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September 27, 1989
"R&D Credit a Tax Break Soon Repaid"
San Jose Mercury News
By Timothy Taylor
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THE research and development tax credit is a necessity, because it's not sensible to base America's technological competitiveness on the expectation that innovators will also be philanthropists.

Every new invention is a sort of gift to society. It benefits not only the inventor, but other companies that copy it, workers who get jobs producing it and consumers who use it. The double handful of recent economic studies that have tried to measure these benefits have calculated that a dollar spent on research and development is an investment in economic benefits that pays a rate return of 50 percent, 70 percent, even 90 percent.

But the same studies calculate that half or less of that return actually goes to the company or person who did the inventing.

Now, I'm not weeping for the inventors. Even given the extremely high risks they face, 20 or 30 or 40 percent is a pretty good average rate of return.

But the hard economic fact is that if others are receiving half or more of the benefit from your work, it's a disincentive to follow up all the promising avenues of research. If society wants the benefits of new technologies and inventions, it has to help innovative companies and people reap higher rewards. The tax credit for R&D is one proven way of doing that. Two economists at The Brookings Institution, Martin Baily and Robert Lawrence, recently studied the effect of the tax credit from its enactment in 1981 until 1985. They found that "the ratio of R&D spending to output, during the period when the R&D tax credit was in effect, grew more than twice as rapidly as it did in the comparable period prior to enactment of the credit."

Baily and Lawrence found that the credit generated about two dollars of R&D spending for each dollar of lost revenue. After the benefits to society as a whole are toted up, they estimate that America's GNP in 1991 will be between $20 billion and $31 billion higher in 1991 as a result of the tax credit between 1981 and 1985.

The total cost of the R&D tax credit is less than $2 billion a year, an awfully good deal for taxpayers.

Our international competition recognizes that. Japan and West Germany, for example, have had an R&D tax credit for years. Although R&D spending in those countries is proportionally about the same at the United States -- about 2.8 percent of GNP -- the U.S. devotes one-third of its R&D spending to defense. Japan and West Germany aim practically all of their R&D at commercial economic development.

Even when the U.S. spends money on non-defense R&D, it doesn't focus on commercial gains. The Council on Competitiveness, a private group chaired by John A. Young of Hewlett-Packard, reported recently: "Within the category of non-defense R&D, the United States spends the lowest proportion on R&D directly related to industrial growth. . . . One estimate suggests that, at most, only about 10 percent of federal R&D is relevant to the technical needs of industry."

The latest incarnation of the R&D tax credit is designed to have an even larger effect than Baily and Lawrence found, for two main reasons.

The first major change is a new base for the tax credit. During the 1980s, a company's R&D credit has been equal to 25 percent of the amount that that this year's R&D expenditures exceed the company's average in the previous three years.

The problem with this formula has been that a company which increases its research budget sharply in one year increases its three-year average, and thus reduces the amount of the credit to be received in the next two years. This is not how good tax policy should work.

In the new legislation, the base for each company would be set according to its average R&D expenditures for 1984-1988. Then, this base will be increased according to the growth rate of the economy, plus 2 percent. The tax credit will then be set equal to 20 percent of how much the company spends above the adjusted base level.

The beauty of this approach is that since a company cannot influence its base, increasing R&D in one year won't reduce the the credit available in future years.

The second major change is to make the credit permanent. It may seem self-evident that an incentive for an uncertain and long-term investment like research and development should be permanent, so that innovators can count on it, but the R&D tax credit has already needed to be resuscitated three times in the 1980s.

When it was first adopted as an experiment in 1981, it was scheduled to expire at the end of 1985. Then it was extended for one year to 1986. Then for two years to 1988. Then for one year to 1989. And now it is before Congress, gasping for life one more time.

Enough experimenting, already. The R&D tax credit works, and it deserves a permanent lease on life in the 1990s. The current bill in the House would do that. On the other hand, the current proposal in the Senate is to extend the credit for one more year, one more time.

I'm generally skeptical about tax credits of any sort. Too often, they seem like nothing but a special break for a special interest. But R&D is a special case, a case where the free market fails to provide innovators a large enough share of the economic benefits they generate.

Unless the government adjusts the incentives, America will continue to underinvest in research and development.

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