CRS REPORTS ON R&E CREDIT, POSSIBLE REFORMS.

                       CRS REPORT FOR CONGRESS

[2] Using data submitted to the Securities and Exchange Commission, this report assesses how nearly 900 companies with the largest R&E budgets could, or could not, claim credits in 1994. Illustrative calculations indicate that about one-third of them, mainly companies established before the mid-1980s, qualified for the maximum effective credit of 13% on additional qualified research expenses. A remarkable 38% of the companies in the sample were launched since about 1985 and qualified as "start-up" companies. Some 44% of the sample, mainly start-up companies, received effective credits of only 6.5% on additional qualified outlays, half of that received by others. Because substantial expenses do not qualify, effective credits on the total cost of R&E projects were smaller. About 22% of firms in the sample could not claim credits. Nearly all were pre-existing firms, excluded because their sales had grown faster (or fallen more slowly) than their qualified research expenses since the base period. Defense contractors, who do much R&E, are prominent among these.

[3] The R&E credit would have been amended and extended by the Balanced Budget Reconciliation Act of 1995, which was vetoed. Pending bills, H.R. 2994 and S. 1568, would extend it and certain other provisions through 1997. One amendment would allow small R&E tax credits to firms at which R&E intensity has declined. This report discusses the proposed amendments. It also examines other approaches designed to make the credit more effective, including a modest increase in the rate, repealing the limit that only half of research expenses can yield credits, and making the credit partially refundable. Such changes would increase credits especially to research-intensive start-up firms. The report also considers a proposal to give firms with reduced R&E a new start by permitting adoption of a new base period. Under budget-making rules, any revenue losses would have to be offset.

                              CONTENTS

[5] To limit revenue losses and tax preferences for R&D investments that would have happened without tax incentives, the expired provision contained rules that resulted in major differences in tax treatment among firms and types of R&D projects. The largest total credits (6.5% of all qualified research expenses) went to firms at which research intensity had doubled or more than doubled since the mid-1980s and to firms established since that time with research- to-recent-sales ratios of 6% or more. ADDITIONS to R&E spending by these firms, however, were rewarded with only half the credit given for additions by pre-existing firms with smaller increases in research intensity or by new firms with research-to-sales ratios between 3% and 6%.

[6] Capital-intensive research projects received smaller subsidies than labor-intensive projects. Increases in R&E spending by firms at which research intensity had declined since the mid-1980s and at newer firms with research-to-sales ratios below 3% received no credits; under a proposed amendment most of them would receive small credits. These differences in credits for added R&E spending imply that society places different values on added efforts in differing circumstances. No justification for these different valuations is apparent. Some of them could be eliminated with relatively small revenue losses.

[7] Earlier research by CRS found that the expired tax credit probably was too small to compensate investors in private-sector R&D for the sizeable returns to their investments that normally escape them and are received instead by their competitors, their customers and others in society. It therefore appears that too little R&D is undertaken by private investors, and that larger subsidies to this activity could accelerate advances in living standards, assuming that the amount of R&D undertaken would respond to larger subsidies. Recent research has indicated that the amount of private R&D investment would increase by about one dollar in the short term and perhaps by two dollars in the longer run for every additional dollar of subsidy extended through the R&E tax credit. ²

[8] This report clarifies how many and what kinds of firms could claim tax credits for R&E expenses under the expired provision, how much in tax offsets various classes of firms could claim, and how many and what kinds of firms could not claim them. It also examines proposed amendments to the expired provision and other possible amendments that would make the tax credit somewhat larger and more uniform in size at the margin. It does so using data for nearly 900 companies with the largest R&D expenditures in the United States in 1994. Before describing the analysis and its results, the report summarizes how the tax preferences for R&E work(ed).

I. HOW THE R&E TAX PREFERENCES WORK(ED) ³

[9] The R&E tax credit is one of two tax preferences for research and experimentation. The other preference, which remains in effect, allows firms to recoup costs of conducting R&E, other than those of machinery and structures, by deducting them from taxable income in the year they are incurred, instead of recouping them through depreciation allowances stretched over the economic lives of the resulting technology assets (for instance, over 20 years in the case of a patentable item). This practice, governed by Section 174 of the Internal Revenue Code of 1986, is called "expensing" these R&E costs. Such deductions are not permitted if the technology (for instance, a patent) is purchased from an inventor or another firm.

