CRS Report Examines the Research Tax Credit

                       CRS REPORT FOR CONGRESS

[2] The R&E tax credit has never been a permanent component of the federal tax code, although it has been in effect almost continuously since July 1981. Since its enactment as part of the Economic Recovery Tax Act of 1981, the credit has been extended 10 times and significantly modified five times. In practice, the credit can be viewed as three discrete credits: a regular credit, an alternative incremental credit (AIRC), and a basic research credit. Each is incremental in that the credit is a certain percentage of qualified spending above a base amount. The rates for the regular and basic research credits are 20%, while the rate for the AIRC ranges from 2.65% to 3.75%. Owing to certain rules governing its use, the marginal effective rate of the regular credit typically is substantially lower then 20%.

[3] Analysts who have studied the credit's effect on business R&D investment seem to agree that it has been effective in boosting it. Yet some think that the credit has been less effective than it could be in spurring R&D investment with large external benefits. Critics point to five problems with the current credit that limit its efficacy: (1) its lack of permanence; (2) its seemingly weak and disparate effect on firms investing in R&D; (3) its non-refundable status; (4) its ambiguous definition of qualified research; and (5) its inefficient targeting of R&D projects that generate large external benefits.

[4] A number of bills to modify the credit have been introduced in the 107th Congress. All of them would extend the credit permanently. In addition, two proposals (H.R. 41 and S. 41) would increase the three rates of the AIRC. Two others (H.R. 1137 and S. 515) would create a new AIRC and revise the basic research credit to improve their incentive effects. On the whole, the bills would enhance the credit's effectiveness. None of the proposals, however, would address all the policy issues raised by the design and operation of the current credit. Critics contend that failure to resolve such issues as what constitutes qualified research and how to make the credit more beneficial to all firms investing in R&D is likely to prevent the credit from achieving its potential to stimulate increased spending on R&D projects with substantial social returns. (The report will be updated to reflect new legislative proposals or action by Congress related to the credit.)

 CONTENTS

[6] Furthermore, most economists agree that in free-market economies, business investment in R&D is likely to be less than the socially optimal amount. A major reason for this shortfall is the presumed inability of individual firms to capture all or even most of the economic benefits generated by R&D. Numerous studies of the economic effects of innovation have indicated that the social returns to business R&D investments far exceed the private returns. These so-called external benefits are known as positive externalities and are regarded by most economists as a type of market failure. To correct this failure, these same economists favor the adoption of public policies aimed at increasing a nation's investment in R&D.

[7] The federal government supports R&D in a variety of ways, direct and indirect. Direct support comes in the form of federal spending on basic and applied research and development in critical policy areas such as health care and defense. A chief source of indirect support is tax incentives for business investment in research. Current federal tax law contains two such incentives: (1) an expensing allowance for qualified research spending under section 174 of the Internal Revenue Code (IRC), and (2) a tax credit for eligible research spending under IRC section 41, which is also known as the research and experimentation (R&E) tax credit. In FY 2000, the cost of these incentives -- expressed as the equivalent in federal outlays -- totaled $4.2 billion, while federal R&D spending totaled $83.1 billion. ¹ The expensing allowance has been a permanent fixture of the IRC since it was first enacted in 1954, whereas the R&E tax credit has been a temporary provision of the tax code since it first went into effect in July 1981 as a result of the Economic Recovery Tax Act of 1981. ² To date, the credit has been renewed 10 times and significantly modified five times.

[8] This report examines the current status of the R&E tax credit, several important policy issues raised by it, and proposals in the current Congress to address these concerns. It concludes with a brief assessment of how these proposals are likely to affect the credit's effectiveness. ³

DESIGN OF THE CURRENT R&E TAX CREDIT

[9] The R&E tax credit actually consists of three discrete credits: a regular credit, an alternative incremental credit, and a basic research credit. In any tax year, firms with qualified research spending are permitted to claim the basic research credit and either the regular credit or the alternative credit.

