R&D Tax Credits: They Work! Will Policymaker’s Listen to the Evidence?

As we approach the end of 2012, the currently expired U.S. R&D tax credits are being altogether ignored by the media, and generally ignored by policy makers. Nothing has been done this year to ensure that firms will receive the same benefits as in the past. This leaves firms guessing as to whether or not they should increase or decrease their investments in R&D, or move them abroad.  The evidence on the effectiveness of R&D tax incentives continue to mount.  In the latest edition of New Economics Papers in Technology and Industrial Dynamics, another compelling analysis by Bond & Guceri, “Trends in UK BERD after the Introduction of R&D Tax Credits,” shows that R&D tax incentives not only bolster business investment in R&D, but businesses respond even more than previously predicted by Bloom et al.  The analysis shows that especially in high-tech manufacturing, the R&D tax credit causes a substantial increase in R&D, which provides further evidence that a permanent R&D tax credit is needed here in the United States.

The study shows that when R&D costs are treated more favorably by the tax code than capital investment, firms react.  In 2002, the UK introduced tax incentives that effectively dropped the user-cost of R&D investments by 13 percent.  This cut induced firms to invest, and in the years that followed, R&D expenditures rose at a faster rate than previous models by Bloom et. al predicted.  This is compelling, as it shows that firms do recognize the potential for R&D to increase profitability.  However, the unsubsidized risk is just too much; which causes firms to look to other less risky, short-term investment options.  Because firms concentrate on their current stock prices, they have a very difficult time taking on bold R&D investment efforts because the future profits are so uncertain.  By stepping in and changing the incentives, the UK’s policy makers enabled firms to justify taking on the riskier investments of R&D, and the benefits are real.

Not only do firms profit, but consumers and other firms also benefit from the new knowledge created; sparking further development of new products.  R&D induces competition, it brings new products to market, and it solves real problems that we face societally. Regular capital investments simply do not have this effect on the greater economy.  When a firm erects a building, it doesn’t benefit anyone else.  This is why R&D is so critical; it has positive effects that spill-over and the benefits are significant.

As shown in the figure, Bond & Guceri’s empirical evidence is clear; firms both small and large react when tax treatments promoting R&D are put into place.  R&D is the most overlooked, yet arguably the most important source of U.S. growth.  When you combine highly skilled workers with R&D, growth occurs and standards of living increase.  Since the U.S. R&D tax incentives have already expired, policy makers should take heed, and introduce a bold, permanent R&D incentive plan.  Business expenditures on R&D are especially critical for the United States’ future, as federal R&D budgets are currently in turmoil.  Since there are questions as to how much the federal government will fund R&D activities due to budget pressures, policy makers must act to ensure that businesses have incentives to pick up the slack.

As the U.S. slides further behind in the international race to lure more tech and manufacturing investment, there needs to be a bold move by policy makers to ensure the United States moves back to the top from its current position at 27^th in R&D tax incentives.  The United States used to be number one, can we get there again?  We believe that the answer is “yes”, but only if policy makers listen to the evidence and then promote the fuel that runs the U.S. engine of growth: R&D.  Policy makers should not only make the R&D tax credit permanent, but they need to increase it substantially.  If they do not, then increasingly global firms will continue to move their innovative activities abroad.  In effect, if the environment is not properly staged for innovation here in the United States, policy makers will not only limit our internal future growth, they will guarantee that U.S. competitiveness will decline.