As Congress contemplates implementing comprehensive 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. reform, several of the deductions and credits that pepper the U.S. tax code are being reevaluated and considered for elimination in an effort to offset the cost of tax rate cuts and simplify the overall tax code. One of the more prominent credits being evaluated is 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. , which was passed in 1981 to encourage private firms to conduct research. However, some proponents of this credit have actually proposed expanding it: in the last few weeks, two bipartisan bills have been filed that would expand the R&D tax credit, and the Information Technology and Innovation Foundation (ITIF) has published a report calling for Congress to preserve and expand the credit.
ITIF’s report argues that the R&D tax credit should be preserved due to the positive externalities involved in research. By “positive externalities,” ITIF means that research does not just benefit each business’s profits, but also often provides broader benefits to society at large. Because companies may not consider these broader benefits when deciding whether to spend more money on research, there is a risk that U.S. businesses will decline to invest in socially beneficial research projects and that the economy as a whole will produce a less-than-optimal amount of research. For example, one of the studies cited by ITIF estimates that in 20 prominent private research projects there were average private returns of 26 percent, compared to a social return of 99 percent from improved products and use of resources. According to advocates of the R&D tax credit, such as ITIF, the credit can partially correct for this market failure by increasing the returns firms receive for research investments.
One of the key issues regarding the R&D tax credit is the complexity of the provision. The R&D tax credit is awarded for 20 percent for qualified research expenditures above a base level, determined by a company’s history of research spending since 1981. Companies may choose to claim the Alternative Simplified Credit instead of the regular R&D tax credit, which provides a tax credit equal to 14 percent of qualified research expenditures over 50 percent of a three-year spending base. Both calculations for the R&D tax credit are as complicated as they sound, which makes them difficult for corporations to carry out. The definition for “qualified” research expenses is also vague and difficult to parse, requiring research to be laboratory, technological, marketable, and non-stylistic in nature to qualify for the credit.
According to Dr. Jason Fichtner and Adam Michel of the Mercatus Center, the complexity of the R&D tax credit is not only wasteful in necessitating significant legal expenditures to administrate, but also provides an advantage to larger companies that can more readily tackle these legal barriers. Their research shows that in 2011, the largest 0.13 percent of firms filed 14 percent of claims for the R&D tax credit and received 82 percent of the total dollar value. This disparity indicates that the complexity of the R&D tax credit causes economic distortions that make the marketplace less competitive. The Mercatus researchers go as far as to advocate the complete abolition of the R&D tax credit in favor of a reduction in the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rate, which some studies suggest would also increase private research expenditures.
However, it is unclear that there is a better alternative than the R&D tax credit to address the market failure caused by externalities in private research. Most studies of R&D tax credits estimate the cost elasticity of private R&D as approximately 1, which means that every dollar awarded by the credit inspires an additional dollar of private research. In contrast, the study cited by the Mercatus Center, which argues that corporate tax cuts could be used as an alternative to the tax credit, estimates that a 10-point reduction in the corporate income tax boosts R&D spending by 9 percent. This effect is several times smaller than what is estimated for the R&D tax credit and casts doubt on whether a nontargeted solution can effectively address concerns about externalities. Nonetheless, there is a trade-off here between efficiency and simplicity, and the Mercatus Center is correct to note that eliminating the credit altogether would simplify the tax code.
One potential reform of the R&D tax credit is to make it more accessible to smaller firms, which could also help it be more effective at encouraging private research in general. A prominent study in the United Kingdom estimated that relatively small firms roughly doubled their research expenditures after an R&D tax credit was expanded to apply to them. This amounted to a cost elasticity of 2.6 among these firms, one of the largest results measured for an R&D tax credit, which suggests that small firms are relatively more responsive to these credits. Congress has already taken steps to make the credit accessible to smaller firms by making it permanent and allowing it to apply against Alternate Minimum Tax liability in 2015. Simplifying the credit would further improve small firms’ ability to claim it.
Several solutions have been proposed to simplify the R&D tax credit to make it more accessible to smaller firms. The Mercatus Center has proposed amending the credit to use the simpler definitions of research used to calculate deductions, and to eliminate the regular credit in favor of the Alternative Simplified Credit. More recently, a bipartisan bill by Representatives Pat Tiberi (R-OH) and John Larson (D-CT) seeks to broaden the definition of eligible expenses, alongside an expansion to the simplified credit.
The R&D tax credit is a difficult issue, as it serves to correct a real market failure but introduces additional complexity to the U.S. tax code. If the credit is to be preserved or expanded, the structural issues in the R&D tax credit should be addressed to allow it to more effectively encourage private research.
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