THE EXPENSING PRIVILEGE

[10] Both firms that expense and those that recoup investments through depreciation may reduce taxable income by the same amount over the life of the asset; only the timing of the deductions differs. Lower taxes enjoyed by expensing are only temporary, and their value is the return that can be earned on the amount of taxes deferred during the period of deferral. Mathematically, however, allowing expensing is equivalent to freeing from tax all income from the share of the investment that qualifies for it. ⁴ If after-tax returns would be 65% of pretax returns in the absence of tax preferences (the marginal tax rate on most corporate income is 35%), then the expensing preference raises these returns by more than half to 100% of pretax returns. The expensing privilege is estimated by the Joint Committee on Taxation to cost $2.1 billion per year. ⁵

THE CREDIT

[11] The incremental R&E tax credit, authorized in Section 41, which expired in June 1995, allowed businesses conducting R&E to claim a credit against federal income taxes equal to 20% of the difference between their qualified research expenses in the current year and a base amount. To calculate the base amount, the firm first had to derive its "fixed base percentage," which was its qualified research expenses as a percent of its gross sales revenues in the period, 1984 to 1988. (If this percentage was greater than 16, then this maximum fixed-base percentage was used to calculate the base amount.) The base amount equaled the fixed base percentage of the firm's average gross sales revenues in the 4 tax years preceding the year for which the credit was being calculated. This formula was substituted in 1989 for the original 1981 provision in order to increase the incentive to boost R&E spending. ⁶

[12] The small and disparate credits described on page 1 above stem from certain aspects of this complex provision, in particular, (1) the required deduction of any tax credit from the amount expensed, (2) the 50% rule, (3) the provision for "startup companies," and (4) the limitations on qualified research expenses. Each of these aspects will now be described in turn.

THE EXPENSING ADJUSTMENT

[13] Beginning in 1990, any credit that was taken had to be subtracted from the amount of R&E outlays that could be expensed. Because this requirement in effect added the amount of the credit to taxable income, which for most corporations is taxed at 35%, the effective rate of the credit was reduced by this percentage from the statutory rate of 20% to a maximum of only 13%.

THE 50% RULE

[14] The base amount, furthermore, could not be less than 50% of the current year's qualified research expenses, a proviso that I call "the 50% rule." This rule limited the expenses that could generate credits to one-half of current qualified outlays and placed a maximum on the effective rate of credit at 6.5% of these outlays, in contrast to the 20% statutory rate. This rule also introduced serious disparities between the MARGINAL credits accorded to firms constrained by it and those received by firms that were not constrained by it.

[15] The 50% rule meant that, when qualified research expenses reached double the base amount, any further increase raised the base amount by half of that increase, and only half of the increase generated tax credits. Hence it cut the effective rate of the credit for ADDITIONAL R&E expenses (the marginal rate) from 13% to 6.5% for businesses at which R&E-to-sales ratios had more than doubled since the base period and for firms with ratios more than twice the 16% maximum fixed base percentage.

[16] This marginal effective rate constituted the incentive to increase R&E expenditures and the disincentive against reducing them. Paradoxically, this marginal rate was only half as great as that faced by firms at which R&E intensity had increased but had not doubled. At these firms the entire amount of any increase in qualified research expenditures generated credits equal, after the expensing adjustment, to 13% of the increase. Hence the 50% rule, crafted to limit the amount of inframarginal R&E spending that generated credits, resulted in a marginal incentive that was twice as strong for some firms as for others. It now applies extensively to "start-up companies," which are discussed next.

PROVISION FOR START-UP COMPANIES

[17] Until Section 41 was amended further in 1993, companies without at least 3 tax years with both qualified R&E outlays and sales revenues during the 1984-1988 base period could not claim credits. Given the high rate at which new firms are launched, more and more such firms were excluded. Under the 1993 amendment, such "start-up firms" were assigned a uniform base percentage of 3% for their first 5 taxable years beginning after 1993; base percentages derived from their individual experiences were to be phased in over the subsequent 5 years.

[18] In research-intensive industries, therefore, many start-up firms had a nine-year advantage in calculating their R&E credits; only after the ninth year would their formulas have been based on their own experience like those of pre-existing firms. The 50% rule, however, affected start-up firms with qualified research expenses greater than 6% of their previous 4 years' average sales, because the uniform base percentage was less than half the current level. For most high-tech start-up firms the effective marginal rate of the credit was limited by this provision.

LIMITATIONS ON QUALIFIED RESEARCH EXPENSES

[19] The definition of qualified expenses in Section 41 encompassed only wages and salaries of researchers, their direct supervisors and support staff, directly related supplies and computer time-sharing. Outlays like those for utilities, rents, leasing fees, travel, insurance, taxes and administrative overhead, not to mention durable equipment and structures, were excluded. Even employee compensation other than wages (for instance, non-wage fringe benefits) was excluded. Paralleling these limitations on qualified expenses for in-house R&D, only 65% of amounts paid to others for eligible research could be counted toward the credit. These limitations, intended to facilitate compliance and monitoring, reduced the significance of the credit further and caused large disparities among credits for different types of projects.

