The R&D tax credit expired on Dec. 31, 2011, and its passing produced hardly a noticeable ripple throughout the high-tech industry. That’s not because American business doesn't miss the financial benefits from this tax incentive, but because many companies understand that it’s only a matter of time until Congress again revives it. Congress has frequently let the credit expire, then acted to reinstate it retroactively.
But what is the value of this credit? And does it make sense for Congress to restore it?
The research credit has been in existence for over 30 years. During that time, not one company has announced an invention or product that was produced as a result of the R&D tax credit. Unlike government subsidies that have gone to the Defense Advanced Research Projects Agency, the National Science Foundation or the Energy Department, we taxpayers have nothing to show for our investment in the research credit.
The reason is fairly obvious: Companies do not undertake research projects because of a small tax subsidy. Instead R&D projects are initiated because companies need them to compete in a global market and they will engage in research regardless of whether or not a tax credit is available.
The credit is calculated as a percentage of R&D wages, and the percentage can be either 20 percent or 14 percent, depending on how a company computes the credit. But the impact of many restrictions imposed by Congress effectively means the credit generally amounts to only about 5 percent of research expenditures, hardly enough to make a company engage in research it otherwise wouldn’t undertake.
Congress imposed restrictions to reduce the cost of the credit, but at same time these limitations diminish its effectiveness. Despite its weak effect, the credit is expensive, costing taxpayers an estimated $10 billion per year.
The original purpose of the R&D tax credit was to increase research expenditures, and many economic studies claim that the credit increases research expenditures on a one-to-one basis, meaning that for each dollar of credit there is one additional dollar of R&D expenditure. These studies are contrafactual, or what-if calculations. They look backward and try to determine what would have happened if there were no research credit.
Although supporters of the R&D tax credit trumpet these studies as evidence of that the credit is working, a one-to-one ratio is actually evidence of ineffectiveness. An effective incentive should have a multiplier effect, providing an increase of $3 to $4 of R&D for each dollar of credit. Moreover, these studies do not square with the failure of companies to demonstrate that any additional research was undertaken because of the credit. For $10 billion in credit, it is fair to ask to see some concrete results.
Part of the problem with the research credit is that it goes to companies that do not need it. Over 80 percent of the credits earned go to very large companies. Apple, Google, Microsoft and Intel already have billions of dollars in the bank, and are therefore unlikely to increase their R&D expenditures as a result of a small tax incentive. On the other hand, start-ups that can use additional financing do not benefit from the credit since they are not profitable and have no tax liability against which they can apply the credit.
The U.S. government has been very generous to the high technology industry. In addition to financing a large portion of basic research, thereby saving industry the expense, Washington allows a 100 percent tax write-off of R&D expenditures, and allows companies to transfer their intangible property rights to offshore tax havens. It is therefore not surprising that companies manufacture their products offshore since doing so allows them to avoid U.S taxes on their manufacturing profits.
To give these companies a research credit in addition is to reward, in many cases, behavior that is detrimental to the U.S. economy.
The economic theory supporting the R&D tax credit is that companies do not fully capture all the returns resulting from an invention and, as a consequence, market forces do not provide adequate stimulus for R&D activity. It is therefore argued that it is the role of the government to compensate for this market failure by providing a tax subsidy.
While this theory does not square with free market economics, that fact has not stopped members of Congress from both parties along with the president from enthusiastically supporting renewal of the credit. In fact, as the centerpiece of his science and technology policy, President Obama has recently proposed increasing the amount of the tax credit while extending it 10 years.
The R&D credit does not increase R&D expenditures, and the $10 billion we spend each year on the credit is mostly a financial transfer from the government to large multinational corporations with no benefit to U.S. taxpayers. It is not the federal government’s responsibility to finance or subsidize the ordinary business activities of corporations, especially when that subsidy does not provide the desired effect.
Now that the R&D tax credit has expired, it’s a good time to let it be.--Michael Rashkin is a tax attorney who has worked in the high-tech industry for more than 40 years, including 13 years at Apple and 12 years at Marvell Semiconductor. The opinions expressed here are his alone, and do not reflect those of any organization.