Wagner’s Nirupama Rao Evaluates First 10 Years of R&D Tax Credit

By Robert Polner

The Research and Experimentation Tax Credit—known as the R&D tax credit—was approved in 1981. Though intended as a temporary measure, it has since been renewed 15 times, drawing broad support from both political parties to provide corporations with a financial incentive to invest in research and development. How well has it worked?

A recent paper by Nirupama Rao, assistant professor of economics and public policy at the Robert F. Wagner Graduate School of Public Service, addresses the question by examining the impact of the tax credit in its first 10 years, using confidential IRS data from corporate tax returns. The credit arose based on the idea that while R&D spending generates spillovers that help society as a whole, such expenditures are not accounted for in corporate decision-making, leading to less than optimal R&D.

Under the legislation, a baseline level of R&D investment is defined specific to each firm (based on the average of the firm’s prior three years of R&D spending). Corporations can claim the tax credit for spending that exceeds the baseline. This helps ensure that U.S. taxpayers aren’t paying for something that corporations would have done even without the special tax credit.

But the credit’s design has led firms to face very different credit rates on their marginal R&D spending—depending on their R&D trajectory. Due to the moving-average definition of the baseline, some firms faced negative marginal credit rates, while others have received the full 25 percent subsidy.

Yet despite the credit’s convoluted design, Rao’s working paper, entitled “Do Tax Credits Stimulate R&D Spending?”, found that the impact of the tax credit on a firm’s investment in research was substantial between 1981 and 1991. Rao estimates that a 10 percent reduction in the user cost of R&D due to the availability of the tax credit led the average firm to increase its research intensity—the ratio of R&D spending to sales—by 11 percent in the short run. Long-run estimates, according to the paper, imply that firms increase spending even further, with wages and supplies accounting for the bulk of the rise.

Smaller and younger firms appeared to respond more immediately to the tax credit, suggesting that they may face lower adjustment costs or liquidity constraints in financing R&D. Long-run analyses show no evidence that firms of varying sizes allocated their research spending over time to maximize their R&D tax credits. Still, the kind of R&D that the federal credit deems qualified research is an important margin on which the credit affects a firm’s behavior.

Lawmakers of both parties have proposed making the R&D tax credit permanent. The complicated design of the credit, says Rao, may have to be reconsidered.

“Making this particular version of the research credit permanent may not be the best policy,” Rao wrote in a May 14 essay in U.S. News and World Report. “Instead, policymakers should redesign the credit with permanency in mind, as a policy instrument this powerful should not be applied in a way that is the chance product of past legislative compromises, or the arbitrary outcome of historical accident.”

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