What is R&D?

The tax authorities need to know the answer to this question to give a credit. So what do they say?
If you go to HMRC website to "Which costs qualify for R&D Relief?" you get directed to

To qualify as R&D, any activity must meet the definitions set out by the Department of Trade and Industry (DTI) - this organisation is now known as the Department for Business, Innovation and Skills. These guidelines state that the activity must contribute directly to seeking the advance in science or technology or must be a qualifying indirect activity.

if you follow the first link you find its complicated.  Here are some quotes

To qualify as R&D, activities must fall to be accounted for as R&D under GAAP, and under whichever standard, as R&D (see BE Studios v Smith Williamson Ltd, HC04C0110).

Following the Guidelines, then, for there to be R&D, a company must be undertaking a project to seek an advance in science or technology through the resolution of scientific or technological uncertainties.

And

The advance being sought must constitute an advance in the overall knowledge or capability in a field of science or technology, not a company’s own state of knowledge or capability alone

And (my italics)

There may well be an important difference between a project for the development of a commercial product and an R&D project within the meaning of the legislation. A company with a project to produce a new product will often consider the whole project to be R&D. But this is not necessarily correct for the purposes of R&D tax relief. The activities that constitute R&D for tax purposes are those activities undertaken as part of the project which fall to be accounted for as R&D under generally accepted accounting practice and also fall within the special definitions set out in the BIS Guidelines (formerly DTI Guidelines) for activities to be treated as either ‘directly contributing’ to seeking the advance in science or technology, or as ‘qualifying indirect activity’.

Other aspects of the project will not be R&D for tax purposes, either because they are not seeking an advance in science or technology or because the activities fall outside the scope of R&D for tax purposes. For example, the BIS Guidelines (formerly DTI Guidelines) specifically exclude certain activities from the scope of R&D for tax purposes,

The fact that there is some advance in science or technology being sought within the project for the development of a new product does not make the whole of that project an R&D project for the purposes of the relief. So, for example, market research to identify the demand for the new product is not part of the R&D. A project for the development of a new product, that is not of itself R&D, may contain elements or sub- projects that can be R&D projects for the purposes of the relief. It is those elements or sub- projects undertaken with an aim to extend knowledge in a field of science or technology to which the relief applies. The sector in which activity is taking place does not change this

Finally we have a concrete example:

There is guidance on the meaning of R & D for tax purposes in BE Studios v Smith Williamson Ltd (the case number at the High Court is HC04C0110).
BE Studios had a project to produce new software. Mr. Justice Evans-Lombe accepted that it was not sufficient that the claimant’s products were innovative or cutting edge for them to be R&D within the meaning of the statute. The fundamental test was whether the software work sought to achieve a scientific and or technological advance, and formed the whole or part of a project to resolve scientific and or technological uncertainty on a systematic basis.
On the subject of computer games, he indicated that there were a number of stages in the production of a computer game. These involved conception or acquisition of the ideas for the game, planning, script-writing, drawing and designing backgrounds and characters, creating animated sequences and soundtrack and programming the result of these. He said ‘none of these activities without more necessarily involve qualifying R&D’.
He was presented with an extensive description of the company’s objectives in terms of new functionality and computer environments, but said that this nowhere described any new scientific or technological knowledge. The judge found that there was no evidence presented that supported the claim that R&D within the BIS Guidelines (formerly DTI Guidelines) had been carried out.

 

Index numbers

I am today at the launch of the Global Innovation Index.  It takes a large range of countries, and a  massive range of indicators, from ICT intensity to FDI for each country.  It then weights these various measures within each country by 0.5 or by 1.  The combination of these measures adds up to an index, and it turns out that Switzerland is one and the UK is two.

If one is going to construct an index, one needs to understand a bit of index number theory and mechanics.  Thus turns out to be important, as we know from the ONS RPI and CPI.  We can learn from this and this link is useful, Differences between the RPI and CPI Measures of Inflation

"The basic approach to the measurement of inflation adopted by both the CPI and RPI is the same. Both track the changing cost of a fixed basket of goods and services over time and both are produced by combining together around 180,000 individual prices for over 650 representative items. Differences arise due to coverage, the population base of the indices and the way in which individual price quotes are combined at the first stage of aggregation."

let us focus on the way these are combined.

At the first stage of aggregation, the RPI is constructed using an arithmetic mean (AM).
There are two different methods, applied to different items but, for example, the AM would be calculated as follows;
if one price increased by 25% from the base period (which=100) and another decreased by 20% their new index values would be 125 and 80 respectively. The AM of these is;
125+80 =102.5, 2

indicating an ‘average’ price increase of 2.5%.

