92039: The Research and Experimentation Tax Credit

Gary Guenther

Government and Finance Division

August 10, 1999

CONTENTS

• SUMMARY
• MOST RECENT DEVELOPMENTS
• BACKGROUND AND ANALYSIS
• Current Research and Experimentation Tax Credit
• Basic Research Credit
• Expensing of Certain Research Costs
• Legislative History of the Credit
• Economic Rationale for Government Support of Research and Development
• Effectiveness of the R&E Tax Credit
• Policy Issues Raised by the Current Credit
• Measures to Extend or Modify the R&E Tax Credit in the 106th Congress

LEGISLATION

CONGRESSIONAL HEARINGS, REPORTS, AND DOCUMENTS

FOR ADDITIONAL READING

SUMMARY

Corporations are able to claim a credit against their federal income tax liability for qualified spending on research and experimentation (R&E) above a base amount. The determination of a firm's base amount depends on whether it is an established firm or a startup firm. Two R&E credits are available: a regular credit with a fixed rate of 20%, and a three- tiered alternative credit with rates ranging from 1.65% to 2.75%. They expired on June 30, 1999.

The R&E tax credit has always been a temporary provision of the Internal Revenue Code. It has been extended 9 times, most recently by the Omnibus Consolidated and Emergency Supplemental Appropriations Act of 1998 (P.L. 105-277), which reinstated the credit from July 1, 1998 to June 30, 1999. Congress also had made at least 5 substantive changes in the credit. Among the noteworthy ones: the Tax Reform Act of 1986 reduced the credit's rate from its original level of 25% to 20%; the 1989 Omnibus Budget Reconciliation Act (OBRA89) altered how the base amount was calculated; and the Small Business Job Protection Act of 1996 established the alternative credit.

Conventional economic theory provides a cogent rationale for government subsidies for basic and applied research. In general, the market economy is thought to operate efficiently when the decisions of consumers and producers are not distorted by government intervention. However, the market economy does not generate efficient outcomes in all areas, and one of the areas where it fails to do so is the generation of new technical knowledge. Firms are thought to underinvest in the research that creates this knowledge because of the enormous uncertainties surrounding its costs and results, and because they cannot capture all the economic returns arising from R&D investments. As a result, without government subsidies private industry is inclined to invest less in research than its potential economic benefits would justify. Such a shortfall is an important public policy issue because technological advance propels long-term economic growth.

Despite a consensus among economists and policymakers on the desirability of government support for research, the current R&E tax credit is open to criticism on several grounds. One problem is that it is uncertain if tax incentives are the optimal way for the government to spur technological innovation. Some argue that direct government funding of basic and applied research would be more efficient and effective than granting firms a tax credit for research that many of them would perform anyway. Moreover, the current R&E tax credit has flaws that undercut its effectiveness: it is not permanent; it has a marginal effective rate far below its statutory rate; and it is based on an ambiguous definition of qualified research.

In the 106^th Congress, there is strong, bipartisan support for permanently extending the credit. But the Clinton Administration is on record as favoring a one-year extension of the credit, from July 1, 1999 to June 30, 2000. The effort to renew the credit is currently entangled in a larger and heated debate over how large of a cut in the taxes paid by individuals and corporations over the next decade should be enacted. President Clinton and the congressional leadership are at odds over the size and composition of such a reduction. As a result, it is uncertain if the credit will be extended anytime soon.

MOST RECENT DEVELOPMENTS

To encourage the development and diffusion of new commercial technologies, the federal government offers several tax subsidies for research and development (R&D). One is the research and experimentation (R&E) tax credit, which expired on June 30, 1999. According to the congressional Joint Committee on Taxation, the revenue cost of the credit could total an estimated $1.6 billion in FY1999.

There is strong bipartisan support for extending the credit in the 106^th Congress. To date, 6 bills to make the credit permanent have been introduced: S. 195, S. 680, S. 951, H.R. 760, H.R. 835, and H.R. 1682. More important, the House passed a bill (H.R. 2488) on July 22, 1999 cutting taxes for individuals and corporations that includes a 5-year extension of the credit from July 1, 1999 to June 30, 2004. And the Senate approved a different version of H.R. 2488 on July 30, 1999 that includes a permanent extension of the credit. Under the conference agreement approved by the House and Senate on August 5^th, the credit would be extended retroactively for 5 years, from July 1, 1999 to June 30, 2004, and each of the 3 rates making up the alternative incremental credit would increase by 1 percentage point. Yet it is far from certain that an extension of the credit will be enacted anytime soon because President Clinton has indicated that he intends to veto the conference agreement on H.R. 2488. In its budget request for FY2000, the Clinton Administration proposes to extend the credit merely for another year, from July 1, 1999 through June 30, 2000, and to make it apply to qualified research performed in Puerto Rico.

