Meeting New Challenges for U.S. Industry
Fixing the Research Credit
Even as economists describe the importance of R&D in a knowledge-based economy and policymakers increase their fiscal commitments to other forms of R&D support, the United States has yet to take full advantage of a powerful tool of tax policy to encourage private sector investment in R&D. More than 17 years after it was first introduced, the research and experimentation tax credit has never been made permanent and has not been adapted to reflect contemporary R&D needs. Instead, the credit has been allowed to expire periodically, and in the past few years, even 12-month temporary extensions have become chancy political exercises. Despite these difficulties, recent congressional activity suggests that the political hurdles facing the research credit are not insurmountable. Recently proposed legislation suggests that a political consensus may be emerging on how the limitations of current R&D tax policy can be effectively addressed.
Empirical studies of R&D investment consistently demonstrate that it is the major contributing factor to long-term productivity growth and that its benefits to the economy greatly exceed its privately appropriable returns. It is precisely because these benefits are so broadly dispersed that individual firms cannot afford to invest in R&D at levels that maximize public benefit. The research credit is intended to address the problem of underinvestment by reducing the marginal costs of additional R&D activities. Under an effective system of credits, users benefit from lower effective tax rates and improved cash flow, and R&D is stimulated in a manner that capitalizes on the market knowledge and technical expertise of R&D-performing firms. Unfortunately, the present structure of the credit tends to create winners and losers among credit users and to be of limited value to partnerships, small firms, and other increasingly important categories of R&D performers. These factors have the double effect of reducing the credit's effectiveness as an economic stimulus and limiting the depth and breadth of its political support.
Winners and losers
Under present law, firms can claim credit for their research expenses using either of two mechanisms: a regular credit or an alternative credit. The regular credit is a 20 percent incremental credit tied to a firm's increase in research intensity (expressed as a percentage of revenues) as compared with a fixed historic base. In other words, it rewards companies that over time increase their research expenditures relative to their sales. If a firm's current research intensity is greater than it was during the 1984 to 1988 base period, it receives a 20 percent tax credit on the excess. For example, a firm that spent an average of $5 million on research and averaged $100 million in sales during the base period would have a base research intensity of 5 percent. If it currently spent $12 million on research and averaged $200 million in sales, its research spending would exceed its base amount by $2 million, and it would be eligible for a $400,000 credit.
The fixed-base mechanism, which was established in 1990, quickly created classes of winners and losers whose eligibility for the credit depended on business circumstances that were unrelated to research decisions but that affected the research intensities of individual firms and sectors. These winners were subsidized for research that they would have performed independently of the credit. Losers included firms that were penalized for historically high base research intensities, due in some cases to traditional commitments to R&D investment and in other cases to temporary dips in sales volume during the base period that resulted from trade conditions or other factors. Subsidy of winners and exclusion of losers would both be expected to reduce the credit's overall effectiveness. Analyses by the Joint Committee on Taxation and the General Accounting Office predicted and documented both of these effects.
An alternative credit was established in 1996 to allow the growing class of losers to receive credit for their R&D. Officially known as the alternative incremental research credit, this credit does not depend on a firm's incremental R&D. Instead, credit is awarded on a three-tiered rate schedule, ranging from 1.65 to 2.75 percent, for all research expenses exceeding 1 percent of sales. This credit has the merit of being usable by firms in a range of different business circumstances. Unfortunately, its marginal value-less than 3 cents of credit per dollar of additional research-is a minimal incentive for these firms.
The changing business of R&D
In the period since the credit was established, R&D business arrangements have undergone dramatic changes. Increasing amounts of R&D are being performed by small firms and through partnerships, and larger firms are frequently subject to structural changes that complicate their use of the credit. A special provision of the credit, the basic research credit, is intended to stimulate research partnerships between universities and private firms. This credit applies to incremental expenses (over an inflation-adjusted fixed base period from 1981 to 1983) for contract research that is undertaken without any "specific commercial objective." The total credits claimed under this provision appear to be disproportionately small (approximately one half of one percent of qualified research claims) relative to the growing amounts of research performed by university-industry partnerships. It is thought that the language barring commercial objectives excludes significant amounts of R&D that by most standards would be considered public-benefit research. In addition, research partnerships are increasingly taking forms that fall outside the scope of this credit. These partnerships appear to play an important role in allowing multiple institutions to share the costs and risks associated with longer-term and capital-intensive R&D projects.
Other administrative aspects of the credit make it difficult to use, particularly by smaller firms with limited accounting resources. The definition of qualifying research activities for credit purposes is different from accepted definitions of R&D used for financial accounting and other survey purposes. To qualify for the credit, firms must compile separate streams of accounting data for current expenses and for expenses during the base period. Special rules for the base calculation apply to mergers, spinoffs, and companies that did not exist during the mid-1980's base period. Phase-in rules for the base tend to adversely affect many research-intensive startup firms. Depending on their research intensity trajectories over their initial credit-using years, startups can be saddled with relatively high fixed base intensities that reduce their future ability to apply for credit.
Lack of permanence, then, is only the first of many difficulties that limit the effectiveness of present law, both as a policy instrument and as a salable tax provision in which a broad base of R&D performers would hold significant political stakes. These are unfortunate circumstances for a tool that has otherwise been shown to be a cost-effective means of stimulating R&D and that could play a critical role in spanning the policy gap between early and late phase R&D. Studies of the credit's cost effectiveness in the 1980s, when the credit structure was substantially different, showed that the credit stimulated as much as two dollars of additional R&D for every dollar of tax expenditure. These results have been widely cited by advocates as justification for extensions of the law in its present form, but an improved credit could be much more effective.
