How the R&D Tax Credit Is Like Duct Tape

May 28, 2013

U.S. technological research and development has been indirectly subsidized since 1981 through tax credits. The original goal in creating the federal Research and Experimentation Tax Credit was for it to be used as a temporary measure to create new research and development (R&D), but it has become a duct-tape-like fix for America's underwhelming technological development, say Nirupama Rao and Stan Veuger in U.S. News & World Report.

  • The original framework was set up to incentivize corporations to invest in new research and development.
  • The underlying rationale was 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 it can be ensured that firms internalize the spillovers or positive externalities and invest the "socially optimal" amount in R&D.

The federal Research and Experimentation Tax Credit defined a firm-specific baseline level of R&D spending, and technological firms would only be allowed to take the tax credit for expenditures above the level established. The spending level was defined as the average of the research company's previous three years of R&D spending. When the program first started it was supposed to be a short-term solution, so this was not completely unreasonable.

  • The average expenditure level for the previous three years was a given that firms could no longer influence.
  • The 50 percent baseline only applied to firms with extreme growth rates that were unlikely to be related to the credit.

The government kept giving extensions to the program and suddenly technological firms had a mixture of incentives:

  • The firm would receive a tax credit for research spending above its baseline in a given year, although such spending would raise its own baseline in the future.
  • 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 others faced a nearly 25 cent tax and most firms received something in between.

The government wants to incentivize new development in U.S. technology, but if they want to be successful in this pursuit they will have to create a new tax credit that is designed for permanency.

Source: Nirupama Rao and Stan Veuger, "How the R&D Tax Credit Is Like Duct Tape," U.S. News & World Report, May 16, 2013.


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