According to estimates by the National Science Foundation, U.S. spending on research and development totaled $220.6 billion in 1998, an increase of 7.3% over 1997. And the Battelle Memorial Institute is forecasting another 7% rise in 1999. Private industry accounted for 65% of total R&D spending in 1998 but only 25.5% of U.S. expenditures on basic research. More important, growth in real U.S. spending on R&D has accelerated since the mid-1990s, rising from an average annual rate of growth of 0.9% in 1990 to 1995 to a rate of 4.3% from 1995 to 1998.

BACKGROUND AND ANALYSIS

Current Research and Experimentation Tax Credit

Under Section 41 of the Internal Revenue Code (IRC), a firm can claim a tax credit equal to 20% of the amount by which its qualified research and experimentation (R&E) expenditures exceed a base amount. Such an incremental design is intended to minimize both the likelihood that a firm would receive a tax subsidy for research and development (R&D) it would undertake without the credit, and the revenue cost of such a subsidy. The credit, which has been extended 9 times and significantly modified 5 times, expires on June 30, 1999.

A firm's base amount is determined by multiplying a taxpayer's "fixed-base percentage" by its average gross income in the preceding 4 tax years. This amount must equal 50% or more of a taxpayer's qualified research expenditures in a given tax year. The fixed-base percentage depends on when a firm first performed qualified research and earned gross income in the same tax year. If it did both during 3 of the years from 1984 to 1988, then its fixed-base percentage is the ratio of its combined qualified research expenditures to its combined gross income in that period, up to a maximum ratio of 0.16. All other firms are considered start-up firms and assigned a fixed-base percentage of 0.03 for the first 5 tax years after 1993 in which they have qualified research expenses; during the 6th through 10th tax years after 1993, their fixed-base percentages will be gradually adjusted to reflect their actual research intensities.

Under a law enacted during the 104th Congress (the Small Business Job Protection Act of 1996, P.L. 104-188), a firm can choose an alternative three-tiered credit during its first taxable year after June 30, 1996; this credit is also due to expire on June 30, 1999. Once a firm claims the alternative credit, it can switch to the regular credit only with the permission of the Secretary of the Treasury. The alternative credit is also incremental in design and comprises three fixed rates: 1.65%, 2.2%, and 2.75%. Under it, a firm can claim a credit equal to the sum of 1.65% of its qualified research expenses above 1.0% to 1.5% of its average gross receipts during the previous 4 years, 2.2% of its qualified research expenses above 1.5% to 2.0% of its average gross receipts in the previous 4 years, and 2.75% of its qualified research expenses above 2.0% of its average gross receipts in the previous 4 years. Because these base amounts are independent of a firm's research intensity, most firms with qualified research expenditures that are unable to use the regular credit should be able to claim the alternative credit.

One of the more vexing issues in using the R&E tax credit is the definition of research spending that qualifies for the credit. The Internal Revenue Service (IRS) has issued numerous regulations addressing this issue. Current regulations state that three types of research expenditures qualify: (1) "in-house" expenses of the taxpayer for wages, salaries, and supplies; (2) certain time-sharing costs for the use of computers in qualified research; and (3) 75% of the total amount paid by the taxpayer for contract research performed by certain nonprofit research organizations. The credit does not apply to capital equipment and structures used in research; nor does it apply to overhead expenses related to research, such as utilities, rents, leasing fees, insurance, taxes, and the non-wage compensation of researchers, their supervisors and support staff. In general, qualified research is research performed in the United States that is aimed at discovering new technical information that the taxpayer could use in developing new or improved products or processes. The research is supposed to focus on the functions, performance, reliability, or quality of a firm's product lines or production methods.