Now compare with the CPI

At the same level, the CPI uses a geometric mean (GM) which, taking the values used in the adjacent example is calculated thus,
125*80 = 10000 =100 , indicating that there has been
no change in prices.

An advantageous property of the geometric mean is that it can better reflect changes in consumer spending patterns relative to changes in the price of goods and services.

This formula effect means the CPI is higher relative to the RPI by about 0.8 percentage points for June 2010.

So it very much matters what weights are chosen.  One might experiment with the weights, which is what is done in the Report.  So that goes partway to checking how robust this all is, but one also needs to know how the index is constructed: why use arithmetic, which is what they do, and why chose 0.5 and 1?


Technical note. Why are these two indices in the example above different?  It is not really to do with the spending pattern weights, although that is an advantage of the geometric method.  Rather it is to do with transitivity of indices.  Consider a rise from 100 to 150 and back to 100.  On a percentage basis, inflation has risen by 150-100/100=50% in the first period and fallen by 150-100/150=33% in the second period.  But 50-33 is not equal to zero.  This is the problem with arithmetic means done this way which do not return to their base level, here 100, when adding percentage changes.

A further note on this.

Further note

The way to think of the geometric index is that it is an arithmetic average of the logs of the prices i.e. = ½*ln125+1/2*ln80 where “ln” is a natural log (so the index is calculated as the square root of the product of the two numbers).  One property of logs is that a log relation “flattens” as the number gets larger, so that a log change from 0-10 is much larger than a change from 1,000 to 1,010 even those the absolute change is 10 in both cases.  This “downweighting” of the larger numbers has a desirable economic property for it controls in part for substitution bias.  That is, as goods get more expensive, they are downweighted in the index, but that is correct since more expensive goods are presumably consumed less.  This intuition tells you that a better but more complicated index would weight log changes by their shares in total expenditure which is just what official price indices do: note that the billion dollar price index does not do this.

In case this is still seen as arcane, remember that UK pensions are now updated by the CPI and not the RPI.  That has lowered their updating and in fact counts for the bulk of austerity savings in the UK.   

Finally, back to the Innovation Index

This paper, http://arxiv.org/pdf/1104.3009v2.pdf contains a discussion of how adding and multiplying can give different results.  That's only part of the point.  The index adds up a measure of, for example, GDP growth, expenditure on schools and number of YouTube videos uploaded (see  Appendix III, esp page 403).  But without a clear view on the relative weights of these indicators it is hard to interpret the overall index.

Various teaching links: taxes on windows and the number of windows.

Do agents respond to incentives?   Yes they do: putting windows in their house for example.

 Oates, Wallace E., and Robert M. Schwab. 2015. "The Window Tax: A Case Study in Excess Burden." Journal of Economic Perspectives, 29(1): 163-80, show the following.

 They have tax records between 1747 and 1757 from the UK. As they say

We focus initially on the observations in our dataset from 1747 to 1757. As
we discussed above, the window tax was unchanged over this period and included
three notches. A homeowner in this period paid no tax if the house had fewer than
10 windows; a tax of 6 pence per window if the house had 10–14 windows; a tax
of 9 pence per window if the home had 15–19 windows; or a tax of 1 shilling per window if the home had 20 or more windows. Thus the marginal and average tax rate jumped sharply when a consumer installed the 10th, 15th, or 20th window.

 Do agents respond to incentives?  As they then say

If the window tax distorted behavior, then we should expect to see “too many”
homes with 9, 14, or 19 windows.

And this is just what they find on their sample of 496 homes during this period in Ludlow, a market town in Shropshire.



As they say

There are sharp spikes in the number of homes at all three
notches.12 At the first notch, 18.8 percent of the homes have 9 windows, while
4.2 percent have 8 windows and 4.2 percent have 10 windows; at the second notch,
17.7 percent have 14 windows, while 6.0 percent have 13 windows and 1.6 percent
have 15 windows; and at the third notch, 6.5 percent have 19 windows, while
3.4 percent have 18 windows and 1.0 percent have 20 windows.

Various FTMBA teaching links

1. Do agents respond to incentives?

a. How Converse sneakers reduce their tariffs#
b. Cesarian-section deliveries when rewards are higher


2. Supply and demand
Rare earth

3. Elasticities and revenues
The London congestion charge.

4. Two-sided markets.
What Spotify is doing.

5. Barriers to entry.  See table 1 for a very good summary of natural and strategic entry barriers in UK banking, especially around IT and capital regulation.