In his Budget speech, Treasurer Josh Frydenberg announced that the federal government would introduce a new round of changes to the Research and Development Tax Incentive.

Industry Update’s readers will know that I have long been concerned about a Morrison government bill aimed at cutting $1.8 billion from the value of the Incentive, the most important measure integrating the taxation and innovation systems.

The Tax Incentive is especially important to manufacturers, who conduct the bulk of private-sector R&D in Australia.

The good news from the budget announcement is that the bill is unlikely to go ahead. Instead of a $1.8 million cut, the government claims there will be a $2 billion increase. The government also has decided to drop a $4 million cap on refunds for firms with an annual turnover of less than $20 million.

The bad news is that the new changes retain an intensity scale for calculating the tax offsets of firms with a turnover of more than $20 million, which includes all of Australia’s large manufacturers.

And yet again, the government passed up an opportunity to introduce a premium rate of the Incentive for businesses that collaborate on R&D with universities and research agencies such as the CSIRO.

A collaboration premium was suggested in the so-called Three Fs review of the Tax Incentive in 2016, by Chief Scientist Alan Finkel, then Treasury chief John Fraser and then head of Innovation Australia, Bill Ferris.

It is a change that would unleash Australia’s innovative capabilities by creating an alliance of blue collar and white coat.

Our universities and science agencies are as vital a part of the innovation system as industry itself, and a well-designed innovation system would ensure that the capabilities of industry and researchers are brought together as closely as possible.

The Morrison government, however, does not seem to understand this. It shunned the proposed collaboration premium and instead adopted a less welcome Three Fs suggestion, the intensity scale for assessing the R&D activity of larger firms.

Intensity scales measure a firm’s commitment to R&D by expressing its R&D expenditure as a proportion of its total operating costs. For manufacturers, the bulk of operating costs comprise wages, purchase of raw materials and equipment, and investments in the supply chain. Specific R&D activities will always be a small proportion of the total operating costs for manufacturers, but that is no indication of the inherent value of the R&D they undertake.

The manufacturing sector is the most innovation-intensive in the economy, and manufacturers spend four times the national average on R&D. In submissions and evidence to a Senate inquiry into the now superseded R&D bill, many of them warned that introduction of an intensity scale would force them to move either their R&D or their manufacturing offshore.

It is less likely that they will be faced with that choice after the changes announced by the Treasurer, because the number of tiers in the proposed intensity scale has been reduced from three to two. Under the three-tier scale most manufacturers would have fallen into the bottom tier, cutting the offset they receive from 8.5 per cent to 4.5 per cent.

That is no longer the case, but it does not change the fact that intensity measures are a fundamentally flawed means of assessing the value of R&D activities. The intensity scale continues to discriminate against Australian companies that conduct both R&D and manufacturing in Australia. Multinationals that can manufacture offshore and conduct R&D here will be better placed to claim the highest rate of 16.5 per cent.

The costs typically incurred by large manufacturers mean that they will also be unfairly disadvantaged by the $150 million cap on claims under the Incentive. The government could have lifted this cap in the measures announced in the budget but did not do so.

Under the impact of the severe recession brought about by the COVID-19 pandemic, putting R&D activities and manufacturing jobs at risk is hardly a prescription for recovery.

Nor is cutting the amount available to universities for research, which will be a consequence of the new system for funding student places. The $1 billion for university research included in the budget is a one-year top-up, but universities will need several times that amount over the next five years.

The changes to the Incentive announced in the budget were included in an omnibus bill introduced into parliament the next day. Labor did not oppose this bill, because it also included the cuts to income tax, which we support as a stimulus to the economy.

We remain concerned, however, about the damage the intensity measure will do to innovative manufacturers in Australia.

If the government is serious about its plans to rebuild Australia’s manufacturing capabilities, it needs to think again about how to make sure the Tax Incentive operates effectively, and about how to forge collaboration between industry and researchers.

Senator Kim Carr is a Labor Senator for Victoria and a former Minister for Innovation, Industry, Science and Research.

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