Tax Reform Should Expand R&D Tax Credit

Tax Reform Should Expand R&D Tax Credit
AP Photo/J. Scott Applewhite

Congress is in the midst of tax negotiations that may determine if Republicans deserve to maintain control of Congress in 2018. For over a decade, Republicans have emphasized fundamental tax reform as a way to promote economic growth. Now, tax reform will test whether they can translate control of government into reforms that benefit Americans.

There is no question that we need faster economic growth; without it, American living standards will stagnate and government programs will become insolvent. Yet in their zeal to generate enthusiasm among their base, Republicans are neglecting those aspects of tax reform that are most closely linked to the investment and innovation that promotes growth. One of these is the research and development tax credit.

The United States enacted the world’s first research and development tax credit in 1981. The size of the credit is rather small: The Joint Committee on Taxation estimates that it will cost taxpayers $57.5 billion over five years. Unlike most other special provisions, the credit actually addresses a clear market failure. When firms invest in research, most of the benefit goes to society in general. One study looked at a series of prominent innovations and found that the average return to the company making them was 27 percent. But the return to society was 99 percent — over three times greater. The Obama administration estimated that every dollar spent on research generates between $2 and $3 in social welfare. That’s because research is one of the primary sources of innovation, and innovation is what drives higher productivity and improved living standards.

Clearly we want companies to do more research. But companies are reluctant to spend more if most of the benefits go to others. The R&D tax credit addresses that concern. Companies basically get a tax credit for about half the research they do. For over 30 years, the tax credit was temporary. Congress had to reinstate it, sometimes retroactively, over a dozen times. Congress finally made it permanent in 2015. Academic studies estimate that every dollar of lost revenue results in roughly $1 of additional research and $2 to $3 in social value.

For the last few decades, nations have been engaged in an increasingly fierce battle to capture a greater share of investment and production activity. A large number of countries have lowered their statutory corporate tax rates substantially. Many have implemented innovation boxes to tax profits derived from intellectual property at a lower rate. Tax incentives for research have also been popular. In 1991, the United States had the most generous research tax credit in the world, measured by the amount of profit needed to offset an additional dollar of research. Now we are 25th among OECD countries because other nations have created or expanded their incentives.

Expanding the R&D credit matters because the credit is mainly taken by industries that are engaged in international competition, such as automobiles, software development, pharmaceuticals, and aerospace. When other countries increase their incentives for doing research but we don’t, U.S. companies in these and related industries lose competitiveness. And because companies can increasingly move research virtually anywhere they want, U.S. companies have responded by increasing R&D faster offshore than in the United States.

Yet the R&D tax credit is like the forgotten child of tax reform. The current version of the House tax bill makes no changes to the credit. This is not good enough. At a minimum, the Alternative Simplified Credit, which most companies use, should be increased from its current value of 14 percent to 20 percent of qualified research expenditures. Research by the Information Technology and Innovation Foundation estimates that this change would create 162,000 new jobs, generate 3,850 additional patents a year, and increase annual productivity growth by 0.054 percent. GDP would also increase by $66 billion a year. Finally, total tax revenues from the increased economic activity would begin to exceed the revenue costs within 15 years. This change would make the United States more competitive in research-intensive industries, encouraging more domestic research and boosting both productivity and innovation.

There is a fundamental imbalance between what middle-class Americans demand from government and what they are willing to pay for. Tax reform that focuses on cutting individual tax rates to pacify supporters will not solve this dilemma. But tax reform that encourages companies to invest in America and find the newest innovations might. There are early reports of a bipartisan compromise on lower corporate tax rates accompanied by greater incentives for investment and research. The administration and Congress should focus first and foremost on these efforts, which should include strengthening the R&D credit.

Joe Kennedy (@JV_Kennedy) is a senior fellow at the Information Technology and Innovation Foundation, a leading science and tech-policy think tank, where he focuses on tax and regulatory policy.

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