competitiveness have been given serious consideration at EU level. The First Action Plan for Innovation in Europe was born in 1996 on the basis of the recommendations proffered by the 1995 Green Paper on Innovation, to which we briefly turn. Recommendations of the 1995 Green Paper on Innovation. Route of Action 7 of the Green Paper deals specifically with a recommended set of actions needed to create EU fiscal regimes beneficial to innovation (CEC, 1995). In particular, the document stresses the importance of tax measures in favour of venture capital (to avoid double taxation), training, and industrial and intellectual property titles, in parallel with moderate public spending compatible with the aims of Economic and Monetary Union. Other important recommendations also refer to the need to create a more equal fiscal treatment of intangible and tangible investment, and to broaden the

13 Note that the creation in 1998 of the BSPCE (Bons de Souscription de Parts de Crateurs dEntreprises) has partially addressed this issue (see below). 14 All encompassing in the sense that the policy should contain technological, training, financial and legal aspects.

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tax relief to encourage individual investors towards investment in innovation (CEC, 1995: 42). It should be noted that this Route of Action cautiously warns against the advantages and drawbacks of fiscal incentives as well as against the sensitive nature of fiscal policy; in line with the principle of subsidiarity, it also re-iterates the paramount responsibility of Member States in the area of taxation and social security policy (CEC, 1995: 42). In spite of its timid wording, the 1995 Green Paper opened up new pathways; in particular it led to the First Action Plan for Innovation in Europe (1996).

First Action Plan for Innovation in Europe (CEC, 1996) At the Florence Summit, the European Council requested the Commission to establish a plan of action for the measures to be undertaken in the field of innovation15. Covering Member States actions in the areas of taxation and incentives, the ensuing First Action Plan for Innovation in Europe refers to a limited number of priority initiatives that had already been announced in the Green Paper. This initial action plan identifies three areas for action:

(i)

the fostering of an innovation culture (i.e. measures aimed at stimulating creativity, entrepreneurship, and geographical & professional mobility),

(ii)

the establishment of a legal, regulatory and financial framework conducive to innovation, and

(iii)

a better articulation between research and innovation.

It should be noted that the third area for action deals particularly with the problem of the absorptive capacity of firms within a nation, i.e. the problem of the sourcing, understanding and application of the new technology 16 . Taxation issues relating to innovation fall within the scope of the first and second areas for action. In particular, the Action Plan recommends a review of all fiscal provisions pertaining to the European capital markets for innovative companies (such as the New Market Federation or EASDAQ), and to investment in risk capital and equity. With increased monitoring of research and innovation performance, and with a greater level of assistance in favour of the individual Member States, the Commissions First Action Plan for Innovation in Europe lays down the basis for a reinforced innovation strategy in the EU. At the EU level, the above mentioned Commissions proposal for a directive on a common system of taxation applicable to royalty payments made between cross-border

15 Conclusions of the Presidency, 21st and 22nd June 1996, SN/300/46. 16 For more on the notion of absorptive capacity, see Cohen and Levinthal (1990).

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associations of companies (CEC, 1998) can be seen as a fruitful outcome of the Action Plan. The French 1999 Innovation Law, which acts principally at the fiscal level by facilitating the conditions of attribution of BSPCEs (Bons de Souscription de Parts de Crateurs dEntreprises), can be regarded as an example of a national initiative consistent with the spirit of the Action Plan. These BSPCEs are aimed at the creation of (French) innovating companies, with a large growth potential, and non-quoted on the stock exchange, therefore of a small size. The many advantageous facets represented by these bons de souscription or shares, are thus aimed at stimulating entrepreneurial and innovative activity among selected wage earners, in particular among the community of researchers and scientists. However, as underlined by the CGP (1999: 419), this initiative is nevertheless quite weak due in particular to its short life expectancy. Although the initiative has been extended until the year 2001 (by the 2000 Loi de Finance), the underlying uncertainty surrounding its further prorogation is not conducive to the attraction of high calibre engineers and other research personnel in the companies concerned.

Concluding remarks

While suggesting an insight into the complex relationship existing between taxation and innovation, this article has highlighted the unsatisfactory technological performance of the EU in the recent past, and the progress made in relation to the design of an all encompassing innovation policy at EU level. Although technological collaboration can be traced back to the early 1980s, a serious consideration of the fiscal treatment of technology started to be given in the second part of the 1990s only17 . An inevitable problem in tax practice is that technological advances develop more rapidly than the tax law, very often resulting in barriers to investment in future competitiveness. The most obvious example is where nothing tangible is provided through a business transaction, such as the case where an entity desires to purchase a computer programme which is sent to him via a modem. Whereas the 1995 Green Paper paved the way for a more comprehensive Innovation Policy in the EU, the resulting 1996 Action Plan for Innovation in Europe clearly makes some recommendations in terms of the required fiscal changes pertaining to technology. In the past four years, little progress has however been noticed, with perhaps the exception of the indirect taxation of services delivered by digital means. Numerous penalising tax practices (at national level) still hamper the full
17 See in particular CEC (1996).

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exploitation of creativity and entrepreneurship in the EU. For example, the French and other EU taxation and social contribution regimes are not very conducive to the geographical and professional mobility of researchers (CGP, 1999)18. Tax regimes in the EU (particularly income tax systems) should be geared at promoting the mobility of researchers, as well as the development of stock option schemes. Moreover, since the creation of a tax credit for innovation in the EU remains hampered by many obstacles, a tax credit for patents could be put in place. This tax credit would reduce the costs associated with patenting activities, and would be based on the level of expenditure connected with patent applications. Spain and Portugal are the EU countries for which the large firms ratio of tax subsidies to R&D expenditure is the highest. Conversely, the most innovative countries in the EU (namely Germany, the Nordic Countries and the UK) display the lowest ratios. This is greatly explained by the preferential fiscal treatment accorded to imported high technology as opposed to the domestically sourced technology. It can therefore be argued that the fiscal bias against technology has successfully been addressed by the peripheral countries of the EU, countries that are eager to upgrade their productive structure via the attraction of high technology investment. Finally, in spite of sporadic and ephemeral attempts at introducing fiscal incentives for innovation in various EU legislation frameworks (such as the UK Finance Bill of March 2000, and the French 1999 Innovation Law), the favourable fiscal treatment of high technology in most of the EU countries still lags behind that of the USA and of a number of rapidly developing economies in Asia.

18 In this regard, one can refer to Ricout G Lexpatriation des franais tablis hors de France, acteurs du rayonnement international de notre pays, Rapport du Conseil Economique et Social, Paris.

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