[20] If expenses that did not qualify for credits constituted one-third of the cost of an R&E project, for example, then the maximum effective rate of credit on the entire investment would have been only 8.7% instead of 13%, and the maximum effective rates limited by the 50% rule would have been only 4.3%. Given the narrow definition of expenses qualifying for the credit, they often constituted less than half of the total investment.

[21] The staff of the Joint Committee on Taxation estimated that the provisions of Section 41, if the expired version were reinstated without change, would lose revenues of $2.2 billion by FY1998. ⁷

II. DATA

[22] Data on sales revenues and R&D outlays, among many other things, are submitted by publicly traded companies to the Securities and Exchange Commission in their "Form 10-K Reports" and converted into a computer-usable data base by Compustat, Incorporated. Companies in the sample used here -- those with the largest dollar outlays for R&E in 1994 -- range from General Motors, which devoted $7 billion to these purposes, to Truevision, Inc., a maker of peripheral equipment for computers, which spent not quite $7 million. Large foreign-based multinational companies were excluded, as well as some firms with incomplete records that clearly were spun off from pre-existing larger corporations. Nearly 900 companies remained.

[23] The definition of R&D spending to be reported to the Securities and Exchange Commission is more inclusive than the definition of research expenses that qualified for R&E tax credits under Section 41 of the Internal Revenue Code. Reported spending includes fringe benefits, certain other indirect costs of R&D and, in many cases, costs of structures and equipment, which did not qualify for credits. To narrow this difference in at least a rough way, an assumption was made that 30% of the stated R&D costs fell outside the definition in Section 41, and that 70% were qualified expenses under that section. Because of the simplistic nature of such a uniform assumption, the results of the analysis are illustrative and not precise, particularly with regard to individual companies.

III. ACCESS TO CREDITS IN 1994

[24] As indicated in the description of the expired provisions above, R&E credits could be claimed either (1) by firms with ratios of qualified research expenses to the preceding 4 years' average sales higher than their research-to-sales ratios in the base period, 1984-88, or (2) by "start-up firms" that had fewer than 3 years of data in the base period but, after 1993, had qualifying research expenses exceeding 3% of their previous 4 years' average sales revenues. Companies not in one of these categories received no credits. First we shall examine how firms with base-year data appear to have related to the R&E credit.

FIRMS WITH BASE-PERIOD DATA

[25] About 62.5% of the companies in the sample had at least 3 years of data in the base period. They include many of the familiar names of corporate America, plus some not-so-familiar firms, often in high-tech industries. According to the illustrative calculations, some 44.4% of the sample had such base-period data and reported increased R&E intensity in 1994. These firms -- about seven of every ten firms with base-period data -- qualified for tax credits. Some 18.1% of the sample had qualified research expenses in 1994 lower than their base amounts and hence did not qualify for tax credits. This division is summarized in Table 1 on the following page.

PRE-EXISTING FIRMS WITH INCREASED R&E INTENSITY

[26] According to the calculations, 12% of the sample qualified in 1994 for the maximum credit possible as fractions of their total qualified research expenses, because their qualified expenses are estimated to have been more than double their base amounts (QRE > 2BA in the table). They were constrained by the 50% rule that limits expenses against which credits may be taken to a maximum of 50% of their qualified research expenses in the tax year (see page 4 above). As indicated in Table 1, their average effective rate of credit was 6.5% of their qualified research expenses, although the credits were less than that percentage of total R&E costs, because capital costs, fringe benefits and other indirect costs did not qualify for credits.

               TABLE 1. ESTIMATED ACCESS OF SAMPLE FIRMS

[28] Such firms also received credits equal to 6.5% of any increases in qualified R&E outlays (marginal outlays), which constituted the tax incentive to raise R&E spending and the disincentive against reducing it. As indicated on page 4 above, this was not the strongest marginal incentive possible under Section 41. Marginal incentives twice as powerful bore on firms not constrained by the 50% rule -- in other words on firms at which R&E intensity had increased since the base period but had not doubled (BA < QRE < 2BA in the table).

