CRS REPORT EXAMINES HISTORY, RECENT CONGRESSIONAL ACTION ON RESEARCH CREDIT.

CRS ISSUE BRIEF

THE RESEARCH AND EXPERIMENTATION TAX CREDIT

Updated November 17, 1993

by David L. Brumbaugh Economics Division

THE RESEARCH AND EXPERIMENTATION TAX CREDIT

SUMMARY

A credit against Federal income taxes for annual increases in research has been available since 1981. The credit's statutory rate is 20%; it applies to the excess of a firm's qualified research expenses over a base amount linked to the firm's research spending during a specified period in the past.

The credit has been a temporary provision of the tax code since it was first enacted. And while the provision has been scheduled to expire on a number of occasions it has always been extended. Indeed, the R&E credit actually did temporarily expire at the end of June, 1992. However, the Omnibus Budget Reconciliation Act of 1993 (P.L. 103-66, H.R. 2264) extended the credit for 3 years on a retroactive basis, from July 1, 1992 through June 30, 1995.

Economic theory generally favors the idea of some manner of Government support for research. While markets are usually thought to operate more efficiently when they are not distorted by government intervention, they may not function smoothly in the case of research. As a result, without government support private industry invests less in research than is warranted by society's needs. The shortfall can be important. The advances in technology spawned by research can result in increased productivity -- a leading source of gains in the Nation's standard of living.

But the issue is not quite as straight-forward as it first appears. First -- and perhaps most significant in this era of continuing Federal budget deficits -- the R&E tax credit reduces tax collections by the U.S. Treasury. Thus, extension of the R&E tax credit must compete for funds with other uses that some would argue are equally, if not more, deserving. Second, some have argued that while Government support of research may be a good idea in principle, a tax credit is not the best way to provide that support. It is argued that direct funding of research projects may be more cost effective than the R&E tax credit.

The R&E credit has often been a focus of congressional attention. The provisions of the Economic Recovery Tax Act of 1981 that first implemented the credit included a "sunset" provision under whose terms the credit would have expired at the end of 1985. Congressional action on five subsequent occasions extended the credit. The most recent extension of the credit -- that which expired at the end of June -- came with the Tax Extension Act of 1991.

Congress has also made substantive changes in the credit on several occasions. In 1981, the credit's rate was initially set at 25%; the Tax Reform Act of 1986 reduced the rate to 20%. And the 1989 Omnibus Budget Reconciliation Act (OBRA89) made important alterations in how the credit is calculated -- changes that enhanced the credit's incentive effect.

MOST RECENT DEVELOPMENTS

The research and experimentation (R&E) tax credit provides a tax benefit to firms that increase their research outlays beyond a certain level. The credit is a temporary provision that has been scheduled to expire but has been extended on a number of occasions. Most recently, the credit expired on June 30, 1992. However, the Omnibus Budget Reconciliation Act of 1993 (P.L. 103-66, H.R. 2264) extended the credit retroactively for an additional 3 years, from July 1, 1992 through June 30, 1995.

BACKGROUND AND ANALYSIS

BACKGROUND

The Federal Government supports a broad range of research, both directly and indirectly. Direct funding is related to national objectives such as national defense, public welfare, and economic competitiveness. Since 1981, indirect support has included a research and development tax credit for private sector firms.

The research and experimentation (R&E) tax credit was first enacted as part of the Economic Recovery Tax Act of 1981 (ERTA) as an incentive for firms to increase their research spending. The credit's statutory rate was initially set at 25% (the rate was later reduced to 20%) and applied only to increases in a firm's research spending over its average research spending in a base period consisting of the preceding 3 years. In calculating the credit, however, a firm's base period research was not permitted to be less than 50% of the current year's research spending. As described below, however, the Omnibus Budget Reconciliation Act of 1989 (OBRA89) made major changes in the base period calculation.

A large part of the R&E tax credit rules is devoted to defining the research expenses that are eligible for the credit -- a key task, since it requires identification of the types of outlays that deserve subsidizing. Part of the credit's rules specify the types of activities that constitute "qualified research" for purposes of the credit. At the same time, not all outlays for qualified research are eligible for the credit; additional rules stipulate the types of outlays for qualified research that are actually eligible for the credit.

The credit's rules stipulate that "qualified research" does not include research conducted outside the United States, research in the humanities or social sciences, or research funded under a grant or contract. As initially enacted, however, further definition of qualified research was not included in the Internal Revenue Code but was left for elaboration by Treasury regulations. The regulations, in turn, set forth a relatively general definition of qualified research as research in the "experimental or laboratory sense."