Building a better credit
The research credit needs to be structured in a way that does not create classes of winners and losers on the basis of conditions unrelated to research spending, and it must provide an effective stimulus to research for as many firms as possible. The credit should also accommodate the increasing variety of business arrangements under which R&D is being performed, including the increasing proportion of R&D performed by partnerships and smaller firms. Where possible, compliance requirements should be simplified for all credit users. All of this needs to be done without creating new classes of losers, without multiplying revenue costs, and with minimal impact on aspects of present law that already work acceptably well.
Recent legislation introduced by Republicans and Democrats of both chambers offers encouraging signs that these legislative challenges can be met. The most active topic of legislative interest has been that of stimulating research partnerships. A bill (H.R. 3857) introduced in the 105th Congress by Reps. Amo Houghton (R-N.Y.) and Sander Levin (D-Mich.), similar in wording to a prior bill introduced by Rep. Richard Zimmer (D-N.J.), would extend a 20 percent flat credit to firms for their contributions to broad-based, public interest research consortia. Bills introduced by Sen. Alfonse D'Amato (R-N.Y.)-S. 1885-and Rep. Sam Johnson (R-Tex.)-H.R. 3815-are designed to improve tax incentives for partnerships for clinical research. Each of these proposals is designed to reach a specific class of partnerships that receives little incentive under present law.
Two more recent proposals have taken more comprehensive approaches to improving R&D tax policy. Bills by Sen. Pete Domenici (R-N.M.)-S. 2072-and Sen. Jeff Bingaman (D-N.M.)-S. 2268-would make the research credit permanent and take measured steps to address difficulties inherent in the present credit structure and improve its applicability to partnerships. Sen. Domenici's proposal would revise the regular credit by requiring firms to select a more recent period (their choice of 4 consecutive years out of the past 10) as their base. This would allow historically research-intensive firms, who were previously shut out from the regular credit, to benefit from a 20 percent incremental rate. It would also reduce the tax credits granted to firms whose bases, by now, are unreasonably low. The Domenici bill also takes an inclusive approach toward improving credits for research partnerships. The commercial objective exclusion in the basic research credit would be modified to accommodate typical university-industry partnerships, and qualifying partnerships would be expanded to include those involving national laboratories and consortia.
Sen. Bingaman's proposal builds on the foregoing, incorporating many features of the Domenici bill while reducing the political risk of creating potential credit losers. Instead of changing the base rules for the regular credit, the Bingaman bill retains the regular credit without modification and focuses improvements on the alternative credit. Users of an improved alternative credit would have access to a 20 percent marginal rate, plus a 3 percent credit for their maintained levels of R&D intensity. The improved alternative credit is designed to combine the immediate cash flow benefit of the regular credit with the accessibility of the present alternative credit. In order to simplify compliance, the definition of qualifying activities for the improved credit is aligned with the Financial Accounting Standard definition of R&D, which is based on the National Science Foundation survey definition and is familiar to business accountants. To improve the credit for research partnerships, the Bingaman bill redefines qualifying activities for the basic research credit in a manner following the Domenici bill. In addition, the basic research credit and a credit for research consortia are restructured as flat credits, as in the Houghton bill. Small firms would benefit from the above definitional simplifications, as well as an improved credit phase-in schedule for startups.
Unpublished analyses by the Joint Committee on Taxation suggest that comprehensive improvements of the sort envisioned by the Bingaman bill can be implemented without substantially increasing the credit's revenue cost, in part because legislative changes are restricted to aspects of present law that account for small fractions of current tax expenditures. Politically, however, those improvements could be expected to have an important impact. They are sufficiently comprehensive to address the most common criticisms that are leveled at the current credit. In addition, they might engage sufficient numbers of R&D performers who are disenfranchised under current R&D tax policy to broaden and strengthen the political constituencies in favor of a permanent research credit.
The economic need for effective R&D tax policy remains as strong as ever, but the current credit is unlikely to be made permanent in its present form. Recent legislative developments offer hope of a path out of that political box. The comprehensive bills by Sens. Bingaman and Domenici, in particular, indicate an emerging consensus on the policy issues that need to be addressed and a willingness by members of Congress to address them. These are encouraging signs for private sector R&D performers and may play a key role in the research credit's economic and political success.
J. Fountain, Social Capital: A Key Enabler of Innovation, in Investing in Innovation, Lewis M. Branscomb and James H. Keller, Eds. Cambridge, Mass.: MIT Press, 1998.
General Accounting Office, "Additional Information on the Research Tax Credit." Washington, D.C.: GAO/T-GGD-95-161, 1995.
B. Hall, "R&D Tax Policy During the Eighties: Success or Failure?" Tax Policy and the Economy vol. 7, 1993, pp. 1-36.
Joint Committee on Taxation, Description and Analysis of Tax Provisions Expiring in 1992. Washington, D.C.: Joint Committee on Taxation, JCS-2-92, 1992.
Office of Technology Assessment, The Effectiveness of Research and Experimentation Tax Credits. Washington, D.C.: OTA-BP-ITC-174, 1995.
G. Tassey, The Economics of R&D Policy. Westport, Conn.: Quorum, 1997.
K. C. Whang, A Guide to the Research Tax Credit: Why We Have It, How It Works, and How It Can Be Improved. Washington, D.C.: U.S. Congress, Working Paper Series, Offered to the Joint Economic Committee Minority, December 1998.
Kenneth C. Whang analyzed R&D tax policy for the Joint Economic Committee's minority staff during the 105th Congress.