The Federal Research and Development (R&D) Tax Credit

Investments in research and development (R&D) are the most favored type of investment in the federal tax code, subject not to taxes but to subsidies (negative taxes). These subsidies arise from the combination of expensing (deducting intangible investment costs from taxable income immediately rather than over the life of the investment), deductibility of interest for debt financing, and the R&D tax credit available under Section 41 of the Internal Revenue Code (IRC). Companies are allowed two options when claiming the R&D credit: a 20% credit commonly referred to as the regular credit, or a 14% credit known as the alternative simplified credit (ACS). Because of the specific designs of each of the credit options, the effective credit percentages are lower than these headline percentages. CRS estimates that the current effective average R&D tax credit for marginal investments is 8.2%. These design features reflect an attempt to apply the credit only to incremental investment, but that approach has not been successful. Due to its current structure, the credit is no more efficient at targeting marginal investment than a flat credit for all research. The credit is part of the general business credit, which is limited to 75% of taxable income. Without corporate tax benefits, the marginal effective tax rate (METR) on new investment is estimated at 27.2%, reflecting the corporate rate of 21% and additional taxes at the shareholder level. Expensing alone results in a 7.8% METR, as it leads to a METR of 0% for the corporate-level tax. The credit, along with expensing, results in a marginal effective tax rate on new investment of minus 30.3%; that is, a subsidy rather a tax. When the benefits of debt finance are added, the effective rate is minus 47.2%. The effect on investment incentives can be seen through the tax wedge, the percentage change in the minimum pretax return on an investment required by investors. For an investment without corporate tax benefits subject to the 27.2% METR, the pretax required return increases by 37.4%. The tax incentives for R&D result in a decrease of 32.1%, with the pretax required return falling below the after-tax required return. The effect of the credit on investment can be estimated based on the change in the user cost and the responsiveness of investment to the user cost. The user cost is the sum of required return to pay investors, the taxes, and the decline in the value of the asset over time. The user cost rises by 7.4% with no tax benefits, but falls by 8.6% with the credit, and by 12.6% with debt included. To estimate the effect on investment, these percentages are multiplied by the elasticity (the percentage change in investment divided by the percentage change in cost). Earlier studies estimated an elasticity of -1.0, although recent estimates indicate that R&D is responsive to the user cost with an elasticity between -2.0 and -4.0. These estimates suggest that, compared to expensing, the credit increases R&D investment by 8.6% to 34.3%, and with the benefits of debt finance as well, increases the R&D investment by 12.6% to 50.5%. Research spending and the innovation it generates can create spillovers, or benefits or costs that are not captured by the firm undertaking the research. Positive spillovers exist when the social benefits of research exceed the private returns. In such a scenario, too little research is undertaken and there exists an economic justification for government intervention via tax and nontax subsidies. Estimates typically indicate that the social returns to R&D are two to four times the private return to firms (and one estimate found a ratio of 20). That suggests that too little investment is made in R&D with the current credit. Under the assumption that the ratio of social to pretax return is constant as investment expands, CRS estimates that an increase in the current effective average R&D tax credit rate of 8.2% to 14% or 21% is required to optimize economic efficiency depending on if the social returns to R&D are either two or four times the private returns. A number of policy options for the credit might be considered. The credit could be simplified and have the same incentive effect as substituting a flat credit around 8.2%. Another option is to increase the credit to encourage more investment because of the high social returns to this investment. There are also options to make the credit more available to start-ups and firms with losses, including offsetting against payroll taxes, removing the general business credit limit, or making the credit refundable. Another option is to attempt to target projects with higher social returns by increasing subsidies for collaborative research, or by increasing funding for government research.