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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 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 percent from 35 percent) and dramatically reducing the taxes U.S. companies pay on their foreign profits. Some people worried that the latter would increase the incentive for companies to move overseas. That concern is lower now that the top corporate rate is 21 percent, but it points to the continued need to ensure that America’s tax system is competitive with those of our main competitors. Unfortunately, the reform did not increase incentives for research and development, which remains unchanged, having dropped to the the 25th most generous within the OECD over the last two decades. 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.
The Ernst & Young report shows that this increase runs counter to the global trend. The movement has not been unanimous. Japan and Russia, for example, limited the availability of their R&D tax credits. But these countries are in a minority. A number of countries have sweetened their incentives. Of the 41 jurisdictions surveyed by E&Y, 14 forecast new or more generous research tax credits in 2018. A partial list of initiatives begun in the last two years includes the following:
- 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 percent to 110 percent over several years.
- The new coalition government in Germany proposed new tax breaks for R&D, particularly small and medium enterprises.
- The United Kingdom increased its tax credit from 11 percent to 12 percent 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 increases living standards. But companies are able to capture only a small portion of the social benefits from their research. One study looking at 20 prominent innovations calculated the median private rate of return at 29 percent. The median social rate, however, was a stunning 99 percent. The Obama administration predicted that making the research and development tax credit more generous would stimulate two to three dollars of social benefit for every dollar 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 percent from its current rate of 14 percent.
Continued research and development remain central to solving challenges such as global warming, cancer, better transportation and housing, and improved security. They are also critical to creating high-paying middle-class jobs. Finally, higher private research increases the value of the billions of dollars that the federal government already spends on direct research. Because of this the United States must remain competitive in the international competition for research dollars. Even more so, it needs to 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.