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A recent report by the Congressional Budget Office (CBO) shows last year’s tax reform significantly increased the cost of conducting research and development (R&D) in the United States. The reduced tax generosity toward R&D will cost the U.S. economy, because R&D is an important component of national competitiveness and higher living standards.
A well-designed tax code would lower the after-tax cost of R&D, because R&D delivers large social benefits beyond those captured by the companies that conduct it. Unfortunately, the 2017 tax reform increased the effective tax rates on R&D. The result likely will be slower technological advancement and lower living standards.
Prior to 2018, the effective tax rate (ETR) for R&D was -31 percent, reflecting significant subsidies that increase the rate of return from what it would otherwise be. The ETR for debt financed R&D was -92 percent, versus -16 percent for equity-financed R&D. This is because companies get a deduction for interest payments but not for dividends. The average typically financed R&D was -29 percent for C corporations but -54 percent for pass-through entities. Reflecting the fact that the latter avoid tax at the business level.
Tax reform has not been kind. CBO confined its estimates to equity-financed investments by C corporations. Whereas the pre-2018 ETR was -14 percent, the ETR after reform jumped to 11 percent. This is because the law instituted the requirement to amortize research expense over five years starting in 2022. Prior law allowed companies to deduct these costs in the year incurred. This change alone significantly increases the after-tax cost of R&D from what it was prior to the reform. The credit itself is among the least generous in the OECD even before tax reform.
Tax reform was sold to the American public based on its expected contribution to economic growth. Certain changes, such as the cut in corporate rates and the institution of first-year expensing should increase investment and direct it toward more productive activity. However, it is especially disappointing that Congress not only failed to increase the R&D tax credit, but actually made the situation worse. To correct this, lawmakers should make expensing permanent and expand the R&D tax credit.