[29] Some 32.3% of all sample firms, as shown in Table 1, are estimated to have qualified for credits not constrained by this rule. These firms constituted about one-half of all firms with at least 3 years of base-period data. They included all manner of large and middle-size companies across the spectrum of industries. They could have claimed credits that spanned the range from very small to nearly 6.5% of total qualified research expenses and, according to these illustrative calculations, would have received an unweighted average credit of 3.1% of such expenses. ⁸ The credits as percentages of total R&E outlays would have been smaller because of the varying shares of total outlays that fall outside the narrow definition of qualified expenses.

[30] Although these firms received credits less than the maximum as fractions of total qualifying expenses, they received larger credits for their marginal outlays -- 13% of qualifying expenses. They therefore faced twice as strong a tax incentive to boost qualifying spending and twice as strong a disincentive against reducing it as that faced by firms discussed above that had boosted their qualified research expenses to more than double their base amounts.

PRE-EXISTING FIRMS WITH REDUCED R&E INTENSITY

[31] Firms with reduced R&D intensity could not obtain tax credits under the 1989 formula. According to the illustrative calculations this list also includes many household names: IBM, GE, DuPont, Digital Equipment, United Technologies, Xerox and Eastman- Kodak. The list is heavy with defense contractors and oil companies. Many defense contractors could not claim credits because R&D efforts had dropped off with the fall in defense procurement in the late 1980s and early 1990s. Oil companies and associated industries slowed technology development after oil prices declined sharply from the extremely high levels that prevailed between 1979 and 1985.

[32] This list also includes many high-tech electronics and pharmaceutical firms, such as Sun Microsystems, Amgen and Advanced Micro Devices. Their failure to qualify for credits stemmed from the fact that their sales had grown faster than their R&E spending, often because of successful products derived from past R&E. The list also includes companies that appear to have been flagging in the intense competition of the computer industry.

A REMARKABLE NUMBER OF START-UP FIRMS

[33] Of the top corporate R&D spenders in 1994, a remarkable 37.5% reported fewer than 3 years with both sales and R&D outlays during the base period, 1984 through 1988. These companies qualified as start-up firms under the 1993 amendment to Section 41. As might be expected, they included many makers of computer equipment, software, telecommunication equipment, semiconductors, other electronics, pharmaceuticals and medical equipment, plus an admixture of firms making other specialized machinery and chemicals. The capability to launch and finance rapid growth of many such high-tech companies constitutes one of the great strengths of the American economy. ⁹

[34] Of the 37.5% of the sample that appear to be start-up companies, 31.8% (more than 5 out of 6) had qualified 1994 research expenses estimated to exceed 6% of their average annual sales between 1990 and 1993 (QRE > 0.06S in Table 1). Because of the provision that the base amount could not be less than one-half of the qualified research expenses in the tax year, these companies could not use the statutory 3% base provided for start-up firms but were required to substitute a base equal to one-half of their qualified expenses. Hence the overwhelming majority of start-up firms received the maximum 6.5% average rate of credit (see Table 1), limited by the rule that credits could be claimed on a maximum of 50% of qualified expenditures. The same 50% rule limited their marginal credits also to that rate, which was smaller than those received by start-up firms with lower research intensities.

[35] Firms with tax-year R&E expenses greater than 3% but less than 6% of their previous 4 years' average sales received smaller average credits as percentages of qualified research outlays but twice as large a reward for additional (marginal) expenditures. According to the illustrative calculations, they would have received credits averaging about 2.7% of qualified outlays and ranging widely between 0.3% and 6.4%. All could claim credits of 13% against marginal outlays. As indicated in Table 1, only 1.7% of the sample had R&E intensities gauged to fall into this range in 1994.

[36] Under the 1993 formula, no credits could be claimed by start-up companies with qualified R&E expenses less than 3% of the preceding 4 years' average sales. Only 4% of the sample (about one- tenth of the start-up companies) had estimated R&E intensities below that threshold in 1994.

IV. SIZE OF TAX INCENTIVES AND DISPARATE TREATMENT OF R&E INVESTMENT'S

[37] An issue receiving little attention in Congress is the inefficiency that stems from widely differing effective marginal rates of tax credit extended to R&D-intensive firms and R&D projects. These differences imply that society places higher values on adding R&D at certain firms than at others and on adding R&D of certain types than others, when little or no basis for such different valuations exists. The differences may also be seen as unfairly discriminatory among firms and projects.

[38] The differences are created by the basic incremental structure of the credit, complemented by the 50% rule, and by the narrow definition of qualifying research expenses. These features were devised to focus the incentive on marginal decisions to increase or reduce R&E investment, restricting the extent to which credits are granted for investments that would have been made anyway. They also limit the revenue loss. But the inefficiency and unfairness can perhaps be reduced without materially sacrificing these goals.

