A recent report by Ernst & Young documents continued efforts by countries to enact additional tax incentives to reward companies for research and development. The purpose of these incentives is two-fold. Of course, these countries would like to attract more research activity from overseas. But maybe even more important, they want to increase domestic investment from within their own borders.
There is strong evidence that tax incentives increase both.
The United States passed comprehensive tax reform in 2017. The bill took the important steps of lowering the corporate tax rate to a much more competitive level (down to 21% from 35%) and dramatically reducing the taxes U.S. companies pay on their foreign profits.
The new rate eased worries that U.S. corporation would move to countries with lower taxes. This was a valid concern, as we need to ensure that America’s tax system is competitive.
Unfortunately, however, the reform did not increase incentives for research and development. The U.S. has now dropped to 25th in incentives for research among countries in the Organisation for Economic Cooperation and Development. In fact, the reform bill actually increased the after-tax cost of research spending by requiring companies to expense it over five years rather than deducting it immediately.
At the same time, a number of countries have sweetened their R&D incentives. Of the 41 jurisdictions surveyed by E&Y, 14 forecast new or more generous research tax credits in 2018.
Here is a partial list of initiatives begun in the last two years:
- Austria increased its research and development tax credit by two percentage points.
- Australia’s new budget proposed to increase the expenditure threshold for favorable tax treatment from $100 million to $150 million and make it a permanent part of the tax law.
- China moved to increase the size of its super deduction for research.
- Denmark proposed a schedule to increase its deduction for R&D expenses from 100% to 110% over several years.
- The new coalition government in Germany proposed new tax breaks for R&D, particularly for small and medium enterprises.
- The United Kingdom increased its tax credit from 11% to 12% and created capital allowances for companies that invest in green technology.
The economic rationale for subsidizing research is simple. By boosting innovation and productivity, research has a huge social impact, increasing living standards. But the companies investing in research are able to capture only a fraction of that social benefit in their private returns.
One study looking at 20 prominent innovations calculated the median private rate of return at 29%. The median social rate of return, however, was a stunning 99%.
The Obama administration predicted that making the R&D tax credit more generous would stimulate $2 to $3 of social benefit for every $1 of lost tax revenue. Clearly, we would benefit if companies conducted more of this research.
The United States needs to follow the international trend. The Information Technology and Innovation Foundation has called for increasing the tax credit’s Alternative Simplified Credit to at least 20% from its current rate of 14%.
Continued R&D remains central to solving challenges such as global warming, cancer, inadequate transportation and housing, and economic insecurity. It is also critical to creating high-paying middle-class jobs.
Finally, an increase in private research increases the value of the billions of dollars that the federal government already spends on direct research.
The United States must encourage U.S. companies to increase their investment in the future by boosting their research budgets. The best way to do this is by lowering the after-tax cost of research.
Joe Kennedy is a senior fellow at the Information Technology and Innovation Foundation (ITIF).
This article originally appeared in the ITIF's Innovation Files.
