Smart Tax Policy: Fueling Productivity and Growth Through R&D Investment 3

With Congress currently focused on business investment incentives, a critical area for boosting economic growth lies in how we treat research and development (R&D). Emerging evidence underscores that the benefits of R&D spending are even more substantial than previously recognized.

R&D isn’t just another operational cost; it’s the core driver of long-term productivity and innovation. As lawmakers seek to enhance growth through effective tax policies, immediately allowing businesses to fully deduct their R&D expenses and simplifying the R&D tax credit’s requirements represent the most readily achievable steps.

The Current Tax Landscape for R&D

The tax code defines qualified R&D expenditures broadly, encompassing direct and indirect costs for developing or improving products or processes, including wages, supplies, and asset depreciation.

Currently, companies must spread these deductions over 5 years for domestic R&D and 15 years for foreign R&D. This delayed tax relief diminishes its present value, effectively increasing the cost of R&D.

Furthermore, a tax credit exists for a portion of these expenditures, offering a direct reduction in tax liability. However, claiming this credit reduces the corresponding deduction, creating a dual, albeit somewhat complex, form of tax benefit.

While R&D spans basic, applied, and developmental research, the tax code largely treats them uniformly. This overlooks the significant long-term societal benefits of basic research, which often struggles for private funding due to its inherent uncertainty.

Shifting Trends in R&D Investment

Over the last seven decades, total R&D spending in the US has grown significantly as a share of GDP, from 1.3 percent in 1953 to 3.4 percent in 2023. However, this growth has been accompanied by a decline in public investment relative to an increase in private investment.

Notably, private sector investment increasingly favors developmental research (nearly 79% of business R&D in 2023), which focuses on commercialization, while basic and applied research lag. Although crucial for bringing innovations to market, developmental research doesn’t generate the same broad, long-term benefits as more fundamental research. Encouragingly, business-funded basic research has seen recent growth.

The Distinct Advantages of R&D: Spillover and Diffusion

R&D stands apart from other investments due to its significant spillover effects – the spread of knowledge that benefits others without direct compensation. These spillovers can lead to widespread societal improvements. Studies indicate that the economic returns from R&D investment surpass those of physical capital. Moreover, research findings can diffuse rapidly, meaning R&D conducted internationally can be as valuable as domestic efforts.

Given the specialized nature of research teams and the increasing cost of groundbreaking discoveries, penalizing companies for funding international research could lead to the acquisition of these valuable teams by foreign competitors, harming US competitiveness. It’s also important to note that many developed nations offer more generous R&D tax incentives than the US.

While private R&D leans towards development, public R&D tends to generate more impactful spillovers. Government agencies and universities often conduct basic research, which is widely disseminated and yields broader economic advantages. The lack of patent protection for much basic research facilitates its adoption and further application by other firms. Smaller businesses, in particular, often experience greater productivity gains from public R&D spillovers.

The Impact of Full R&D Expensing

The Tax Foundation estimates that immediate R&D expensing offers a substantial return in economic output for each dollar of tax revenue reduction. This analysis likely underestimates the true growth impact by not fully accounting for spillover effects.

Research from Stanford Business School suggests that the recent requirement to amortize R&D has already led to a significant decrease in R&D expenditures and an increase in effective tax rates for businesses. Permanently reinstating full expensing would likely spur a similar increase in research investment. It could also simplify the tax landscape and encourage more R&D investment from smaller companies.

Addressing the R&D Tax Credit Gap

Large firms currently utilize the R&D tax credit at a much higher rate than smaller firms, even though smaller firms often benefit more from such credits. This underutilization by startups and SMEs, which are frequently at the forefront of innovation, is due to a lack of awareness and the complexities of compliance.

To better support basic research, policymakers could enhance and redesign the R&D credit to specifically target this area, potentially by fostering greater collaboration between businesses and universities or non-profit research institutions. While a current credit exists for university basic research, it doesn’t cover expenses incurred by firms themselves.

Conclusion: Getting R&D Policy Right

Smart tax policy is crucial for fostering R&D, a key engine of productivity and growth. The most immediate and impactful step is to allow companies to fully deduct their R&D costs in the year they are incurred. Congress should also simplify the R&D tax credit to improve its accessibility for startups and small businesses and consider refining it to better incentivize fundamental research with significant spillover potential.