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Reading Up on the R&D Tax Credit

2 min readBy: Scott Drenkard

Today, Jason Fichtner and Adam Michel at the Mercatus Center released a paper on the research and development tax credit. The R&D tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. is one of the larger components of the federal “taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. extenders,” a host of credits and deductions that are temporarily reinstated each year, sometimes even after the tax year is entirely over. Their findings:

The credit has no proven results. Economic literature suggests that tax incentives for R&D have a small and uncertain ability to increase private research spending—essentially, a dollar in R&D tax incentives amounts to a dollar in increased R&D spending. But this extra spending is not shown to significantly increase measures of innovation, and may even reduce the quality of research.

“R&D” is poorly defined. Imprecise definitions of qualified research make it impossible to successfully target socially beneficial R&D. Moreover, the definition of qualified research used for the tax credit is different from the definition used in other sections of the tax code, which increases administrative and compliance costs.

The credit drives additional costs. Because the credit cannot be precisely defined, businesses are incentivized to spend large amounts of time and money lobbying Congress and tax regulators to ensure the credit is renewed and tailored to suit their specific interests. Significant resources are also wasted as parties attempt to interpret, litigate, and follow the law. These rent-seeking costs decrease the predicted positive effects of the credit and diminish any resulting economic growth.

Temporary tax policy creates uncertainty. Since 1981, when the R&D credit was first voted into law, it has expired and been extended 16 times—on average, every two years. Uncertainty about the future of the tax credit paralyzes business investment and harms economic growth.

The credit favors big business. The R&D tax credit is chiefly used by the largest corporations; the top 1 percent of US firms claim more than 82 percent of all research tax credit dollars. The smallest 95 percent of firms claim less than 5 percent of credit dollars.

Fichtner and Michel suggest eliminating the program outright and lowering the overall corporate tax rate as an ideal, but also have four interim policy suggestions. Those are: 1) make the credit permanent, 2) disallow filers from taking the credit on an amended return, 3) simplify the definition of “research” to the IRC Section 174 definition, and 4) replace the parallel systems of the regular research credit and the alternative simplified credit (ASC), only allowing firms to calculated the credit through the ASC.

The whole paper is here.

More on tax extenders here.

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