The research and experimentation (R&E) tax credit – alternatively referred to as the R&D tax credit, the research tax credit, or the credit for increasing research activities – is a tax provision designed to incentivize innovation by making research activities cheaper for businesses. The R&E credit is one of the “tax extenders,” a set of federal tax provisions that expired on December 31, 2013, but have routinely been renewed in the past.
While the purpose of the credit is clearly important, changes might increase its bang-for-the-buck. Furthermore, the fact that the R&E credit expires every few years severely blunts its effectiveness. The credit – either in its present form or a reformed one – should be permanently extended and paid for (at an estimated cost of $77 billion over ten years, as currently structured) if Congress deems it important enough to keep. Otherwise, it should be allowed to expire for good.
Why and How Does the Government Incentivize R&D?
New technology is one of the prime drivers of long-term economic growth. However, the process that leads to innovations like penicillin, cell phones, and the internal combustion engine is complex and risky, marked by uneven progress.
In a capitalist economy, invention is primarily driven by competition between firms to provide better or cheaper products, but many economists believe that, despite intellectual property protections, inventors and firms are unable to capture the full economic value of their work. When patents eventually expire or firms reverse engineer each others’ work, the original firm’s returns on the research that went into those products are diminished. For example, the transistor, which was developed at Bell Labs, has fundamentally changed the world we live in, but Bell Labs long ago lost any claim to exclusivity for producing transistors.
Because firms are unable to capture all of the profits from the outcome of research activities, the financial benefits of research to those who conduct it are lower than the benefits to the public as a whole.1 The bottom line is that absent outside intervention, the private market would probably produce an inefficiently low level of research. Moreover, firms have biases towards producing products with more certain outcomes – and ones that will show up positively on quarterly earnings statements in the near future – so corporations may eschew highly risky, long-term research opportunities even if the potential rewards are enormous.
The government helps to correct for this market failure by directly funding research through scientific agencies and universities – such as NASA, the National Institute of Health (NIH), and the National Science Foundation (NSF) – and by indirectly incentivizing research through devices like the R&E credit.
The R&E credit incentivizes research activities by reducing tax liabilities for companies that spend money on that research, which lowers the after-tax cost of those activities. The credit is equal to a certain percentage of a business’ qualified research expenses (QREs) in excess of a base amount. The credit can be claimed either by corporations that pay taxes or by shareholders in S-corporations or other types of pass-through entities that place corporate income, losses, and credits onto their owners’ tax returns. The full value of the credit can only be claimed by taxpayers with sufficient tax liabilities, however, because it is not refundable.
Taxpayers can carry the credit back one year and forward for 20 years, so even if a taxpayer can’t apply the full benefit of the credit in the current tax year, some flexibility is available. In addition to the R&E credit, research expenses (under a somewhat broader definition than allowed for the credit) can also immediately be deducted. However, the deduction is reduced by the amount that is claimed for the credit so that businesses may claim either the deduction or the credit for a particular expense, but not both.
Which Expenses Are Eligible for the Credit?
Expenses that qualify as QREs include wages and salaries of employees and supervisors who are conducting research, supplies, and a portion of research that is contracted to outside entities. The credit cannot cover depreciable durable assets like buildings and equipment, overhead expenses, or non-wage benefits for personnel.
There is a four-part test to establish whether particular expenses are QREs. In general, expenses must be incurred in the course of conducting research that: roughly follows the scientific method of inquiry and evidence; is “technological in nature” and relies on principles of the physical or biological sciences, engineering, or computer science; will be used to develop a new or improved product, process, or software that will be sold, leased, licensed, or used by the taxpayer; and seeks to improve the quality, functioning, or performance of a product.
For example, the costs incurred in designing a new type of battery that would be marketed to phone manufacturers would qualify for the credit. Likewise, the expense of developing software to market to online retailers that would speed consumer transactions would qualify.
Some expenses that do not qualify as QREs include: efficiency, management, or consumer surveys; research conducted to improve style, taste, cosmetic, or seasonal design factors; research in the social sciences, arts, or humanities; research conducted outside the U.S.; and research funded by another entity. There is no bright-line distinction between activities that qualify as QREs and those that do not. This has been the source of much friction between the Internal Revenue Service (IRS) and taxpayers.
How Much is the Credit Worth?