[10] The regular R&E tax credit is equal to 20% of a firm's qualified research spending above a base amount. Such a design is incremental in nature and is intended to induce firms to spend more on R&D than they otherwise would by lowering their after-tax cost of doing so. (If the regular credit were flat in nature, it would equal 20% of a firm's entire spending on qualified research.) Several rules govern the determination of a firm's base amount. First, it must equal 50% or more of a firm's qualified research expenses in a given tax year -- a rule sometimes referred to as the 50-percent rule. Second, a firm's base amount hinges in part on whether the firm is considered an established firm or a start-up firm. Established firms are those that had taxable incomes and qualified research expenses in three of the years from 1984 to 1988, and start-up firms basically are all other firms. For all firms, the base amount is the product of a fixed-base percentage and average annual gross receipts in the previous four tax years. An established firm's fixed-base percentage is the ratio of its total qualified research spending to total gross receipts from 1984 to 1988, capped at 16%. By contrast, a start-up firm's fixed-base percentage is set at 3% during the first five years it has taxable income and qualified research spending; thereafter, the percentage gradually changes so that by the firm's eleventh year it equals the ratio of total qualified research expenses to total gross receipts in five of the six previous tax years chosen by the firm. In general, a firm can claim the regular credit only if its ratio of qualified research expenses in the current tax year to average annual gross receipts in the previous four tax years is greater than its fixed-base percentage.

[11] A crucial factor in claiming the regular or alternative R&E tax credits is the definition of qualified research spending. In practice, there are two sides to this definition. One is the nature of qualified research. Under IRC section 41(d), research must satisfy three criteria in order to qualify for the regular or alternative R&E tax credit. First, the research must relate to activities that can be expensed under IRC section 174 -- which is to say that the activities must be "experimental" in the laboratory sense and aimed at the development of a new or improved product or process. Second, the research must be undertaken to discover information that is "technological in nature" and useful in the development of a new or improved product, process, computer software technique, formula, or invention that is to be sold, leased, licensed, or used by the firm performing the research. And third, the research must relate to activities that constitute a process of experimentation whose goal is the development of a product or process with "a new or improved function, performance or reliability or quality." In spite of a mandate from Congress in the Tax Reform Act of 1986, the Internal Revenue Service (IRS) has yet to issue final regulations clarifying the kinds of activities that constitute qualified research for the period after 1986.

[12] The other side of the definition of qualified research expenditures is the expenses that are covered by the credit. Under current law, these expenses are the wages and salaries of employees engaged in qualified research, the cost of materials and supplies used in this research, leased computer time used in this research, 75% of payments for qualified research done under contract by nonprofit scientific research organizations, and 65% of payments for qualified research done under contract by certain other organizations. The credit does not apply to the cost of structures and equipment used in qualified research and relevant overhead expenses, an exclusion that reduces the marginal effective rate of the credit.

[13] Most firms undertaking or financing qualified research that cannot claim the regular credit should be able to claim the alternative incremental R&E tax credit. Under current law, however, firms may not claim whichever credit is more advantageous from one tax year to the next. Rather, once a firm elects the alternative credit, it must continue to claim that credit in future tax years unless it receives permission from the IRS to switch to the regular credit. Calculating the alternative credit is somewhat more complicated than calculating the regular credit. ⁴ The alternative credit exhibits a three-tiered rate structure and is equal to 2.65% of a firm's qualified research spending above 1% but less than 1.5% of its average annual gross receipts in the previous four tax years, plus 3.2% of its qualified research spending above 1.5% but less than 2.0% of its average annual gross receipts in the previous four tax years, plus 3.75% of its qualified research spending greater than 2.0% of its average annual gross receipts in the previous four tax years. In general, firms benefit from the alternative credit if their qualified research expenses in the current tax year exceed I% of their average annual gross receipts during the past four tax years.

