Tax Analysts Blog

'Extortion' and the Research Credit

Posted on Oct 28, 2013

In a 2012 book from Yale University Press (Innovation Economics: The Race for Global Advantage), Robert Atkinson and Stephen Ezell explore the fascinating topic of innovation in the increasingly globalized modern economy and the government policies that can promote it. The authors got my attention because they seem to relish challenging conventional wisdom, and they refuse to be pigeonholed into the usual partisan categories that frame the national tax debate.

Because large U.S. corporations do so much of our nation’s research and development, Atkinson and Ezell are ardent advocates of tax cuts for multinationals. But unlike most conservatives who readily share their views on corporate tax, they are not antitax small-government zealots. They favor increased government spending if it is directed toward infrastructure and technology. They even favor income tax increases on the wealthy if the revenue raised is used to promote business innovation. They ask: “Does anybody really believe that the better way to grow the economy is to let high-income individuals keep $65 billion more of their earnings to buy another Armani handbag or Jaguar car, instead of letting the business engines of competitiveness and innovation save $65 billion in taxes to invest in research, skills, and equipment?" Good question. But it is doubtful the Tea Partiers--who want tax cuts for individual and small business--would agree.

As part of their pro-growth agenda, Atkinson and Ezell want to expand the U.S. research credit and make it permanent. That goal is shared by nearly everybody in Washington, including President Obama (p. 13). The authors make the case as well as anyone:

Twenty years ago, the U.S. R&D credit was the most generous in the world. Today, because many nations
have instituted their own, more generous R&D tax incentives, U.S. R&D tax credit generosity has dropped
precipitously in rank, to twenty-seventh in the world. Expanding the credit would help make the United States
a more attractive location for internationally mobile R&D and lead to greater R&D investment in America.

But—despite the political consensus to the contrary—I remain unconvinced. It's not that the research credit lacks solid economic justification -- unlike most private sector spending, research produces knowledge spillovers that benefit the economy. Those "positive externalities" mean the government should provide subsidies in order to correct the free market's less-than-socially-optimal level of research spending.

The problem is not with the theory of the credit but with its execution. I have been around a while and have researched the research credit since its inception in 1981. My take is that the essential problem of the credit has only grown worse: It is impossible to find a practical definition of subsidy-worthy research in the 21st century. It is less clear than ever where corporate research ends and other innovation-inducing functions like design and software development, begin. There is little empirical work regarding why, in this modern economy in which investment spending defies categorization, some business-building activity should be subsidized and others not. This inability to target incentives to where they should go means scarce resources are inappropriately and arbitrarily assigned to certain activities, certain businesses, and certain industries while others are left in the cold. What was intended as an incentive for productive activity by clever scientists and engineers turns out to be an incentive for totally unproductive activity by clever lawyers, accountants and lobbyists.

Other problems with the credit include: (1) diminished incentive effect because of uncertainty about the definition of qualified research, about the amount of the credit because of the credit's complicated structure, and about the fate of the credit, which Congress always has on temporary status; (2) an inability to provide the incentive to small and start-up firms without tax liability (even though it is widely believed that those firms' research is particularly productive); and (3) large compliance and administrative costs.

In a new book (Extortion: How Politicians Extract Your Money, Buy Votes, and Line Their Own Pockets) Hoover Institution fellow Peter Schweizer highlights another unattractive feature of the credit: the unseemly political process surrounding the repeated renewal of its technically temporary status. Schweizer writes about Congress:

    "They trot out the R&D tax credit every few years, and it's always with their hands open, looking for money,"
    says [former Microsoft executive Bob] Herbold. "It's like an annuity for them. They won't make it permanent because it doesn't make sense for them to make it permanent."
Repeal of the research credit could fund a reduction of approximately 1 percentage point in the corporate tax rate. The benefits of the credit as it works in practice are questionable. In contrast, a reduction in the corporate rate would undoubtedly be a big plus for America's competitiveness. It will be interesting to see what House Ways and Means Chair Dave Camp decides to do with the research credit in his much-anticipated tax reform proposal due for release before the end of this year.

Read Comments (3)

David L. ClickOct 30, 2013

Agreed - Congress' treatment of the research tax credit is both ridiculous and
reprehensible, although the extortion angle was new to me. The research credit
is a product of the 1980s and needs to be completely rethought. Your blog of
October 21 about knowledge based capital raises a contemporary tax policy
issue. The OECD argues that policy makers should adopt an enlarged concept of
innovation and improve the design of research tax credits accordingly. Such an
approach is long overdue. But having a tax credit to encourage innovation is
still an important tax policy tool. The current research credit has a pile of
administrative problems, but its intent, to reward innovation, still has a
place in the Code to keep the U.S. competitve in global markets.
Nice profile of you in this weekend's Washington Post!
Best wishes, DC

Rob AtkinsonOct 30, 2013

Marty how can I say anything critical about a review which says such nice
things about our book? But I am afraid your critique of the R&D credit is
grounded in neoclassical economics thinking that puts allocation efficiency
first (e.g., tax everything the same) over innovation economics thinking that
puts dynamic efficiency first, and as ITIF shows the R&D credit clearly leads
to more R&D than without it.
Therefore, cutting it would mean less R&D. And the evidence is clear that R&D
leads to higher economic growth. So no R&D credit equals less growth.

Your point about extortion: the answer is easy. Critics should advocate for
permanency, not abolition. Re not subsidizing all activities with positive
externalities, its better to subsidize some than none.

Re incentive for lawyers, not scientists. That is simply not what the scholarly
economic evidence says. The consensus is that $1 of credit spurs at least $1.40
in R&D.

Re complicated structure. The Alternative Simplified Credit established a few
years ago, is as the name implies, much more simplified than the regular credit.

Finally, the re problems with definitions of qualified research: this is a
problem Treasury could certainly reduce should they choose to.

To paraphrase my Armani quote, do we really want to give Home Depot and local
electric utilities that don't compete globally 1 point off their corp rate
while raising the effective rate for technology companies (including, IT,
aerospace, autos, pharma, etc) that do compete globally, while at the same time
reducing the amount of corp R&D performed in the U.S. I certainly don't.

Douglas OffermannNov 19, 2013

There is more than enough historical evidence to conclude that over-time
governments do over-reach their effectiveness for the common good of man. When
that line is crossed people, not organizations, will oppose it.

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