TAX FOUNDATION FELLOW TESTIFIES ON INTERNATIONAL COMPETITIVENESS.

Mr. Chairman and Members of this distinguished Committee, my name is Tony Billings and I am Senior Research Fellow at the Tax Foundation and Associate Professor of Tax Accounting at Wayne State University. I am honored to be here to share ideas on the interaction of tax policy and international competitiveness. The specific focus of my presentation is on:

The role of U.S. tax policy in influencing global market share for technologically-intensive products. I will point out that U.S. tax policy toward technological innovation needs to account for the economic environment of the 1990s.

Prior research has shown that national governments can help its businesses gain market share and, to a lesser extent, control trade position (magnitude of trade deficit or surplus). ¹

INFLUENCING GLOBAL MARKET-SHARE OF GOODS AND SERVICES. The typical tools available to national governments include:

1) imposition of tariffs;

MAJOR SHORTCOMING OF CURRENT INTERNATIONAL TAX POLICY

One major shortcoming of U.S. tax policy is:

the failure to offer the U.S private sector adequate economic incentives to encourage R&D activities. Investment alternatives such as R&D typically are not as profitable as other investments over the short run and have been proven to benefit from incentives.

RESEARCH AND DEVELOPMENT AND INTERNATIONAL COMPETITIVENESS

Past research has shown that between 40 and 90 percent of economic growth in the U.S. can be directly attributed to technological advances. In addition, most technological advances result from private sector R&D outlays rather than government R&D projects. R&D is the lifeblood for the growth of an economy, a country, or a firm. It contributes greatly to how global market share for goods and services is divided and, therefore, directly impacts the relative standard of living among trading nations. Every U.S. presidential administration since the early 1960s has recognized this fact and has sought to encourage R&D spending by tax incentives or by government-sponsored R&D programs.

Unfortunately, current U.S. tax policy toward R&D is based on the notion that the U.S. is the dominant competitor in the world for technologically-intensive products. While there is some truth to this notion, the fact is that the U.S. technological dominance is eroding at a rapid pace.

Since the late 1960s, the U.S. share of the global sales of technology intensive products has declined from 27.5 percent to 20.9 percent in 1986. Conversely, Japan's share has increased from 7.2 percent to 19.8 percent. ² All other countries, except for the United Kingdom's 3 percentage points drop, have remained constant.

Concomitant with this, the Japanese have significantly increased their non-defense related R&D from 2 percent to 2.8 percent of GNP, while the U.S. has not increased its non-defense R&D spending since 1981. ³

The question then arises as to whether the U.S. loss of market share is attributable to inadequate R&D and/or to inefficient R&D in the private sector.

STUDY ON MULTIPLIER EFFECT OF R&D

Recently, I conducted a comprehensive study comparing the private-sector R&D efficiency of Japan and the U.S. for fourteen industrial groups over the 1980-1987 period. This efficiency measure compared such factors as the multiplier effect of R&D on sales and on value-added years two through five after the performance of the research and development. In essence, this efficiency which the study constructs measures the effect of R&D spending on sales and value- added.

The analysis, summarized in Table 2, shows that the U.S. food, textile, rubber, metals, fabricated metals, and other miscellaneous manufacturing industries exhibit significantly higher efficiency indices than their Japanese counterparts. This means the U.S. realizes a greater return on its R&D in these industries. Japanese paper, chemical, petroleum, machinery, and scientific equipment industries show significantly higher efficiency indices than comparable U.S. industries. No significant differences were found between U.S. and Japanese stone, electrical equipment, and transportation equipment industries.

U.S. INDUSTRIES HAVE EFFICIENT R&D PROGRAMS. The analysis clearly indicates that U.S. industries do not take a back-seat to the Japanese in the multiplier-effect of R&D on sales and value-added up to five years after the performance of the R&D. Indeed, in a number of the industries, the U.S. has a significantly higher multiplier effect; and in a number of other industries, both countries are equally efficient in performing R&D. Other things being equal, for the same level of R&D spending, U.S. firms would perform as well or in some cases better than Japanese firms. For this reason, the loss of market position for technologically-intensive products does not appear to have resulted from inefficient R&D programs in U.S. industries but from inadequate levels of R&D funding.

SUGGESTED R&D TAX POLICY

Three policy suggestions emerge from my study: 1) reallocate funds from government-sponsored R&D programs to a tax expenditure, 2) revise the R&D tax credit provisions to allow for a credit based on total R&D, and 3) combine R&D tax incentives with export incentives.

FIRST: REALLOCATE GOVERNMENT-SPONSORED PROGRAMS TO A TAX EXPENDITURE THROUGH THE R&D TAX CREDIT. The way to encourage private sector R&D is through a tax expenditure rather than government- sponsored projects. In this regard, research has amply demonstrated that most technological breakthroughs result from private-sector projects rather than government-sponsored projects./4/ In this way, the market would allocate the resources rather than the government. Private sector alliances and collaboration with research universities would go further in allowing American firms a competitive edge internationally.

SECOND: R&D FORMULA SHOULD BE BASED ON TOTAL R&D OUTLAY. Under current policy, a tax credit is allowed on incremental R&D spending. The formula should be revised to base the credit on total R&D outlay in the current period. In a sense, all R&D spent in the current year is incremental because it allows the exploitation of existing knowledge. Technological innovation is more often made possible from building on prior knowledge of the firm, industry of membership, or unrelated industry. In many instances, current spending is necessary to take advantage of past breakthroughs outside the firm or industry. Through current spending, significant spill-overs can also result in both related and unrelated products or industries.

Past R&D is a sunk cost and, as such, eligibility for the R&D credit in the current period should not be based solely on past spending. In this regard, the incremental credit formula ignores the nature of R&D spending patterns. A more appropriate approach would be to base the credit on the total R&D outlay in the current period. Alternatively, firms should be allowed to calculate the credit under both an incremental formula and a formula based on total outlay in the current period.

THIRD: COMBINING R&D TAX INCENTIVES WITH OTHER MEASURES. R&D incentives should also be coupled with other measures practiced by our major trading partners. One such measure is to offer export incentives through the classification of certain export sales as foreign source income.

PAYING FOR ADDITIONAL R&D TAX INCENTIVES. How do we pay for the aforementioned changes? A reallocation of funds from government- sponsored R&D projects to a tax expenditure would foster greater R&D efficiency in American industries without a revenue cost to the U.S. Treasury. In this way, the cost of record-keeping and monitoring the funds under government-sponsored projects would be minimized. The tax expenditure approach would be amenable to channeling R&D funds into industries or products for which the greatest probability of exports exist and would go a far way in stimulating exports.

The declining global market share of technology intensive products is a symptom of a crisis in the making. Failure to encourage the most efficient R&D investment may further erode the U.S. position internationally.

                              FIGURE 1

NSD: Not significantly different using 5-percent cutoff (p<.05).

MD: Significant using 10-percent cutoff (p<.10) but non-significant using 5-percent cutoff (p<.05).

U.S.: Indicates that U.S. industry has significantly higher mean value using 5-percent cutoff (p<.05).

Japan: Indicates that Japanese industry has significantly higher mean value using 5-percent cutoff (p<.05).

² Technology intensity is assumed to be present where the cost of R&D exceeds 2.5 percent of value added.

³ National Science Foundation 1988.

⁴ Nelson, R. (1959), "The Simple Economics of Basic Scientific Research," Journal of Political Economy, 67(3), 297-306.