[14] Moreover, firms that hire certain eligible organizations to perform basic research on their behalf may claim a basic research tax credit for those expenditures. A primary aim of the credit is to foster close research collaboration between the U.S. private sector and U.S. universities. The credit is equal to 20% of payments for contract basic research above a base amount, which has nothing in common with the base amount for the regular R&E tax credit. ⁵ IRC section 41(e) defines basic research as "any original investigation for the advancement of scientific knowledge not having a specific commercial objective." The credit does not apply to basic research done outside the United States, or to basic research in the social sciences, arts, or the humanities. In addition, the basic research credit applies only to payments made to eligible organizations, which are defined as educational institutions, nonprofit scientific research organizations that are not private foundations, and certain grant-giving organizations. It does not apply to payments made to joint research consortia involving a group of firms in the same or similar industries or to federal laboratories.

EFFECTIVENESS OF THE R&E TAX CREDIT

[15] How effective is the current R&E tax credit in boosting business R&D investment? Ideally, such an important policy question would be answered by comparing the social benefits from the added R&D induced by the credit with the social opportunity costs of using the tax revenue lost by the credit for other purposes. Unfortunately, such an answer is not available and is unlikely to become available anytime soon because of the serious problems raised by attempts to measure the social returns to R&D and the social opportunity costs of federal support of R&D. ⁶ As a result, economists have focused their attention on estimating the additional R&D stimulated by one dollar of the credit -- which is a measure of the credit's cost-effectiveness -- and the share of total U.S. R&D spending that might be due to the credit.

[16] The credit stimulates increased business R&D investment by lowering the cost to a firm of undertaking another dollar of R&D beyond its base amount. Alternatively, the credit increases the expected profitability of R&D investment relative to the expected profitability of alternative investments a firm could make by lowering the cost of capital for R&D investment, which in turn encourages the firm to undertake R&D that would otherwise seem unprofitable and too risky. The credit's statutory rate is 20%, which means that the federal government effectively pays for 20% of the cost of this added research. Thus, a crucial consideration in measuring the cost-effectiveness of the credit is the responsiveness of business R&D investment to decreases in the after-tax cost of R&D caused by the credit. Available studies of the credit's effectiveness have concluded that in the period from the mid-1980s to the early 1990s, firms responded to the R&E tax credit by increasing their R&D investments between one and two dollars for every dollar of the credit they claimed on their tax returns. ⁷ Although these studies are marred in varying degrees by a variety of methodological flaws, on the whole, they imply that the credit has been a cost-effective policy tool. They also imply that the credit has accounted for only a small share of domestic R&D investment: in 1996, for example, the credit appeared to be responsible for about 2% of the $121 billion that U.S. firms spent on R&D.

POLICY ISSUES RAISED BY THE CURRENT R&E TAX CREDIT

[17] While there is a broad consensus among economists and policymakers that it is desirable to support private R&D through tax incentives such as the R&E tax credit, this unity starts to crack and crumble when the question of whether the current credit provides adequate or appropriate support is addressed. Some argue that the credit is less effective than it could or should be because of a variety of flaws in its design. Critics generally point to what they consider five flaws that must be remedied if the credit is to exert its desired stimulus: (1) a lack of permanence, (2) weak and disparate incentive effects, (3) non-refundable status, (4) an ambiguous definition of qualified research, and (5) its application to R&D that yields substantial private returns but meager social returns. Each policy issue is discussed below.

LACK OF PERMANENCE

[18] The current R&E tax credit is due to expire on June 30, 2004. It has never been a permanent fixture of the IRC, despite many attempts to extend it permanently in the nearly 20 years it has been in effect. ⁸ In fact, the credit has been extended 10 times, most recently by the Ticket to Work and Work Incentives Improvement Act of 1999 (P.L. 106-170, a law that is also referred to as the Tax Relief Extension Act of 1999).