Unfortunately, the structure of the credit is quite complicated, as so many elements of our desperately-in-need-of-reform-tax code are. Although the R&E credit is referred to as one entity, it actually consists of four different parts: (1) the regular research credit, (2) the alternative simplified credit (ASC), (3) the basic research credit, and (4) the credit for energy research. In any given year, a taxpayer may claim either the regular or alternative simplified credit along with both of the others.
The regular credit and the ASC are really just two different calculation methods for the credit. Both are structured to be worth a portion of QREs beyond a particular base amount. The credit is structured this way in order to avoid subsidizing activities that the taxpayer would have undertaken anyway and to focus the credit’s incentives on research that might not have been undertaken in its absence.
Taxpayers who elect the ASC must generally continue to calculate their credit according to the ASC unless they get permission to switch from the IRS. The credit is computed differently depending on whether the firm is a start-up or not. Both the ASC and regular credit calculation usually involves QREs and gross receipts from the last few years and compares that base to current year QREs.2
The ASC is usually more generous than the regular credit, particularly if a firm has: a base amount that is large under the regular credit; incomplete records for determining its base amount; gross receipts that have grown significantly in recent years; or a complicated history (e.g., one that includes mergers and acquisitions). In 2010, the ASC accounted for approximately 60 percent of the credit value claimed through either the ASC or regular credit.
The basic research credit is available to firms that contract with particular non-profit organizations to do basic research. This credit is mainly designed to incentivize firms to work with colleges and universities. It is available for research that is intended to advance scientific knowledge without any particular commercial application. Like the regular credit and the ASC, the basic research credit is worth a percentage of expenditures above a base amount (which is meant to approximate what the firm might do in the absence of the credit).
The energy credit is calculated as a percentage of payments made to certain non-profit entities for energy research. Because there is no base amount that taxpayers have to exceed to qualify, the energy credit is the most generous of the four (as a percentage of total research expenses).
What Should Happen to the Credit?
The R&E tax credit serves an important purpose – in fact, out of all the tax extenders, R&E is the only one that the Domenici-Rivlin Debt Reduction Task Force endorsed keeping. There are a number of aspects of the credit, however, that limit its effectiveness, including high compliance costs, base amounts that may be inefficiently set, the inability of many companies to claim the credit, and continual expiration of the provision.
Some of these problems may be difficult to solve. Compliance costs are high for both companies and the IRS – substantiating what is and is not a QRE is painful for all involved. Clarifying what qualifies as a QRE may help somewhat, but it is difficult to strike the right balance between ease of administration and ensuring that the credit is properly targeted at activities that would otherwise lack investment. Furthermore, it is impossible to read the minds of CEOs to determine how much research they would do absent the credit. But if Congress desires more precise targeting of the credit, there are some changes to its structure that may increase the bang-for-the-buck.3
Because the credit is nonrefundable, companies that do not have positive tax liabilities cannot claim it; many younger, R&D-intensive companies are in this position. Thus, the credit mostly helps larger companies. Despite the fact that more than 15,000 taxpayers claimed $6 billion in credit benefits in 2005, 549 large corporations (with receipts of $1 billion or more) claimed more than half of that value.
The most obvious – and easily fixable – issue with the R&E credit is its recurring expiration. If taxpayers are not certain whether the credit will be maintained in future years, its incentives toward more research are blunted. Similarly, extensions that apply the credit retroactively largely defeat the credit’s purpose. The R&E tax credit, whether in its current form or a new one, should either be permanently extended and paid for or removed from the tax code for good.
1 This can be exacerbated if some companies are content to produce knock-off products that utilize others’ research – an instance of the so-called “free-rider” problem.
2 In this context, a “start-up” is a firm that had both QREs and gross receipts in a single tax year for the first time later than 1993. For some established firms who elect the regular credit, the base is generated from gross receipts and QREs from 1984 to 1988.
3 The Government Accountability Office (GAO) suggests that these changes could include eliminating the regular credit and changing the ASC such that the base would be at least 50 percent of current-year QREs.
KEYWORDS: DOMENICI-RIVLIN DEBT REDUCTION TASK FORCE, INTERNAL REVENUE SERVICE, NASA, NATIONAL INSTITUTE OF HEALTH, NATIONAL SCIENCE FOUNDATION, QUALIFIED RESEARCH EXPENSES (QRES), RESEARCH AND EXPERIMENTATION TAX CREDIT