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
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
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
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
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
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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