[19] This lack of permanence is a concern to many analysts, policymakers, and business executives because it is thought to diminish the credit's effectiveness. It does so by subtly encouraging business managers to ignore or downplay the credit when making decisions on the size of their firms' R&D budgets. A temporary R&D tax credit compounds the substantial uncertainty that surrounds expected after-tax returns on prospective R&D investments. This added uncertainty may deter managers from undertaking R&D projects that they would be likely to pursue if the credit were made permanent.

WEAK AND DISPARATE INCENTIVE EFFECT ON FIRMS INVESTING IN R&D

[20] Some find fault with the current R&E tax credit for having what they describe as weak and disparate effects on the firms that invest in qualified research. These critics contend that such effects are not justified on economic grounds and reduce the potential economic efficiency gains from the credit.

[21] There are two sides to the contention that the credit's incentive effect is weak. On the one hand, critics maintain that the marginal effective rate of the credit is too low to boost business R&D investment to levels that would be warranted by the social returns to R&D. According to this line of reasoning, the optimal R&D tax subsidy would raise the real after-tax rate of private return to business R&D investment to the level of the real after-tax rate of social return. Various studies have concluded that the median private rate of return on R&D investment is roughly half of the median social rate of return. ⁹ Assuming this estimate is reasonably accurate, the optimal R&D tax subsidy might seek to double the after-tax private rate of return to business R&D investment. In a 1995 CRS report, William Cox maintained that, at a corporate tax rate of 35%, the optimal R&D tax subsidy would lead to an average ratio of after-tax returns to pre-tax returns of 130%. ¹⁰ By contrast, he estimated that, in combination, the current research expensing allowance and R&E tax credit yielded average ratios of after-tax returns to pre-tax returns ranging from 101% for capital-intensive R&D projects producing assets with a 20-year economic life to about 125% for labor-intensive R&D projects producing assets with a 3-year economic life. ¹¹ His results suggested that current R&D tax subsidies were insufficient to offset the presumed failure of firms to invest in R&D at socially optimal levels.

[22] On the other hand, critics point out that the marginal effective rate of the credit is significantly below its statutory rate of 20%. This gap stems from three rules governing the use of the credit. One rule, known as the basis adjustment, specifies that any credit claimed must be subtracted from research expenditures that are deducted under IRC section 174. Such an adjustment, which has the effect of taxing the credit a firm claims at its federal income tax rate, lowers the marginal effective rate of the credit from 20% to 13%. A second rule, referred to as the 50-percent rule, requires that a firm's base amount for the credit equal 50% or more of its current-year qualified research expenses. Established firms whose ratios of current-year qualified research spending to gross income are more than double their fixed-base percentages or whose ratios are more than double the 16% cap on the fixed-base percentage and start- up firms whose ratios are above 6% or more than double their transition ratios are hurt by this rule in that it further reduces the marginal effective rate of the credit to 6.5%. Still another rule that lowers this rate is the exclusion of the cost of R&D equipment, structures, and overhead (including the fringe benefits of research personnel) from expenses that are covered by the credit. The magnitude of the rate reduction depends on what share of an R&D investment is ineligible for the credit: as this share rises, the marginal effective rate of the credit decreases further.

[23] There is also reason to believe that the credit's incentive effect varies widely among firms investing in qualified research. This variation is apparent even among firms that increase their qualified research expenditures over time. In a 1996 CRS report, Cox estimated that 78% of a sample of 900 U.S. based firms with R&D budgets ranging from large to small could claim the R&E tax credit in 1994. ¹² And of the firms able to claim the credit, 56% could receive credits with a marginal effective rate of 6.5%, and the remaining 44% could receive credits with a marginal effective rate of 13%. Firms with the lower rate were subject to the 50-percent rule. His analysis also indicated that some of the most research-intensive firms could claim either no credit or credits with a marginal effective rate that was 50% lower than the rate received by firms with much lower research intensities. The results suggested that the credit was most beneficial to firms whose research intensities had grown since their base periods and least beneficial to firms whose research intensities had changed little or not at all or shrunk since their base periods. Critics maintain that there is no obvious economic Justification for such a disparate and almost haphazard pattern of R&D subsidization, assuming the principal policy objective of the credit is to induce firms to spend more on R&D with large external benefits than they otherwise would.