The credit's initial provisions did contain specific language identifying the types of research outlays that were eligible for the credit. Research outlays qualified for the credit only if they were incurred in connection with the taxpayer's current trade or business; research into new lines of business and by firms that have not yet started production were thus ruled out. In addition, capital expenditures for land, depreciable structures, and depreciable machines and equipment were not eligible for the credit. Rather, the credit was generally available only for current outlays such as wages and payments for supplies. Further, under the credit's initial design, only 65% of payments to universities or contracting companies for the conduct of research were eligible for the credit, although this rule was later modified.

CONGRESSIONAL ACTION ON THE R&E TAX CREDIT

The Economic Recovery Tax Act of 1981 contained a "sunset" provision under which the credit would have expired at the end of 1985. The provision was intended to give Congress the opportunity to assess the credit's effectiveness in increasing research and the success of the credit's rules in identifying expenditures worthy of support. And while Congress has yet to make the R&E tax credit a permanent part of the tax code, it has extended the credit five times. Indeed, on several occasions Congress has made exceptions to the general thrust of the tax legislation it was considering in order to extend the R&E tax credit. For example, although the general purpose of the Omnibus Budget Reconciliation Act of 1990 (OBRA 90) was to reduce the budget deficit by cutting spending and raising tax revenue, the Act extended the R&E tax credit through the end of 1991, an action that reduced rather than increased tax revenue.

As well as extending the credit, Congress has made substantive changes in the R&E credit on a number of occasions. The Tax Reform Act of 1986 made a number of modifications. First, in view of the fact that other tax benefits were repealed or scaled back by the Act and that statutory tax rates were reduced, Congress reduced the credit's rate to 20% from 25%. Second, Congress concluded that prior law permitted an overly broad range of activities to qualify as research for purposes of the credit. The Act thus inserted a definition of qualified research into the tax code itself, generally defining qualified research as that undertaken for the purpose of discovering information that is "technological in nature," the application of which is intended to be useful in developing a new or improved product. Research relating merely to style and taste was proscribed by the Act.

The Tax Reform Act also modified the credit's applicability to payments to universities for basic research. On the one hand, the Act abolished prior law's provision that limited the credit's applicability to only 65% of payments to universities and established a separate base period amount applicable only to payments to universities. At the same time, however, the Act provided for a reduction in expenditures that qualify for the credit in cases where a firm's overall donations to universities decline. The intent of the change was to increase the benefit for donations while at the same time limiting any incentive for firms merely to switch donations from other areas to donations that qualify for the credit.

The Technical and Miscellaneous Revenue Act of 1988 (TAMRA) added a rule that reduced the tax savings a taxpayer can obtain from the R&E credit. The rule relates to the R&E credit's interaction with another tax benefit for R&E known as "expensing." The expensing benefit works as follows: just like outlays for tangible capital assets such as machines and equipment, spending on research represents investment in a capital asset -- in this case an intangible one, such as a patent. Like tangible assets, intangible assets produce income over a period of time. Unlike outlays for tangible assets, however, the cost of R&E is not required by the tax code to be deducted gradually as depreciation or amortization. Rather, a special provision of the tax code generally permits R&E costs to be expensed, or deducted in the year they are incurred. Since the cost of intangible capital can be deducted immediately while the asset produces revenue over a period of time, expensing represents a tax benefit.

Prior to TAMRA, a firm could simultaneously use the full benefit of expensing and claim the R&E credit. Under TAMRA, however, the amount of research that a firm was allowed to claim as a tax deduction was reduced by an amount equal to 50% of the R&E credit claimed in that year.

The Omnibus Budget Reconciliation Act of 1989 made major changes in the method by which the credit is calculated. As noted above, prior law's credit applied only to increases in a firm's current year's R&E spending over average R&E spending during the previous 3 years. Under OBRA89, the credit is also limited to the excess of current R&E over a base amount. OBRA89's base amount, however, is computed by multiplying a so-called "fixed-base percentage" by a firm's average gross receipts over the preceding 4 years. OBRA89's fixed-base percentage is the ratio of a firm's research expenses to its gross receipts during a specific historical period: 1984 through 1988.

OBRA89's changes in the credit's base amount are designed to improve the incentive effect of the credit. As described below in more detail, prior law's rules for calculating the credit substantially reduced the incentive effect of the credit for firms in a number of different situations.

