The Case For The Tax Cut

Studies | Taxes

No. 226
Sunday, August 01, 1999
by Bruce Bartlett

Research and Development Credit

Economists are unanimous in their belief that research and development is essential to economic growth. Technological progress is the key to productivity growth and, therefore, rising standards of living.57 However, businesses tend to underinvest in R&D because they cannot capture all of the benefits for themselves; much of the benefit accrues to society as a whole, rather than to the business that financed the R&D.58 For this reason, economic theory says that it is in the interest of the long-term welfare of society to subsidize R&D to some degree.59

In 1981, Congress enacted a tax provision designed to stimulate private R&D. Companies were allowed a tax credit of 25 percent on incremental R&D (currently 20 percent). That is, their taxes were reduced by 25 percent of the additional, not the total, amount of qualified R&D they did each year. By applying the credit only to the annual increase in R&D, Congress hoped to ensure that companies were not rewarded for what they would have done anyway, but only for doing more.

"Studies show the R&D credit stimulated from $1 to $2 of new research and development for every dollar of revenue loss."

Studies of the R&D credit generally have found that it has increased R&D exactly as it was supposed to. A 1995 report from Congress's Office of Technology Assessment found that the credit stimulated $1 of new R&D for every $1 of revenue loss.60 A Commerce Department study that same year found an even higher response: $2 of R&D for every $1 of revenue loss.61 When one considers that the social rate of return on R&D may be several times the private rate of return, one has to judge the R&D tax credit to be one of the most effective government programs ever enacted.

Unfortunately, Congress has been unwilling to make a long-term commitment to the R&D credit. It has never been enacted permanently and has expired on several occasions, most recently on June 30, 1998. Economist Ken Brown of the National Science Foundation believes that this on-again/off-again approach to the R&D credit has robbed it of much of its effectiveness. Firms often plan R&D projects years in advance. If they are not sure the credit will be available, they may scale back their plans.62

A new study from Coopers & Lybrand may help Congress overcome its reluctance and make the R&D credit permanent. It finds that over a 12-year period the dynamic revenue loss is just 35 percent of its static loss. That is, the additional productivity and economic growth stimulated by the credit raise federal revenue by almost enough to pay for itself.63

The Senate version of the tax bill would have extended the R&D credit permanently. The conference agreement extends it only for five years, until 2004. While a result less than optimum, a longer extension of the R&D credit is better than the year-to-year extensions that Congress has implemented in years past.

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