NON-REFUNDABLE STATUS

[24] The R&E tax credit is non-refundable. This means that only firms with positive federal income tax liabilities may claim it. In addition, the credit is part of the general business credit (GBC) and therefore subject to its limitations. For firms investing in qualified research, a key limitation is that the GBC cannot exceed a taxpayer's net income tax liability less the greater of its tentative minimum tax or 25% of its net regular income tax liability above $25,000. Unused GBCs may be carried forward 20 years or carried back one year.

[25] Critics argue that the credit's non-refundable status diminishes the survival or growth prospects of a variety of firms that invest in R&D, especially small start-up firms that have no income tax liability because they are losing money and that face severe liquidity constraints. They note that some firms in this position are likely to end up being highly innovative and successful if they can stay in business long enough. If the credit were made wholly or partially refundable, any firm that claims the credit could count on using it to expand its available funds to invest in R&D during its early years.

AMBIGUOUS DEFINITION OF QUALIFIED RESEARCH

[26] A longstanding concern about the R&E tax credit is that the definition of qualified research is so vague that many firms who might benefit from the credit do not claim it. Moreover, critics maintain that this ambiguity needlessly increases the administrative cost of the credit for both firms eligible for it and the IRS and frequently leads to lengthy legal disputes between business taxpayers and the IRS over whether claims for the credit are valid.

[27] From 1981 through 1985, research that qualified for expensing under IRC section 174 also qualified for the credit, with three exceptions: the credit did not apply to research conducted outside the United States, research in the social sciences or humanities, or research that was funded by another entity. Responding to concerns that qualified research for the credit was being interpreted too broadly, Congress tightened the definition in the Tax Reform Act of 1986. Under the act, qualified research had to meet four criteria: 1) it must qualify for expensing under IRC section 174; 2) it must be intended to discover information that is technological in nature; 3) it must be useful in the development of a new or improved "business component" of the taxpayer; and 4) "substantially all" of the research activities must be part of a process of experimentation. Tax analysts commonly refer to the criteria as the "four-part test." In addition, the act authorized the Treasury Department to issue regulations clarifying the new criteria.

[28] It was not until 1998 that the IRS issued proposed regulations on the definition of qualified research. After receiving extensive commentary from tax practitioners and business taxpayers on the proposed regulations, most of which was critical, the agency released final regulations in late December 2000 (T.D. 8930). However, in late January 2001, the Treasury Department issued an order (Notice 2001-19) suspending these regulations, requesting further comment "on all aspects" of the final regulations, promising a careful review of all questions and concerns raised about the suspended regulations, and pledging to issue any changes to the final regulations in proposed form for additional comment. ¹³ So for the time being, the definition of qualified research remains a thorny problem for practitioners and IRS audit agents.

[29] A primary source of ambiguity in the definition of qualified research since 1986 and a key source of controversy in the lively debate over the proposed and final regulations is what it means to discover information that is technological in nature. This criterion is often referred to as the "discovery test." In both the proposed and final regulations, the IRS interprets the test as research that is "designed to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of technology or science and the process of experimentation utilized fundamentally relies on principles of physical or biological sciences, engineering or computer science." ¹⁴ Many tax practitioners and business taxpayers object to this interpretation on the grounds that it is inconsistent with congressional intent, implies that the credit should apply only to research that achieves a technological breakthrough, and leaves unresolved the crucial question of what constitutes "common knowledge" and "skilled professionals."/15/

INEFFICIENT TARGETING OF R&D WITH LARGE SOCIAL RETURNS

[30] Another important policy issue raised by the credit relates to its "bang for the buck." Some question whether an additional dollar of the credit leads to more investment in R&D with high social returns than would an additional dollar of government spending on research.