An additional change made by OBRA89 was to extend credit eligibility to research related to a firm's prospective line of business. Under prior law, eligible research was limited to research related to a firm's current business. In addition, OBRA89 increased TAMRA's reduction in the amount of research that can be expensed from 50% of R&E credits claimed to a full 100%.

The R&E tax credit temporarily expired on June 30, 1992. And while Congress passed two major tax bills in 1992 that would have extended the credit, the bills were vetoed for reasons not directly related to the R&E credit. While the credit thus remained dormant for the balance of 1992, President Clinton's budget proposals that were announced in 1993 proposed to make the R&E credit permanent. The House-passed version of the Omnibus Budget Act of 1993 (OBRA93) concurred, and would have enacted a permanent credit. The Senate version of OBRA93, however, contained only a one-year extension. The enacted bill (P.L. 103-66, H.R. 2264) extended the R&E credit for 3 years on a retroactive basis from July 1, 1992 through June 30, 1995.

THE RATIONALE FOR GOVERNMENT SUPPORT OF RESEARCH

Economic theory supports the idea of government subsidies for research -- at least in principle. Economic analysis holds that market mechanisms are usually the most efficient way for a society to allocate scarce resources. Indeed, the reduction of tax-related distortions of the market was one of the principal themes of the Tax Reform Act of 1986. In the case of research, however, one or more market failures may occur so that the level of unassisted private spending on research falls short of the amount that is warranted by the benefit the research produces for society as a whole. Empirical studies tend to support the predictions of theory.

There are a number of reasons research spending may fall short of socially desirable levels. For example, some types of research may require sums of capital beyond the reach of most private investors. Or, a firm that has a promising idea for a new invention may be unable to convince outside investors of the merits of the idea, simply because the outsiders do not have enough information or expertise to accurately evaluate the project's real prospects.

The most frequently cited reason, however, for underinvestment in research is the inability of private investors to appropriate the full return from investment in a research project. For example, a particular firm may pour investment funds into a research project that ultimately results in a new product. Patent laws may protect the firm's earnings from the invention for a limited period of time, but patents ultimately expire. As a consequence, other firms are able to produce and sell the product and appropriate part of the return from the invention. The total return to society from the research -- that earned by all the firms that ultimately sell the new product -- is greater than the return that accrues to the firm that initially did the research. And because the level of investment a firm undertakes depends on the return it alone can earn from the investment, without public support firms are willing to undertake less research than is warranted by its return to society.

EVALUATION OF THE R&E CREDIT

While economic theory indicates that some manner of Government support for research is warranted, it leaves open the question of whether the research tax credit itself is necessarily the best way to provide that support. Indeed, some have disputed the effectiveness of the R&E credit as a means of promoting research. It has been argued, for example, that the largest discrepancy between private and social returns to research occurs in the area of basic research -- research not directly related to any particular product or process. It is thus in this area that the largest shortfall in private research occurs. Since only a small portion of private, for-profit research spending is on such basic research, it is argued that a tax incentive for firms to increase research is a less cost-effective means of support than direct Federal funding of basic research through mechanisms such as grants to universities and nonprofit research institutes. In response, others have argued that firms in the private sector are best able to judge which research projects are most worthy of funding. Thus, it is argued that a tax incentive (such as a tax credit) that leaves the ultimate choice of which projects to pursue in the hands of the private sector is the more effective means of Government support.

The effectiveness of the R&E credit in persuading firms to increase research has also been debated. In the past, a focus of the debate was the empirical evidence that has become available since the credit's inception. Some saw the data as confirming the effectiveness of the credit in stimulating research, while others asserted that the empirical evidence shows the credit to be ineffectual. In a 1989 study, the U.S. General Accounting Office (GAO) combined estimates of the credit's effective rate with assumptions about the responsiveness of research outlays to changes in its price, and concluded that the credit increased research spending from between $1 and $2.5 billion over the years 1981-1985. The cost of the credit in terms of foregone tax collections over the same period was $7 billion.

