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R&E Tax Credit

June 16, 1998
Contact: Allison Sayler
Tel: 202-296-2237, ext. 14
Email: asayler@aaes.org

Introduction

Investment in science and engineering research is the lifeblood of technological innovation, which drives U.S. economic growth, environmental progress, and national security. Almost two-thirds of the nation's science and engineering research is funded by private firms. The federal share of total U.S. R&D investment has decreased steadily and currently represents 31% of total R&D spending, down from 57% in 1970

The increasing role of the private sector in funding U.S. science and engineering R&D is likely to continue. Moreover, considering that private firms typically underinvest in R&D when responding solely to the marketplace and that real R&D growth in many manufacturing industries has declined, federal policies - both direct and indirect - that induce additional private R&D investment are essential. Currently, the Research and Experimentation (R&E) tax credit is the centerpiece of the federal government's indirect support for R&D.

The American Association of Engineering Societies (AAES) believes that the R&E tax credit provides an important, market-driven incentive for companies to increase their R&D spending in the U.S. The credit is both a good investment in U.S. productivity and job growth and a critical complement to direct federal subsidies for R&D.

How the R&E Credit Works

In 1981, Congress created the R&E tax credit to encourage business to increase their R&D spending in the U.S. Under section 41 of the Internal Revenue Code, a firm can claim a 20% tax credit on the amount by which its qualified research expenditures (QREs) exceed a base level. Such an incremental design, in principle, minimizes the likelihood of providing a tax subsidy to a firm for R&D that would have taken place in the absence of the credit.

The base amount is determined by multiplying a firm's "fixed base percentage" (the ratio of its combined QREs from 1984-88 to its combined gross income in that period) by its average gross income in the preceding 4 tax years.

QREs generally include salaries and wages, supplies, and 65% of the total amount paid for contract research. Basic research payments to universities and other scientific research organizations are also treated as QREs. The primary expenditures that do not qualify are property, plant, and equipment costs as well as depreciation on R&D capital goods. Qualified research, while not well defined under section 41, must be technological in nature and relate to the development of new or improved business components. Generally, roughly 50 percent of industry R&D expenditures qualify for the tax credit.

Importance to Engineers and Scientists

Because almost 70% of R&E tax credit dollars claimed are investments in the salaries of U.S. research employees, the credit benefits engineers and scientists directly by fostering high-skilled, high-paying jobs in the U.S. In addition to the direct benefit on jobs and wages of engineers and scientists, most studies show that the credit stimulates substantial amounts of additional science and engineering research, which improves productivity across virtually all industries and, thus, our economic strength and standard of living.

At a time when U.S. companies are looking increasingly to moving development of products for foreign markets offshore, the R&E tax credit encourages companies to keep a greater portion of R&D, and the related jobs, in the U.S.

Studies have shown that the credit benefits companies of all sizes and all sectors of the economy. Industries that particularly benefit include: electrical and electronic equipment, communications, chemicals and allied products, biotechnology, machinery, motor vehicles and equipment, instruments and related products, and business services.

Effectiveness of the R&E Credit

The U.S. General Accounting Office, Bureau of Labor Statistics, the National Bureau of Economic Research, and many private researchers agree that the R&E tax credit stimulates substantial amounts of additional R&D. Exactly how much spending is stimulated per dollar of revenue lost (the "bang-per-buck" ratio) varies. Many recent studies, however, support the conclusion that for each dollar lost in tax revenue, the credit stimulates a dollar of new R&D spending in the short run, and as much as two dollars in the long run. This implies long-run gains in productivity, wages, and GDP.

While this ratio is a useful barometer, more important is the net benefit the credit produces for society. Determining what type of research is stimulated by the credit is difficult, however, as is measuring the social rate of return on R&D. R&D investment, in general, provides substantial returns to society. In fact, economists estimate that half of U.S. economic productivity since WWII is attributable to technical progress driven by science and engineering research. And past studies suggest that the median social rate of return on R&D in general exceeds twice the median private rate of return

Most studies have shown that the structure of the R&E credit can also have a significant impact on its effectiveness. When Congress decided in 1990, for example, that taxpayers claiming the credit must forego the deductibility of those qualifying research expenses under a separate section of the tax code (Section 174), it essentially lowered the maximum effective rate of the regular credit from the statutory level of 20% to 13%. In addition, since the base amount can never be less than 50% of current year's QREs, the marginal rate of the credit is frequently capped at 6.5%. This "50% rule" particularly impacts small firms.

Perhaps the most important hindrance to the credit's effectiveness is its temporary status. The continuing short-term approach to stimulating long-term research is a more costly and much less efficient policy than a permanent credit. Many firms overlook the R&E credit when setting their research budgets because they cannot be certain of its future availability as they plan long-term research projects. Repeated on-again, off-again extensions dampen the very incentive value the credit was enacted to promote. This is particularly the case for companies with longer planning horizons, such as biotechnology firms. Allowing gaps in coverage to occur, as happened in 1996, reduces the incentive even further.

AAES Recommendations

Make the R&E Credit Permanent The R&E credit should be made a permanent part of the tax code. While the temporary nature of the credit was originally justified as a way to review the performance of the law, 17 years has been a more than adequate review period. A recent study by Coopers and Lybrand claimed that a permanent credit would stimulate $41 billion in additional R&D by 2010. While current budget constraints are cited as the principal barrier to permanence, we urge Congress to give more weight to the expected long-term gains to society of a permanent credit than is given to short-term revenue loss.
Reform the "Basic Research Credit" to Promote Collaborative Research Studies by the Office of Technology Assessment (OTA), Congressional Research Service (CRS), and others conclude that the current "Basic Research Credit" is ineffective. We believe this is due to its narrow definition of research and its incremental nature. According to OTA, basic research payments to universities and other qualified organizations represented only 0.4 percent of total qualified research in 1992.
The definition of research under this provision should be expanded to include all long-term, high-risk collaborative research. While one of the strengths of the R&E credit is that it leaves decisions on what research areas to fund to the private sector, a robust incentive for long-term collaborative research would increase the credit's spillover benefits to society. Such a credit should foster basic and long-term precompetitive research, which industry has cut back on, and promote company-to-company, company-to-university, and company-to-federal laboratory partnerships. It should also include expenditures for collaborative research involving nonprofit research centers.
Further, because this type of research does not represent a major portion of a typical company's R&D budget, an incremental design - as is currently used under the Basic Research Credit - is not likely to affect decisions on R&D strategies and, thus, not provide a sufficient incentive. By contrast, a 20% flat credit would be much simpler and would likely create the needed incentive for firm's to pursue more long-term research through joint ventures with universities, laboratories, nonprofit centers, and industry-wide consortia. Such research allows firms to share costs, hedge risks, and broaden their technological competence. It can also speed the rate of technology diffusion across firms and produce multiple societal benefits.
Adjust the Base Period To be fair and effective, the base amount realistically has to account for changes in a firm's research intensity over time. The current 1984-88 period is both discriminatory and outdated. While some firms do very well with this base period, many others reap little or no benefit because their sales have grown faster (or fallen more slowly) than their qualified research expenses since the base period. The current 1984-88 base simply is not a reasonable benchmark for many companies given their current business conditions. One proposal worth considering is to permit companies to use any 4-year period within the previous 10 years, which would better match their current business environment while retaining the incremental nature of the credit.
Repeal the 50% Rule The 50% rule reduces the value of the credit to firms that have substantially increased their R&D spending over their base period. This rule is particularly troublesome for small firms, which produce the lion's share of new jobs in the U.S. Under the 50% rule, many high-tech start up firms often see the effective rate of the R&E tax credit cut in half.