[39] The large spillovers of benefits from private-sector R&D investors to others in society, moreover, may warrant larger tax preferences than have existed heretofore. As noted on page 2 above, the effective tax rate on income from investment outlays that qualify for expensing is zero; hence after-tax rates of return on those outlays equal pre-tax rates. An earlier CRS report concluded that after-tax rates of return to R&D investment outlays that qualify for expensing plus a tax credit at an effective rate of 13% would range from about 130% to 140% of pre-tax returns, depending on the economic life of the resulting technology asset. In other words, returns to R&E outlays that qualify for both tax preferences would receive net subsidies from the tax system of 30% to 40%, assuming that the 50% rule does not apply and that the taxpayer has enough taxable income to take full advantage of the preferences. ¹⁰

[40] After-tax returns to entire R&D projects, however, were lower and more varied, depending in part on the share of the project's outlays that went for durable equipment, structures and overhead-type costs that were ineligible for expensing and/or credits. In the above-mentioned report returns were estimated to range between about 100% and 125% of pre-tax levels, assuming that the 50% rule did not apply. If the rule did apply, tax preferences raised after-tax returns to the range of about 95% to 110% of pre-tax levels. ¹¹

[41] Using assumptions drawn from empirical studies of the spillover benefits from private R&D, it also was estimated that the socially optimal after-tax rate of return to R&D investments, in light of those large spillovers and today's corporate tax rate, would average about 130% of pre-tax returns. ¹² According to this analysis, a net subsidy equal to about 30% of pre-tax returns might roughly compensate R&D investors for the benefits of their investments that are lost to others in society.

[42] Past tax subsidies have fallen considerably short of this size. It appears that society's welfare might be increased by larger and more uniform subsidies for private-sector R&D, even though revenue losses would have to be offset under existing budget rules. How this could be accomplished will be discussed in the next section of this report, which also assesses amendments to Section 41 proposed in pending legislation.

V. POSSIBLE CHANGES IN THE R&E CREDIT

[43] Because Congress is expected to consider amending and renewing the R&E tax credit, we shall consider issues that have been raised with regard to the expired provision and potential solutions to them. Two significant problems with the credit have received considerable attention. Others were discussed in the preceding section of this report.

[44] First, many firms, including research-intensive ones, could not claim credits under the expired provision because their sales revenues had grown faster (or fallen more slowly) than their R&E expenditures since the base period, 1984 to 1988. In some cases this happened because highly successful products resulting from earlier R&D boosted sales very rapidly. In other cases it is attributed to the decline in federal spending for military technology development and weapons systems or to the steep decline in energy prices after 1985.

[45] A second issue was raised by some firms that were established during the base period but nonetheless had 3 or more years of sales revenues and R&D expenses during that period. Such firms could not qualify as start-up companies, although competing firms launched a year or two later could do so. Some such companies with fixed base percentages higher than the 3% stipulated initially for start-ups have sought changes in the law to permit them also to qualify as start-ups, enabling them to claim larger credits or in some cases to claim credits when they could not do so without the change.

[46] Third, as indicated in the preceding section, there are reasons to consider changing the tax preference for R&D investments and/or reducing the differences in marginal incentives among firms and types of R&D projects that existed under the expired provision. This could be done in several ways. The report examines these three issues in turn.

CREDITS FOR FIRMS WITH REDUCED R&E INTENSITY?

[47] Table 1 indicated that more than one in five of the nation's largest corporate R&D spenders (22.1%) could not qualify for tax credits in 1994 under Section 41 for reasons discussed above. Two types of proposals have been made to permit such firms to receive credits. The first is to authorize an alternative credit with a much lower rate to apply to ALL qualified R&E expenses or to those above some uniform and low percentage of recent sales. A second approach would permit firms to choose an alternative base period for use in connection with the 1989 formula. These approaches have fundamentally different effects on the incentives to affected firms to increase R&E expenses.

[48] The Balanced Budget Reconciliation Act of 1995, which was vetoed, adopted the first approach, as do bills, H.R. 2994 and S. 1568, now under consideration. In extending Section 41 they propose a one-time option to switch to an "alternative incremental credit." The alternative formula would provide very small marginal credits with statutory rates (see top panel of numbers in Table 2) of 2.75% of qualified research expenses exceeding 2% of the preceding 4 years' average sales; 2.2% of qualified expenses greater than 1.5% but not exceeding 2% of those sales; and 1.65% of qualified expenses between 1% and 1.5% of those sales.

