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Amid all the disputes about tax law, there seems to be a consensus on the wisdom of at least one tax policy: the research and development credit. A strong body of research shows that the credit increases private research by a minimum of a dollar for every dollar of tax revenue lost. That research in turn creates economy-wide benefits of between $2 and $3.
Unfortunately, this evidence and the strong bipartisan support for the credit have not always translated into effective policy. For decades, the credit’s influence was reduced by its temporary nature. Only in 2015 did Congress finally make it permanent. And despite the fact that other nations have enacted more generous tax credits, the 2017 tax reform bill actually weakened the tax treatment of R&D.
For instance, the credit provides less support for newer, pre-revenue businesses. This is because, in order to benefit from a tax credit, firms need a positive tax liability, which normally requires profits. Although they often spend a lot on R&D, many start-ups make little money during their first years, so tax credits are not very valuable. The lack of support for newer firms is unfortunate, because a strong preponderance of evidence shows technology-based start-up companies are an important source of innovation and new jobs in the economy.
Although start-ups may not pay income taxes, they do pay payroll taxes. Legislation championed by Sens. Chris Coons (D-De) and Pat Roberts (R-KS) gave firms with less than $5 million in gross receipts a tax credit against their Social Security tax liability of up to $250,000. But the credit cannot exceed their Social Security payroll taxes, which are about 6.2 percent of wages.
Legislation introduced this week by Sens. Maggie Hassan (D-NH) and Thom Tillis (R-NC)—S.2207—would expand this help by allowing more small firms to take advantage of the tax credit and by increasing its amount. It does this in four ways:
- It expands the number of firms that qualify for a refund of their payroll taxes by raising the maximum amount of gross receipts from $5 million to $10 million per year.
- It doubles the maximum amount of payroll tax that can be refunded from $250,000 to $500,000 and then automatically indexes it for inflation.
- It helps firms reach the cap more quickly by refunding Medicare and unemployment taxes in addition to Social Security taxes.
- It increases the credit for firms that have revenues under $10 million. Most firms currently use the Alternative Simplified Credit (ASC), which provides a credit of 14 percent for research that exceeds half of the average research spending from the last three years. Under the current law, firms with no history of research can only take a credit of 6 percent in their first year conducting research. The Hassan bill would increase the credit to 20 percent in the first year. In the first five years of profitability, a start-up without R&D spending in each of the previous three years could take either a 10 percent credit against their actual research spending that year or a 20 percent credit for R&D spending that is more than half of its average from the past three years. But years without R&D spending would not be counted. Thereafter, the credit would be calculated the same as current law, but with a 20 percent rate.
The net result of this legislation would be to increase support for research by start-ups without breaking the link between the credit and actual taxes paid. This should significantly bolster the U.S. innovation ecosystem—something that is critically needed in era of intense global competition for innovation advantage, especially versus China. Moreover, given past scholarly research, we can be confident that the overall societal benefits of the resulting research will be several times the lost tax revenue and that the expanded credit might even pay for itself.
ITIF has long called for increasing the Alternative Simplified Credit to 20 percent for all firms, and for measures to better enable start-ups to take the R&D credit. The United States was once the leader in supporting private research by innovative firms. In 1990, its R&D tax incentive was the most generous in the world. But by 2016, it had fallen to 25th among OECD countries. Congress should make the Hassan bill part of a renewed effort to incentivize research and encourage innovation.