R&D Tax Credits: They Work! Will Policymaker’s Listen to the Evidence?

glowing bulb

As we approach the end of 2012, the currently expired U.S. R&D tax credits are being altogether ignored by the media, and generally ignored by policy makers. Nothing has been done this year to ensure that firms will receive the same benefits as in the past. This leaves firms guessing as to whether or not they should increase or decrease their investments in R&D, or move them abroad.  The evidence on the effectiveness of R&D tax incentives continue to mount.  In the latest edition of New Economics Papers in Technology and Industrial Dynamics, another compelling analysis by Bond & Guceri, “Trends in UK BERD after the Introduction of R&D Tax Credits,” shows that R&D tax incentives not only bolster business investment in R&D, but businesses respond even more than previously predicted by Bloom et al.  The analysis shows that especially in high-tech manufacturing, the R&D tax credit causes a substantial increase in R&D, which provides further evidence that a permanent R&D tax credit is needed here in the United States.

The study shows that when R&D costs are treated more favorably by the tax code than capital investment, firms react.  In 2002, the UK introduced tax incentives that effectively dropped the user-cost of R&D investments by 13 percent.  This cut induced firms to invest, and in the years that followed, R&D expenditures rose at a faster rate than previous models by Bloom et. al predicted.  This is compelling, as it shows that firms do recognize the potential for R&D to increase profitability.  However, the unsubsidized risk is just too much; which causes firms to look to other less risky, short-term investment options.  Because firms concentrate on their current stock prices, they have a very difficult time taking on bold R&D investment efforts because the future profits are so uncertain.  By stepping in and changing the incentives, the UK’s policy makers enabled firms to justify taking on the riskier investments of R&D, and the benefits are real.

Not only do firms profit, but consumers and other firms also benefit from the new knowledge created; sparking further development of new products.  R&D induces competition, it brings new products to market, and it solves real problems that we face societally. Regular capital investments simply do not have this effect on the greater economy.  When a firm erects a building, it doesn’t benefit anyone else.  This is why R&D is so critical; it has positive effects that spill-over and the benefits are significant.

As shown in the figure, Bond & Guceri’s empirical evidence is clear; firms both small and large react when tax treatments promoting R&D are put into place.  R&D is the most overlooked, yet arguably the most important source of U.S. growth.  When you combine highly skilled workers with R&D, growth occurs and standards of living increase.  Since the U.S. R&D tax incentives have already expired, policy makers should take heed, and introduce a bold, permanent R&D incentive plan.  Business expenditures on R&D are especially critical for the United States’ future, as federal R&D budgets are currently in turmoil.  Since there are questions as to how much the federal government will fund R&D activities due to budget pressures, policy makers must act to ensure that businesses have incentives to pick up the slack.

As the U.S. slides further behind in the international race to lure more tech and manufacturing investment, there needs to be a bold move by policy makers to ensure the United States moves back to the top from its current position at 27th in R&D tax incentives.  The United States used to be number one, can we get there again?  We believe that the answer is “yes”, but only if policy makers listen to the evidence and then promote the fuel that runs the U.S. engine of growth: R&D.  Policy makers should not only make the R&D tax credit permanent, but they need to increase it substantially.  If they do not, then increasingly global firms will continue to move their innovative activities abroad.  In effect, if the environment is not properly staged for innovation here in the United States, policy makers will not only limit our internal future growth, they will guarantee that U.S. competitiveness will decline.