[49] The tables indicate that 18.1% of the sample consists of firms with base period data that had qualified research expenses in 1994 lower than their base amounts (QRE < BA) and hence could not claim credits under the 1989 law. Table 2 (upper panel of numbers) summarizes results of simulations showing how these companies might have fared under the proposed alternative incremental credit. According to the simulations, 12% of the sample (some two-thirds of the firms in question) could have claimed alternative incremental credits, had this amendment been in effect in 1994, because their qualified research expenses are estimated to have exceeded 1% of average 1990-93 sales.

[50] The alternative credits, however, would be much smaller -- both in total and on the marginal R&E project -- than those received under the 1989 formula by most firms with increased R&E percentages. After the expensing adjustment the maximum effective credit for a marginal R&E project would be only 1.8% of qualified outlays (see rightmost column of Table 2). It would pose a weak incentive to increase R&E spending and little disincentive against reducing it.

          TABLE 2. ACCESS OF SAMPLE FIRMS TO R&E TAX CREDITS

[52] This finding points up the fact that the alternative credit would focus less effectively on the margin, where decisions are made between adding and reducing R&E investment, and would award more credits to firms for investment that would happen anyway. If firms were to switch to the alternative credit, they would expect henceforth to receive larger tax credits while facing much weaker tax incentives to boost R&E spending; they might even receive larger tax credits while reducing R&E spending.

[53] According to the illustrative calculations, 4% of the sample consists of start-up firms at which 1994 R&E intensities fell short of 3% of the preceding 4 years' average sales. Such firms would have received no R&E credits under the 1993 provision for start-up companies. All but a few of them, as indicated in the lower panel of numbers in Table 2, could have received small alternative incremental credits under the proposed amendment.

[54] An alternative to this complex amendment would be to alter Section 41 so that companies not entitled to credits under the expired provisions could adopt a new base period. By contrast to the proposed alternative credit, this option would not dull the incentive to boost R&E at the margin nor award many tax windfalls for R&E spending that takes place anyway.

[55] The years, 1992 to 1996, would be a suitable alternative base period. These years, like the original base period, have been years of steady economic growth leading to low unemployment and high utilization of production capacity. Companies at which qualified research expenses exceeded a base amount calculated using the alternate base period could claim the full 13% effective rate of credit on the difference, limited only by the constraints stemming from the 50% rule, which is unlikely to apply, and by the narrow definition of qualified research expenses.

[56] The revenue loss from allowing an alternative base period should be modest within the budget forecasting horizon, because the current tax year would be close to the base period, and R&E intensity normally grows slowly. For some companies R&E intensity would continue to decline, and no credits would accrue. Revenue losses would rise over time, if research intensity of firms claiming credits continues to increase. Official estimates of revenue effects are made by the Joint Committee on Taxation.

[57] In summary, the alternative incremental credit proposed in the pending bills would provide tax reductions to companies with reduced R&D intensities without posing much incentive to slow or reverse the decline. Allowing adoption of an alternative base period would maintain the full force of the tax incentive to increase spending for technology development but would offer no tax reduction to companies at which qualified research outlays continue to decline as percentages of recent sales.

ALTERING THE DEFINITION OF START-UP COMPANIES

[58] To address the desire of some companies founded in the mid-1980s to qualify as start-up companies, an amendment to Section 41 in the pending bills would require all firms with first taxable years beginning after December 31, 1983, to be reclassified as start- up firms and to calculate their credits using the uniform 3% fixed base for their first 5 tax years beginning after 1993.

[59] According to the simulations, 56 firms (6.4% of the sample) would have been reclassified as start-up firms, had this amendment been in effect in 1994. Of these 56 firms, 22 would have benefitted from this reclassification by receiving larger R&E credits. These would have included 6 high-technology firms whose R&E intensity has declined from very high percentages of sales during their initial years. Another 26 firms that would have been reclassified would not have benefitted, because they would have received the maximum credit under either the 1989 formula or the formula for start-up companies.

[60] Surprisingly, eight of the 56 firms that would have been required to use the uniform 3% base percentage for start-up companies would have received smaller credits than under the 1989 formula. The language of the amendment, however, does not permit such firms to continue using the 1989 formula. This disadvantage would have resulted when a company had increased its R&E "intensity" but its tax-year R&E percentage remained less than 3% (which yielded no credit under the start-up formula). It could occur when a firm's base-period R&E percentage was less than 3% and its tax year percentage was substantially higher than 3% but less than 6%.

