R&D Tax Credit Reduces the Price of New Products

April 11, 2019

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The research and development (R&D) tax credit is one of the most important tax tools for increasing innovation and productivity in the U.S. economy. This, of course, translates directly to higher wages and better living standards. The tax currently offers companies a credit of 20 percent on qualifying research expenditures. Most companies choose the Alternative Simplified Credit (ASC), which offers a credit of 14 percent. However, because companies that take the credit cannot deduct research expenditures from their income, the effective rate is only 9.1 percent.

A recent paper by economists Yuchen Li, Yada Zhu and Thomas O. Boucher, “Modeling the Firm’s Response to Research & Development Tax Credit Policies,” in The Engineering Economist shows that the credits’ benefits might be significantly larger than we previously thought. The traditional justification for supporting research focused on spill-over effects to the general society. Research tends to create large social benefits, but a significant amount of these benefits goes to society in general, not to the firm conducting the research. Because firms only consider the private costs and benefits when deciding how much and what type of research to conduct, they underinvest compared to what is societally optimal. Another recent paper by Syracuse University economist David Popp cites several studies as typically showing that social rates of return range from 30 to 50 percent, whereas the private marginal rate of return on investments ranges from just 7 to 15 percent. The result is that we would be better off if firms conducted more R&D.

The R&D credit partially addresses this by lowering the after-tax cost of research, motivating firms to do more of it. The additional spillover effects end up paying for a large share of the credit’s costs. The Obama Administration cited research showing that every dollar of foregone tax revenue generates between $2-3 in social benefits.

Further, the credit does result in more research. Li, an economist at the Beijing University of Technology, and his colleagues estimate that, prior to tax reform, the R&D credit encouraged firms to increase their research by 12.3 percent. The figure for start-ups was smaller: only 9.3 percent. The difference is that new firms often lack enough taxes to apply the credit against. If the ASC were raised to 40 percent, on-going firms would increase their research by almost 150 percent above what they would spend with no credit.

The Li paper tries to estimate a second source of value from additional research. The authors hypothesize that the additional research motivated by the tax credit reduces the cost of the technology and the subsequent price at which the company sells its new product. Since the initial price of the resulting good or service is lower, consumer surplus (the difference between how much a product is worth to consumers and its actual price) will be higher. Prior to the 2017 tax reform, they estimate higher consumer surplus in the form of lower prices amounted to 66.8 percent of the ASC’s cost to the Treasury. The costs are slightly lower for start-ups. If the ASC were 40 percent, higher consumer surplus would still offset 42.7 percent of the lost revenues.

These benefits are in addition to traditional spill-over effects. Together, the combination of research spillovers and higher consumer surplus indicates that even a tax credit of 50-60 percent would pay for itself in the form of higher productivity and better living standards. As Congress slowly turns its attention to the innovation competitiveness challenge from China, policymakers would be well advised to look at an expansion of the R&D credit as a key tool.