Print Friendly

About the author

Justin Hicks joined ITIF in June of 2012 as Senior Economic Policy Analyst. Prior to joining the ITIF as Senior Economic Policy Analyst, Justin Hicks finished his Ph.D. in Economics at the University of California, Merced. His research focused on potential spillovers of cooperative R&D in the international setting as well as the impact of funding on R&D productivity in universities. In his current research, he looks to identify the effect of trade policy on the flow of ideas and home-country R&D productivity. His primary expertise lies in using applied microeconometrics to identify causal relationships using large data-sets. Prior to receiving his Ph.D., Justin achieved a M.A. in economics and a B.A. in Business economics from the University of California, Riverside.
  • Mhyke

    I am not sure why people give credence to these reports from academics who use equations to reach their conclusions and never speak with R&D executives. I have been in the high-tech world since the R&D credit came into being and have never met an executive who actually understands how it works, let alone make any decisions based upon the credit. I sure these executives would be stupefied to find that there are a large group of policy makers who believe they are paralyzed in their decision making because the R&D credit has not been extended. In fact, most of them are oblivious as to whether the R&D credit is in effect or not. Whether the US is first or 27th in the world in R&D incentives makes no difference because companies do not do R&D because of the R&D credit.

  • http://twitter.com/TheEconomist79 Justin Hicks

    Mhyke,

    The reason they are given credence is because; rather than taking into account individual “R&D Executives” (which I have done on MANY occasions, including: Qualcomm, Microsoft, IBM, Ford, among many others), the data simply reveals that companies that invest in R&D pay attention to the incentives both here and abroad. If you talk to IP managers in multinational enterprises, then it is completely clear that R&D incentives have a significant weight in their management strategies and even where they place new labs.

    Most of these “oblivious” executives you mention aren’t big players in the marketplace, and most of their R&D is simply tweaking of other products already on the market. In fact, if they are oblivious, that raises all kinds of questions as to their legitimacy as an “executive.” Since R&E tax incentives have existed in the U.S. on and off since 1985, to not consider them as part of an R&D management strategy is pretty foolish.

    There are certainly exceptions (I can think of many small biotechs back in California that were doing R&D, but were so small that they didn’t even have an IP manager, let alone more than 25 employees.)

    But that isn’t how policy is aimed, nor should it be. Policy should be made based upon two things: what you want done (theory), and what can be done (empirical evidence.)

  • mhyke

    Justin,

    I completely agree that executives respond to tax incentives. But not every incentive is effective and the fact is that the R&D tax credit has minimal impact.

    If you area interested in my facts and my reasoning, please see an article I have written on this subject: The Dysfunctional Research Credit Hampers Innovation, Tax Notes Today, 2011 TNT 109-8.

    Michael Rashkin

  • http://twitter.com/TheEconomist79 Justin Hicks

    I don’t think that I ever stated that there aren’t ways to improve the R&D tax incentives here in the U.S.

    However, the reality is, the data shows that in spite of the problems, firms do, on average, increase their innovative investments as a result. I find it odd that you are arguing against the R&D tax credit, when in your September testimony to the Senate Finance committee that the R&D tax credit should be increased to 30%. (You try to explicitly separate “breakthrough” versus “risk-free” research, and I’d love to know what objective metric you’d introduce to allow policy makers to make this judgement. Incremental changes aren’t risk free; though they do have less potential to cause positive spillovers than basic research.)

    You claim that it hasn’t increased R&D spending, but the data simply shows otherwise (at the aggregate level, on the margin; which is how this is, and should be measured).

    I completely agree that complexity of the current (or I should say expired) credit is an issue, but I wouldn’t want to throw the baby out with the bathwater.

    In addition, this was a national study in the UK; which the US might consider as a better model if it does in fact spur R&D investment in a more effective manner than our incentive (which you’d argue, and I’d agree; that models outside the US are often much better). However, when you argue against R&D incentives generally, rather than helping further the story that we, as a nation, need to increase our investment in innovation, you kill the message. Policy makers aren’t looking at the nuances. They aren’t even considering the question. They need to be compelled that innovation investment is critical in the first place; and it is a conversation that needs to be moved center-stage, rather than… well, completely off-stage (if that.)

    Also, you introduce the issue of corporate tax rates, but this is a completely separate issue. We’d argue that corporate tax rates must be lowered, and that this will make the US more competitive, but this is a separate conversation.