It has proven often difficult in practice, however, to distinguish between research that is truly innovative and research that is merely routine. IRS regulations about the kinds of research that do not qualify for the tax credit try to clarify what research is considered routine. The following kinds of research are ineligible for the credit: (1) research that focuses on the so-called cosmetic aspects of a taxpayer's product lines, such as style, taste, and seasonal designs; (2) research that tries to adapt existing products or services to the needs or wants of particular customers; (3) market research, customer surveys, and routine quality control techniques; (4) research in the social sciences, fine arts, or humanities; and (5) research that is funded by other persons, organizations, or government agencies. But several recent reports by the U.S. General Accounting Office (GAO) suggest that IRS agents still have difficulty identifying research that is innovative.

According to figures reported by the IRS, corporations claimed $2.5 billion in R&E credits in 1994, the most recent year for which data are available. This represented 2.6% of industry spending on R&D and 12.3% of federal spending on non- defense R&D that year. The vast share of credits tend to be claimed by large manufacturing firms. A 1995 GAO report found that in 1992, 71% of the credits were claimed by corporations with assets in excess of $250 million, and 76% of the credits were claimed by manufacturing corporations. Among manufacturing firms, those making computers and related equipment, electronic components, drugs, and motor vehicles accounted for about 59% of the credits claimed by manufacturing sector as a whole in 1992.

However, the revenue cost of the credit is usually not equal to the amount of the credit claimed in a given year. This is because the R&E tax credit is part of the general business credit, and the latter credit cannot exceed a corporation's net income tax, less the greater of (1) the tentative alternative minimum tax or (2) 25% of the net regular tax liability above $25,000. As a result, although corporations claimed almost $1.6 billion in R&E credits and other general business credits totaling $4.5 billion (including carry forwards from previous years) in 1992, they were able to deduct only $1.1 billion in general business credits from their tax liabilities.

Basic Research Credit

Two other provisions of the federal tax code explicitly encourage firms to invest in research. One is the basic research credit, which covers basic research performed under contract by educational institutions and certain other nonprofit organizations and also expires on June 30, 1999. A firm's credit is equal to 20% of its payments for this research above the sum of the greater of two minimum basic research amounts, and any decrease in nonresearch contributions by the taxpayer to eligible universities from the amount in a fixed-base period, adjusted for inflation. In essence, the credit is designed to give corporations a robust incentive for increasing their donations to universities for basic research -- but not by shifting their donations from areas that do not qualify for the credit to areas that do.

Firms appear to have made relatively little use of the basic research credit. In 1994, claims for the credit amounted to $166.5 million, or less than 7% of the $2.5 billion in R&E tax credits claimed that year.

Expensing of Certain Research Costs

The second provision that fosters business investment in R&D is the expensing of R&D expenditures under Section 174 of the IRC. Expensing involves writing off or deducting the full cost of certain business expenses in the year in which they are incurred. This method of cost recovery constitutes an important tax subsidy because it reduces to zero the marginal effective tax rate on the income generated by the assets that are expensed. Because of limitations on the research expenditures that can be expensed, the value of expensing to firms performing qualified research is only a fraction of the costs that are expensed, and an even smaller fraction of their total R&D spending. The discounted present value of expensing of R&D costs in 1996 was an estimated $2.0 billion.

Under Section 174, a firm may deduct qualified R&D expenditures from its taxable income, including payments for research conducted by outside entities under contract. IRS regulations define these expenditures as "research and development costs in the experimental or laboratory sense" that are incurred as part of the taxpayer's trade or business. Spending on structures and capital equipment used in R&D cannot be expensed, but it can be recouped by claiming the depreciation allowances permitted by the tax code.

Deductions for qualified research expenses must be reduced by the amount of the R&E tax credit claimed in the same year. This so-called "recapture provision" in effect adds the R&E credit to a firm's taxable income. When it is combined with the statutory corporate tax rate -- which for most corporations is 35% -- the provision lowers the maximum effective rate of the regular credit from the statutory level of 20% to 13%. The provision has the same effect on the maximum effective rate of the alternative credit. Firms can circumvent the expensing adjustment by claiming a smaller R&E tax credit than they are allowed.