[31] In principle, an advantage of the credit over direct spending is that the government does not choose which R&D projects are subsidized. Instead, firms decide which projects to fund, and the federal government matches business funding above a base amount on a one-to-four basis. ¹⁶ Yet some critics argue that the current credit does a poor job of discriminating between R&D projects with large external benefits and those with meager or no such benefits. Their concern is that it is too blunt a policy instrument to target business investment in R&D that pays greater rewards for society as a whole than the firms investing in the R&D. On the whole, business managers and owners would prefer to avoid such investments in favor of R&D investments that have a greater prospect of generating substantial profits for their firms. Evidence that this preference shapes U.S. business spending on R&D can be found in the latest National Science Foundation data on U.S. R&D expenditures: in 1999, U.S. industry spent a total of $161.7 billion on R&D; and 9% of that amount went to basic research, 20% to applied research, and 71% to development. ¹⁷ To improve the credit's efficiency effects, critics would like to see the credit modified so that it focuses more on spurring business spending on basic and applied research and less on stimulating business spending on the application of the results of this research to the development of new products, materials, or processes.

LEGISLATION IN THE 107TH CONGRESS TO EXTEND PERMANENTLY OR MODIFY THE R&E TAX CREDIT

[32] There appears to be strong, bipartisan support in the 107th Congress for making the R&E tax credit a more effective tool for stimulating increased business R&D investment. In early April 2001, the leaders of the Democratic Party in the House and Senate called for the permanent extension of the credit as part of a "new" strategy for growth in the age of electronic commerce. ¹⁸ About one month later, Republican Senators who are members of the High Tech Task Force sent a letter to Senator Grassley, then chairman of the Senate Finance Committee, requesting that a permanent extension of the credit be part of the tax relief legislation the committee was about to consider. ¹⁹ A total of nine bills (five in the House and four in the Senate) that would extend the credit permanently have been introduced. Two of the bills (H.R. 41 and S. 41), which have attracted broad, bipartisan co-sponsorship, would also increase the three rates for the alternative incremental R&E tax credit. Another pair of the bills (H.R. 1137 and S. 515) would go so far as to create a new and more generous alternative incremental credit, liberalize the basic research credit, and expand the regular credit to include 20% of payments to qualified research consortia and 20% of patent filing fees paid worldwide by qualified small firms.

[33] In addition, President Bush proposed permanently extending the credit as part of the tax cut plan he submitted to Congress on February 8, 2001. It was the only element of the plan targeted explicitly at corporations rather than individuals. A version of the plan passed by the House (H.R. 1836, P.L. 107-16) on May 16, 2001 lacked such a provision, but the version passed by the Senate one week later not only would have extended the credit permanently but also would have increased the rates of the alternative incremental credit along the lines proposed in H.R. 41/S. 41. The Joint Committee on Taxation estimated that the revenue loss from this provision would total $47.8 billion from FY2001 to FY2011. Largely because this projected cost exceeded the $1.35 billion in tax reduction authorized for that period in the FY 2002 congressional budget resolution (H.Con.Res. 83),the provision was dropped from the conference agreement on H.R. 1836 passed by the House and Senate.

[34] The following table summarizes the bills related to the credit in the 107th Congress:

   TABLE 1. BILLS IN THE 107TH CONGRESS TO EXTEND OR MODIFY THE R&E

[35] Each of the bills described above is intended to improve the efficacy of the R&E tax credit by extending it permanently. Such a step would lessen somewhat the considerable uncertainty surrounding expected after-tax returns on prospective business R&D investments and enable firms with planning horizons for R&D projects extending beyond a year or two to count on the credit being available throughout the planning cycle. Under these conditions, the credit might encourage a larger increase in business R&D investment than it currently does.

