How the R&D tax credit is like duct tape

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Article Highlights

  • R&D credit is like duct tape - good temporarily, but needs a permanent fix

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  • Baseline of R&D spending stopped making sense once R&D credit became permanent

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  • Effects of subsidizing R&D are large and lead to large increases in investment

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Oh, the wonders of duct tape! Isn’t it a practically ideal solution for solving minor leakages, temporarily? If that's the only thing you do, using duct tape all the time would be utterly justified.

Similarly, if you were the federal government in 1980 and the only thing you wanted to do is stimulate private-sector research and development expenditures in the next few years, using the Federal Research and Experimentation Tax Credit as actually implemented in 1981 was a wise thing to do.

Similarly? What do you mean? In what possible sense are the R&D Tax Credit and duct tape similar? Is the R&D Tax Credit not the single most glorious example of bipartisan policymaking in contemporary America? Has it not been renewed a total of 15 times since its inception in the early 80s, no matter which party or parties controlled the House, Senate and White House? Well yes, it has. But it could be even better.

The Section 41 Research and Experimentation Tax Credit was explicitly designed as a temporary measure. And much like duct tape is well suited for fixing temporary minor leakages, but not for constructing an entire sewer system, the credit’s design is appropriate for its original transitory objectives but not to serve as a permanent program.

The original framework was set up to incentivize corporations to invest in new research and development. The underlying rationale here is that private-sector R&D spending produces important spillover effects that benefit society as a whole but cannot be monetized by the firm doing the spending. By subsidizing R&D expenditures at the margin we can ensure firms internalize the spillovers or positive externalities and invest the "socially optimal" amount in R&D.

But Congress did not want to expend precious treasure subsidizing R&D corporations would have undertaken regardless of the tax credit. To accomplish this, the law defined a firm-specific baseline level of R&D expenditures, and firms would only be allowed to claim the tax credit for expenditures above this baseline. The baseline itself was defined as the average of the firm's previous three years of R&D spending, or 50 percent of the current year, whichever was higher.

When the program first started, and was supposed to be terminated shortly after, this was not an unreasonable choice. The average expenditure level for the previous three years was a given that firms could no longer influence, and the 50 percent baseline only applied to firms with extreme growth rates that were unlikely to be related to the credit.

But then the extensions came. And kept coming. Suddenly, a firm faced a mix of incentives when expanding its research and development programs: on the one hand, it would receive a tax credit for research spending above its baseline in a given year, but on the other hand such spending would raise its own baseline in the future.

In years in which the firm's R&D spending remained below its baseline, the only effect of the tax credit became that of effectively raising future taxes by raising the baseline without providing any offsetting credit. Some firms effectively received a 25 cent subsidy for each additional R&D dollar spent, while other faced a nearly 25 cent tax and most firms received something in between.

To "fix" this, the moving three-year period average was swapped for a base derived from average research spending between 1984 and 1988: and this, remarkably, is still the case, in spite of rising administrative difficulties (though firms can now opt into an “alternative simplified” regime). Besides that, newer firms - and yes, new firms have been born in the last 25 years - are assigned a somewhat arbitrary baseline of 3 percent of receipts for the first few years.

In a new research paper, one of us studies how these and other counterintuitive effects of Section 41 (and previous legislation with similar goals) impact the actual investment behavior of firms of different sizes, and in different industries. One thing is clear though: the effects of subsidizing R&D are large and not just driven by shifting expenditures across time periods (though there may be some shifts from "non-qualified" R&D expenses). On average, making R&D spending 10 percent cheaper leads to a short-run jump in expenditures of 11 percent, and even more in the long run.

Policymakers and industry understandably advocate bringing greater certainty to the credit by making it permanent; but making this particular version of the research credit permanent – a version borne as a temporary measure – may not be the best policy moving forward. Instead, policymakers should redesign the credit with permanency in mind, as a policy instrument this powerful should not be applied in a way that is the chance product of past legislative compromises or the arbitrary outcome of historical accident. Because, eventually, a duct-tape-based sewer system starts leaking.

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