[61] Virtually any set of rules making distinctions among classes of taxpayers involves some disadvantage for one set relative to another. Allowing certain firms to switch to a lower base percentage would create a new set of firms that are disadvantaged because they were not founded a short time later. The case for adopting this amendment is similar to the case for cutting taxes on any other special subset of taxpayers. Meanwhile the amendment would hurt a few taxpayers that fare better under the 1989 formula. If Congress adopted such a change, it could choose to make the reclassification optional rather than mandatory to avoid hurting some taxpayers while aiding others.

ENHANCING THE RATE AND UNIFORMITY OF THE CREDIT

[62] Increasing the effective rate and uniformity of the R&E credit could be approached in several ways: (1) by repealing the 50% rule; (2) by restoring the 25% statutory rate of credit provided in the Economic Recovery Tax Act of 1981, which first established the credit; and/or (3) by making durable equipment and/or structures used for R&E eligible for expensing and credits. The third option would involve administrative complexities that would need to be explored further. The first two possibilities are considered here.

Repealing the 50% Rule

[63] Repealing the 50% rule would allow all qualified research expenses above the base amount to generate the full 13% credit. To double the effective credits that affected firms could claim for marginal projects from 6.5% to 13% of qualified expenses, it would allow such firms to claim credits against even more of their inframarginal research spending than can be done today and to this extent would increase tax windfalls. Eliminating the 50% rule, therefore, involves trading off one form of efficiency against another.

[64] Most firms benefiting from such a change would be start-up firms, although some pre-existing firms also were constrained by the 50% rule. Some high-tech start-up firms would accelerate their R&D efforts in response to the change simply because it would relax their budget constraints in the frantic competition to commercialize new technologies.

[65] Eliminating the 50% rule would permit credits as percentages of all qualified research expenses to rise from a maximum of 6.5% toward a maximum somewhat below 13%. ¹³ It would allow R&D projects to enjoy subsidies from about 0% to 25% above pre-tax rates of return, depending on the project's capital intensity and overhead requirements and the economic life of the resulting technology.

[66] The revenue loss from eliminating the rule would be curtailed to the extent that nearly three-fourths of the firms affected by it originated since about 1985 and hence are relatively small. After 1998, moreover, firms that qualified as start-ups in 1994 would phase in fixed base percentages related to their own individual histories and then are unlikely to remain subject to the 50% rule. Over the subsequent 5 years, in other words, their R&E credits are likely to decline anyway as percentages of qualified research spending. Of course, new start-up firms would appear.

[67] Because many start-up companies have insufficient income and tax liability to use additional tax credits currently, under current law their added credits would have to be carried forward as offsets against potential future tax liabilities. Making the credit wholly or partly refundable would enhance its current value to such firms. Because of the small size of most affected firms, the majority could benefit fully from refundability limited to a moderate dollar amount. Refundability, however, would require even more vigilant compliance monitoring than the expired provision.

Raising the Statutory Rate of the Tax Credit

[68] The effective rate of credit could be raised for all claimants either by raising the statutory rate of credit from 20% to a higher level or by reducing or eliminating the expensing adjustment (deduction of the credit from the amount expensed), or both. Such increases broaden the range of subsidies to different kinds of projects and raise them so that tax subsidies to labor-intensive projects could exceed the target range of 30% referred to on page 11 above. The optimal increase implied by this analysis, therefore, would be fairly modest.

[69] Restoration of the 25% statutory credit provided in the 1981 legislation that first established the credit, while keeping the expensing adjustment, would yield subsidies ranging from about 5% to nearly 35% of pre-tax returns to firms qualifying for maximum marginal credits. This change would raise the maximum effective rate of credit, after the expensing adjustment, from 13% to 16.25%. Retaining the present statutory rate but eliminating the expensing adjustment would boost the maximum effective rate to the statutory rate of 20% and yield subsidies ranging from 9% to 46%. The average subsidy might be close to the target rate of 30%.

[70] These amendments -- raising the rate and deleting the 50% rule -- would raise after-tax rates of return to R&D investments toward the level estimated to be economically optimal for society (130% of pre-tax returns) and would create somewhat greater equity among types of firms. Little can be done to reduce the discrimination against capital-intensive R&D projects without making capital outlays eligible for expensing and credits. Such a change, however, would involve challenging compliance and enforcement issues.

[71] The revenue losses that would be incurred by amending Section 41 as suggested here would have to be estimated by the Joint Committee on Taxation. Under budget enforcement laws, offsetting revenue gains would have to be found. ¹⁴

OVERVIEW OF THE RESULTS

[72] All told, 34% of the firms in the sample, nearly all pre- existing firms with full base-period data, appear to have qualified for R&E tax credits in 1994 equal to 13% of their marginal outlays; they were unfettered by the 50% rule. Another 44%, mainly start-up companies, could have received the maximum overall credit of 6.5% of total qualified research expenses but also were limited by that rule to the same effective rate of credit on their marginal outlays.