[36] Moreover, two of the bills (H. R. 41 and S. 41) would raise slightly the marginal effective rate of the alternative incremental credit. Such an increase probably would benefit most firms that invest in R&D but are unable to claim. Typical users of the alternative incremental credit include firms whose sales are growing more rapidly than their R&D budgets and firms that are reducing their R&D budgets as part of a broad effort to cut operating costs. The increase in effective rate may also persuade more firms to switch from the regular credit to the alternative incremental credit. Nonetheless, because the marginal effective rate of the alternative incremental credit would still be below that of the regular credit, the increase in rates is unlikely to spur a significant rise in business R&D investment.

[37] The most far-reaching changes in the credit's design -- and hence its impact on business R&D investment -- would be made by H.R. 1137 and S. 515. Besides permanently extending the credit, they would create a new alternative incremental credit to replace the existing one that would be more generous than the regular credit. This enhanced generosity would be due to a lower fixed-base percentage than the regular credit and the absence of the 50-percent rule. In addition, the new alternative incremental credit would have a moving base period tied to a firm's current tax year. As a result, the new credit may be available to more established firms that invest in R&D than the regular credit. H.R. 1137 and S. 515 would also give firms that conduct R&D a stronger incentive to fund basic research through cooperative research ventures and to form such ventures with federal laboratories. In fact, it appears that the bills would give firms a stronger tax incentive to form such alliances than to perform their own R&D projects. The reason is that under the bills, the basic research credit would be transformed into a flat 20% tax credit, whereas the regular R&E tax credit and the new alternative incremental credit would remain incremental 20% tax credits. A flat credit is more valuable than an incremental credit because the former applies to a larger base, all other things being equal. To the extent that these proposed changes in the basic research credit lead firms to channel more of their R&D investments into basic research and less into applied research or development, the bills have the potential to enhance the efficiency effects of the R&E tax credit. Finally, H.R. 1137 and S. 515 would make it easier for small start-up firms to claim a research tax credit.

[38] Although these legislative initiatives are likely to make the credit a more effective policy tool for boosting business R&D investment, there is reason to believe that they may not do enough to enhance its efficiency effects. None of the bills address the vexing issue of how qualified research is to be defined and distinguished from non-qualified research in the real world of business R&D projects. Until this issue is resolved either through final regulatory action by the IRS or legislative action by Congress, the use of the credit will be hampered by disputes between a variety of business taxpayers and the IRS over what research expenses should qualify. Nor would any of the proposals enable firms investing in qualified research that have negative tax liabilities to use any credit they claim in the same tax year. The credit's non-refundable status may retard the growth of small technology-based firms with limited access to debt and equity markets. In addition, none of the bills tackles the difficult issue of how to modify the credit so that it does a better job of distinguishing between business R&D projects with large external benefits and those which have none. If it could be proven that the credit routinely subsidizes projects with larger social returns than private returns, then the credit might be a cost- effective policy tool even if it were to stimulate a smaller increase in business R&D investment than its revenue cost. Finally, none of the proposals would raise the marginal effective rate of the credit above its current statutory rate of 20%. Some credible research suggests that a higher rate may be needed to lift business R&D investment to levels commensurate with its potential social benefits.

² For more information on the section 174 expensing allowance, see U.S. Congress, Senate Committee on the Budget, Tax Expenditures, committee print, 106th Cong., 2nd sess. (Washington: GPO, 2000), pp. 51-54.

³ The discussion presented here is distilled from an earlier CRS report: see CRS Report RL30479, The Research and Experimentation Tax Credit: Current Law and Selected Policy Issues for the 106th Congress, by Gary Guenther.

⁴ For a concrete example of how the regular and alternative incremental credits are calculated for hypothetical established and start-up firms, see CRS Report RL30479, The Research and Experimentation Tax Credit: Current Law and Selected Policy Issues for the 106th Congress, Tables 1 and 2, pp. 7-8.

