Small Business Economics

, Volume 33, Issue 2, pp 207-227

First online:

Absorptive capacity and R&D tax policy: Are in-house and external contract R&D substitutes or complements?

  • Todd A. WatkinsAffiliated withDepartment of Economics, College of Business and Economics, Lehigh University
  • , Lolita Anna PaffAffiliated withEngineering, Business & Computing Division, Penn State Berks Email author 

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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.


R&D Absorptive capacity Tax credit R&D substitution Technology policy

JEL Classifications

O31 O38 L26 L65 L86