Legislative History of the Credit

The R&E tax credit was first enacted as a temporary provision in the Economic Recovery Tax Act of 1981. It was intended to give U.S.-based firms a robust incentive to increase their spending on R&D, a critical element in long-term economic growth. Initially, the credit was equal to 25% of the excess of qualified research expenditures in a given tax year over average qualified research expenses in the 3 previous tax years. This base amount had to equal 50% or more of a taxpayer's qualified research expenditures. Shortly after the credit took effect, a number of analysts discerned a serious flaw in its design: over time, the credit's incentive effect would diminish because increases in R&D spending in the present would result in a larger base amount in the future.

Congress made the first significant changes in the credit when it passed the Tax Reform Act of 1986. The Act extended the credit through December 31, 1988. It also modified the credit in three ways. First, the credit rate was lowered to 20%. Second, the definition of qualified research expenses was narrowed so that it only covered activities directed at generating new technical information that could be useful in developing new commercial products or processes. And third, a separate credit was established for basic research conducted by universities for corporations. These changes by and large reflected the general thrust of the Act, which was to curtail or eliminate most tax subsidies and lower statutory income tax rates.

The R&E credit was further altered by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). Specifically, the Act extended the credit through December 31, 1989. It also reduced the tax savings a taxpayer can obtain from the R&E credit by decreasing the deduction allowed under Section 174 for qualified research expenses by 50% of the R&E tax credit claimed in the same year. (Section 174, it will be recalled, permits taxpayers to expense (or deduct) the full cost of these expenses in the year in which they are incurred.) Before TAMRA, a firm could simultaneously reap the full tax benefits of expensing and the R&E credit.

The Omnibus Budget Reconciliation Act of 1989 (OBRA89) made additional changes in the credit. The most consequential involved a revision in the method for calculating a taxpayer's base amount. Previously, the credit applied only to increases in a firm's R&E spending over its average R&E spending during the previous 3 years. OBRA89 substituted a "fixed-base percentage" for this moving average. This percentage was the ratio of a firm's research expenses to its gross income in 3 of the years from 1984 to 1988. The base amount, then, was determined by multiplying a firm's average gross income in the previous 4 years by its fixed-based percentage. Start-up firms, or firms that had no income or qualified R&E expenses in that period, were assigned a fixed-base percentage of 0.03. These changes were intended to enhance the effectiveness of the credit by severing the link between current R&D spending and future credits. OBRA89 also effectively extended the credit for 9 months by prorating qualified research expenses incurred before January 1, 1991. And it made research related to lines of business a firm wanted to enter eligible for the credit; previously, the credit applied only to research related to a firm's current lines of business. Lastly, the Act increased the reduction in the amount of qualified research expenses that could be expensed from 50% of the R&E credit claimed to 100%.

The Omnibus Budget Reconciliation Act of 1990 extended the R&E credit through December 31, 1991, and repealed the special rule enacted in OBRA89 to prorate qualified research expenditures made before January 1, 1991.

The credit was further extended by the Tax Extension Act of 1991, this time through June 30, 1992. While the Congress passed two major tax bills in 1992 that would have further extended the credit, President Bush vetoed both for reasons not related to the credit. As a result, the credit was in abeyance from July 1, 1992, until the Omnibus Budget Reconciliation Act of 1993 (OBRA93) went into effect. OBRA93 retroactively extended the R&E credit for 3 years: from July 1, 1992, through June 30, 1995. It also revised the method for calculating the base amount of the credit for start- up firms. Congressional inaction allowed the credit to expire on June 30, 1995.

It remained in abeyance until the Small Business Job Protection Act of 1996 was enacted in August 1996. The Act reinstated the credit retroactively from July 1, 1996 to May 31, 1997, leaving a one-year gap in the credit's coverage since its creation in 1981. It also expanded the definition of start-up companies, created an alternative, three-tiered credit, and increased the share of payments for contract research done by nonprofit research organizations eligible for the credit.

The 105^th Congress allowed the credit to expire in 1997. But as part of legislation aimed at achieving a balanced federal budget by FY2002 that President Clinton signed in August 1997 (the Taxpayer Relief Act of 1997, P.L. 105-34), both the regular and alternative credits were retroactively extended from June 1, 1997 to June 30, 1998. The Omnibus Consolidated and Emergency Supplemental Appropriations Act of 1998 (P.L. 105-277) further extended the credits to June 30, 1999. Return to CONTENTS section of this issue brief.