⁵ See Ibid., p. 11.

⁶ Key barriers to measuring the social returns to R&D include developing adequate price indices for the elements of R&D cost for specific industries, specifying the time period in which to assess the productivity gains from R&D, and determining the depreciation rate for a society's stock of R&D assets. For further discussion of these issues, see Bronwyn H. Hall, "The Private and Social Returns to Research and Development," in Technology, R&D, and the Economy, Bruce L. Smith and Claude E. Barfield, eds. (Washington: Brookings Institution, 1996), pp. 141-145.

⁷ See Bronwyn H. Hall and John van Reenen, How Effective Are Fiscal Incentives for R&D? A Review of the Evidence, National Bureau of Economic Research Working Paper 7098 (Cambridge, MA: April 1999) pp. 20-22; Coopers & Lybrand L.L.P., Economic Benefits of the R&D Tax Credit (Washington: Jan. 1998), pp 15-16; and U.S. Office of Technology Assessment, The Effectiveness of Research and Experimentation Tax Credits (Washington: Sept. 1995), p 28.

⁸ The R&E tax credit has been in effect for each year between July 1, 1981 and the present except for the year from July 1, 1995 to June 30, 1996, when it was in abeyance. Since July 1, 1996, the credit has not been renewed to include this period.

⁹ See, for example, Edwin Mansfield, "Microeconomics of Technological Innovation," in The Positive Sum Strategy, Ralph Landau and Nathan Rosenberg, eds. (Washington: National Academy Press, 1986), pp. 309-311.

¹⁰ CRS Report 95-871, Tax Preferences for Research and Experimentation: Are Changes Needed?, by William A. Cox, pp. 7-8.

¹¹ Ibid., p. 13-18.

¹² CRS Report 96-505, Research and Experimentation Tax Credits: Who Got How Much? Evaluating Possible Changes, by William A. Cox, pp. 5-10.

¹³ Sheryl Stratton, "Treasury Puts Brakes on Research Credit Regs; Practitioners Applaud," Tax Notes, vol. 90, no. 6, February 5, 2001, pp. 713-715.

¹⁴ Explanation of Provisions, REG-105170-97, 1998-50 I.R.B. 10.

¹⁵ See David L. Click, "Qualified Research and the Short, Fast Life of the 'Discovery Test,' Tax Notes, vol. 89, no. 3, Oct. 16, 2000, pp. 403-407; Sheryl Stratton, "Final Research Credit Regs Released to Mixed Reviews," Tax Notes, vol. 90, no. 1, Jan. 1, 2001, pp. 9-11; and David L. Click, "Treasury Discovers Problems With New Research Tax Credit Regulations," Tax Notes, vol. 90, no. 11, pp. 1527-1532.

¹⁶ Joseph E. Stiglitz, Economics of the Public Sector (New York: W.W. Norton, 2000), p. 348.

¹⁷ National Science Foundation, Division of Science Resource Studies, National Patterns of R&D Resources: 2000 Data Update (current to March 2001), [http://www.nsf.gov/sbe/srs/nsf01309/ start.html], visited Oct. 2, 2001.

For industry, the NSF defines basic research as "original investigations for the advancement of scientific knowledge . . . which do not have specific commercial objectives, although they may be in fields of present or potential interest to the reporting company;" applied research as "research projects which represent investigations directed to the discovery of new scientific knowledge and which have specific commercial objectives with respect to either products or processes;" and development as "the systematic use of the knowledge or understanding gained from research directed toward the production of useful materials, devices, systems or methods, including design and development of prototypes and processes," but excluding quality control, routine product testing, and production.

¹⁸ Alison Bennett, "Democrats Urge Permanent R&D Credit, Neutral Internet Tax Policy in 'E-Strategy'," Daily Tax Report (Washington: Bureau of National Affairs), April 6, 2001, p. G-5.

¹⁹ Bureau of National Affairs, Tax Core, May 11, 2001.