[73] If the 50% rule were removed, effective marginal credits would be doubled for this large number of firms that has been subject to its constraints. Rates of return on their marginal R&D investments after tax subsidies would be raised substantially. Many start-up firms now subject to the rule are engaged in intense competitive races to commercialize advancing technologies. Those with sufficient tax liabilities to take advantage of increased tax credits presently can be expected to increase their R&D spending substantially. The response of other firms with little or no current profit would be more muted, unless R&E credits were made at least partly refundable. While making the credit uniform at the margin, lifting the 50% rule would allow credits for more of the R&D investment that would occur without tax incentives and hence would yield additional tax windfalls.

[74] Most companies at which R&E intensity had declined could have received alternative incremental credits of the type proposed in pending legislation, had they been available in 1994. This provision, however, would have provided weak incentives to increase R&D or even to halt its decline. About 5.5% of the firms in the sample, nearly all pre-existing ones, could not have qualified for any credit, even if the alternative incremental credit had been in the law in 1994. Permitting an updated base period, however, could maintain the tax incentive to boost R&D spending at its full strength for firms that could not qualify under the expired provision.

² Library of Congress. Congressional Research Service. Tax Preferences for Research and Experimentation: Are Changes Needed? (CRS Report 95-871 S) by William A. Cox. Washington, August 1995, 33 p, See esp. p. 1-9. This report contains further references to research on spillovers of benefits and on the responsiveness of private research outlays to the credit. See especially KPMG Peat Marwick LLP. Policy Economics Group. Extending the R&E Tax Credit: The Importance of Permanence. Prepared by Rudolph G. Penner, Linden C. Smith and David M. Skanderson. November 1994. pp. 23-26.

³ Readers familiar with the tax preferences for R&E may wish to skip to Section II of this report, which begins on page 5.

⁴ For the derivation of this principle, see Gravelle, Jane G. Effects of the 1981 Depreciation Revisions on the Taxation of Income from Business Capital. National Tax Journal, v 35, n 1 (March 1982), pp. 1-20.

⁵ U.S. Congress. Senate. Committee on the Budget. Tax Expenditures: Compendium of Background Material on Individual Provisions. Committee print prepared by the Congressional Research Service. (S.Prt. 103-101, 103rd Cong., 2d sess.) December 1994. p. 51.

⁶ Separately corporations could take a tax credit for increases over a base amount in payments for basic research to qualified organizations (such as universities and scientific institutions). Basic research was defined as "original investigation for the advancement of scientific knowledge not having a specific commercial objective."

⁷ U.S. Senate. Committee on the Budget. Tax Expenditures: Compilation of Background Material, p. 45. (See p. 3, fn. 5 for full citation.)

⁸ An unweighted average, is the simple average of credits received by all firms in the subset without taking account of the varying sizes of those firms.

⁹ Of these roughly 325 firms, a few may not be genuinely new firms but rather undetected spin-offs from other companies or simply companies that failed to report data for three or more years during the base period. Most of them, however, appear to be genuinely new companies.

¹⁰ Congressional Research Service. Tax Preferences for Research and Experimentation: Are Changes Needed? pp. 13-18. (See p. 2, fn. 2 above for a full citation). The subsidy would come in the form of deductions and tax credits sufficient to shelter from tax not only all income from the R&E investment itself but also additional income from other sources.

¹¹ Ibid., p. 15, table 1. Taxation at the statutory corporate marginal rate of 35% with no preferences would reduce after-tax returns to 65% of pre-tax returns.

¹² Ibid., pp. 1-9 and p. 15, table 1. Many studies of private- sector R&D have found that its total benefits to society are much larger than the returns to private investors. Several scholars have concluded that social returns are in the range of twice the before- tax private rates of return in the median case. Although variation about this median undoubtedly is great, this rule of thumb is adopted here and forms the basis for the present argument.

¹³ Credits of firms constrained by the 50% rule were exactly 6.5% of qualified research expenses. Without the 50% rule they could rise to 13% of the difference between qualified outlays and the base amount. If qualified research expenses were, say, 40% of the preceding 4 years' average sales in a very research-intensive start- up firm subject to the uniform start-up base percentage (3%), its credit would come to 12% of qualified outlays.

¹⁴ For suggestions regarding potential offsetting changes, see Congressional Research Service, Tax Preferences for Research and Experimentation: Are Changes Needed? p. 32.