Past studies of the credit's effectiveness, however, are of limited relevance to the current credit because of changes in the credit's structure enacted in 1989. For many firms, the 1989 changes probably increased the incentive effect of the credit substantially, and may well have increased the credit's impact beyond what is shown by the existing data. As described above, under prior law the credit applied to increases in qualified research over average research outlays during the preceding years. The purpose of these so- called "incremental rules" was to reduce the revenue cost of the tax credit while preserving its incentive effect. In practice, however, the moving base-period substantially reduced the incentive effect of the credit. The rule linking credits allowable in the current year to research spending in other years meant that each dollar of research investment in one particular year increased base-period expenditures for future years and hence reduced the amount of future credits that could be claimed. For firms with moderate research growth, the incremental rules could thus reduce the rate of the credit from its nominal 20% rate to an effective rate in the 3% to 4% range. Even more severe effects could occur for firms with either higher research growth or with no growth.

OBRA89's changes in the way the credit's base amount is calculated severed the link between a firm's current research and its future tax credits. Thus, it appears the most severe dampening effects of prior law's base period calculation have been remedied. The current design, however, is not without its own dampening effects. For example, as under prior law, current law defines a base- period amount, and while the calculation of the base-period amount is different from prior law, a firm will still not qualify for the R&E credit if its research outlays shrink below that amount. There is little in economic theory to support this effect. Research by firms whose outlays are shrinking is, in principle, just as valuable as research by expanding firms. In addition, the credit is not refundable; its immediate use is thus restricted to firms with positive tax liabilities in the current year. Firms without current tax liabilities can carry forward credits and use them to offset taxes up to 15 years in the future. Nonetheless, the time value of money renders tax savings in the future less valuable than the same amount of taxes saved in the current year.

CONGRESSIONAL HEARINGS, REPORTS, AND DOCUMENTS

Baily, Martin N. Testimony before the Committee on Finance, United States Senate. In U.S. Congress. Senate. Committee on Finance. Subcommittee on Taxation and Debt Management. Interaction between U.S. tax policy and domestic research and development. Hearings, 100th Congress, 1st session, on S. 58 and S. 716. Apr. 3, 1987. Washington, U.S. Govt. Print. Off., 1987: 116-37.

Cordes, Joseph J. Testimony before the Committee on Finance, United States Senate. In U.S. Congress. Senate. Committee on Finance. Subcommittee on Taxation and Debt Management. Miscellaneous tax bills, 1988: Hearings, 100th Congress, 2d session. July 12, 1988. Washington, U.S. Govt. Print. Off., 1988: 103-10.

Eisner, Robert. Testimony before the Committee on Finance, United States Senate. In U.S. Congress. Senate. Committee on Finance. Subcommittee on Taxation and Debt Management. Interaction Between U.S. tax policy and domestic research and development. Hearings, 100th Congress, 1st session, on S. 58 and S. 716. Apr. 3, 1987. Washington, U.S. Govt. Print. Off., 1987: 99-115.

Mansfield, Edwin. Testimony before the Committee on Ways and Means, United States House of Representatives. In U.S. Congress. House. Committee on Ways and Means. Subcommittee on Oversight. Research and experimentation tax credit. Hearings, 98th Congress, 2d session. Aug. 2 and 3, 1984: Washington, U.S. Govt. Print. Off., 1984: 142-56.

U.S. Congress. Conference Committees, 1989. Omnibus Budget Reconciliation Act of 1989; conference report to accompany H.R. 3299. Washington, U.S. Govt. Print. Off., 1989: 539-45. (101st Congress, 1st session. House. Report no. 101-386)

U.S. Congress. Conference Committees, 1988. Technical and Miscellaneous Revenue Act of 1988; conference report to accompany H.R. 4333. Washington, U.S. Govt. Print. Off., 1988. Volume II, p. 87-8. (100th Congress, 2d session. House. Report no. 100-1104.)

U.S. Congress. Joint Committee on Taxation. Description and analysis of tax provisions expiring in 1992. Joint Committee Print, 102d Congress, 2d session. Washington, U.S. Govt. Print. Off., 1992: 60-8.

____ General explanation of the Economic Recovery Tax Act of 1981. Joint Committee Print, 97th Congress, 1st session. Washington, U.S. Govt. Print. Off., 1981: 117-37.

____ General explanation of the Tax Reform Act of 1986. Joint Committee Print, 100th Congress, 1st session. Washington, U.S. Govt. Print. Off., 1987: 127-40.

FOR ADDITIONAL READING

U.S. Congressional Budget Office. Federal support for R&D and innovation. Washington, 1984. 107 p.

U.S. General Accounting Office. The research tax credit has stimulated some additional research spending. Report No. GGD-89- 114. Washington, 1989. 91 p.