New Evidence That the R&D Tax Credit Promotes Research, Especially in Small Companies

The American Economic Association just published yet another study showing that research and development tax credits are effective in spurring more research by private companies, especially smaller ones. Although large companies conduct most private research, small companies are often more responsive to tax credits because cash flow is so important to their viability. The study should build support for efforts like the bipartisan, bicameral FORWARD Act introduced this week by Sens. Chris Coons (D-DE) and Pat Roberts (R-KS), and Reps. Suzan DelBene (D-WA) and Jackie Walorski (R-IN).

A team led by Ajay Agrawal studied the effect of a recent change to Canada’s Scientific Research and Experimental Development (SRED) tax credit, which gives companies a 20 percent credit for most research spending. This is significantly higher than the 14 percent that U.S. companies receive under the Alternative Simplified Credit. In fact, the U.S. credit has been steadily falling in generosity when compared to other developed countries. The Canadian credit is raised to 35 percent on up to $2 million in research expenditures for small firms with under $200,000 in prior-year taxable income. Moreover, tax credits at the 35 percent rate are fully refundable.

Originally, the higher rate phased out between $200,000 and $400,000 in prior-year taxable income. In 2004, Canada raised the phaseout range by $100,000. Suddenly companies within this range became eligible for the higher credit rate. How did they respond?

The study showed that eligible firms increased their research spending by an average of 17 percent. Much of the response came from firms with no tax liability. This demonstrates the importance of making the credit refundable. Contract R&D spending was more responsive than total research wages because for many small businesses the size of the enhanced credit was not large enough to justify hiring another researcher, but it was large enough to purchase more research from outside parties. Finally, companies were more likely to expand their research spending if they had recently invested in capital equipment for research, such as land and machinery. This is important because the cost of research capital in the United States is scheduled to rise in 2022 when all research spending must be written off over five years rather than being immediately expensed. Amortizing raises the after-tax cost of investment and will result in less research, especially among smaller, cash-constrained companies.

The Agrawal study demonstrates the importance of ensuring research incentives also support younger companies. In addition to making the research credit permanent, the PATH Act of 2015 allowed small companies to deduct research credits against their payroll taxes. The bipartisan FORWARD Act recently introduced by Sens. Coons and Roberts increases the credit in three main ways. First, it raises the threshold for applying the credit to payroll taxes from $5 million to $20 million. Second, it expands the ability to deduct research training expenses. Finally, it expands the credit for collaborative and manufacturing research. The last two changes apply to all firms taking the credit.

Large deficit spending in response to COVID-19 makes higher productivity and economic growth even more important than they were before the crisis. The large social benefits generated by business research argue for Congress expanding the R&D tax credit to drive growth and innovation.