Background on R&D Expensing
Research and development investments are essential to delivering the technologies needed to reduce emissions and keep the world on pace to achieve net-zero emissions by 2050, create new jobs and industries, and ensure the United States remains a global economic powerhouse. A recent International Energy Agency report found that technologies not yet available will deliver around one-third of the emissions reductions needed to meet this climate target, underlining the need for continued R&D investments in the energy sector. In 2022, the United States contributed more than any other country to energy research and development, and has long led the world in R&D. In 2019, America contributed 28% of total global spending on R&D from both the public and private sectors, the largest by any country. Business spending on R&D is crucial and drives investment. In fact, businesses invested more than three times as much in R&D compared to the government.
To incentivize strong private sector investment in R&D, since 1954, Section 174 of the Internal Revenue Code allowed businesses to immediately deduct R&D expenses in the year those expenses were incurred. However, the 2017 Tax Cuts and Jobs Act amended the law, eliminating the full and immediate deduction beginning in 2022. Companies now must spread out the deduction, also known as amortizing expenses, over five years. This leads to a less valuable tax deduction and higher tax burden for companies investing in R&D. Here we explore the impacts of the R&D tax deduction on the U.S. energy research ecosystem, the effects of the R&D tax deduction on energy startups, and the current state of play in Congress to restore immediate expensing of R&D spending.
Impacts on Private Sector R&D Spending
Changes to R&D tax expensing will have significant impacts on R&D spending in the United States and the jobs those investments create. According to a study conducted by Ernst & Young on behalf of the R&D Coalition, the change requiring amortization will result in a reduction in U.S. R&D spending of $4.1 billion annually in the first five years and $10.1 billion in the second five years and beyond. The same study shows that 23,400 jobs will be lost in each of the first five years and 58,600 in each of the second five years.
This policy could diminish the United States’ R&D advantage as other countries do not require R&D amortization. According to a recent analysis by the National Association of Manufacturers, this change makes the United States just one of two developed countries that requires amortization rather than immediate expensing. Meanwhile, China offers a “super-deduction” for R&D that allows for 200% of the eligible R&D expenses incurred by enterprises to be deducted.
These impending reductions in R&D spending come at a time when the innovations that can reduce emissions and generate clean energy are critical to meeting net-zero goals. Energy R&D investments have led to important technologies like solar panels and electric vehicles, and continue to drive innovations in carbon capture utilization and storage, hydrogen, and advanced nuclear.
Impacts on Energy Startups
While immediate R&D expensing is important for the U.S. private sector generally, energy startups are disproportionately impacted by these changes. Energy startups—unlike more established companies—devote a much larger proportion of their budgets to R&D. Without the ability to deduct those expenses immediately, they’ll be saddled with higher tax bills, reducing available capital to grow and scale.
These effects are further compounded by the fact that energy startups typically operate at a loss for a significant amount of time before becoming profitable (ex. Tesla took 18 years to turn a profit), and immediate R&D expensing can help startups keep their businesses alive in the tenuous early years of their existence. Because startups often are operating at a loss and are dependent on venture capital funding and government grants for survival, requiring amortization of R&D expenses essentially taxes income that does not exist, according to analysis by the Tax Foundation.
Take as an example a startup with an idea for clean energy technology they are still developing. As of now they have a worthy idea but no sales or profits. They receive $5 million in funding, perhaps from venture capital or a federal grant. They want to put 100% of that money towards R&D. In the past, that company would have been able to fully deduct those expenses immediately, eliminating their tax burden. Now, that startup would only be able to deduct $1 million in the first year and would have to pay taxes on the remaining $4 million. Since this startup has no profits from which to pay taxes, they have to pay a portion of their funds that would otherwise be spent on R&D and other activities that are essential to their business. This will have a particularly negative impact on startups as it often takes many years for startups to make a profit. This could decrease the overall success rate of energy startups and lead to fewer new technologies getting deployed.
Adding to these concerns, many startups were caught off guard by the changes to R&D expensing in the 2022 tax year. Analysis from the Bipartisan Policy Center shows that many small businesses find it difficult to keep up with the latest on tax policy and the ever-changing nature of tax provisions.
While this change to the tax code has the potential to dampen R&D activities in the United States, there is hope that Congress will act with bipartisan, bicameral legislation to restore immediate expensing of R&D costs. Legislative activity has occurred in the House and Senate this Congress. Earlier this year, Sens. Maggie Hassan (D-NH) and Todd Young (R-IN) introduced S. 866, the American Innovation and Jobs Act, along with 36 Democrat and Republican co-sponsors, which would restore immediate expensing of R&D. Meanwhile in the House, Reps. Ron Estes (R-KS) and John Larson (D-CT) introduced similar legislation—H.R. 2673, the American Innovation and R&D Competitiveness Act—with 154 bipartisan cosponsors. Further, the House Ways and Means Committee marked up its Republican version, the Build It In America Act, H.R. 3938, which retroactively allows R&D expensing back to 2022 and through 2025.
BPC remains optimistic that Congress will find a path forward for a bipartisan tax deal that will restore support for an immediate R&D expense deduction while balancing the need to support workers, families, and fiscal responsibility. This would not only help small business but also our climate, economy, and national security.
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