Virtually all nations want more innovation, and the increased income that comes with it. As a result, many nations provide tax incentives to companies for performing research and development (R&D). The U.S. federal government has two main investment tax credits (ITCs) for R&D: the Regular Credit (RC) and the Alternative Simplified Credit (ASC). Almost three-quarters of U.S. states accounting for over 80 percent of R&D performed also provide tax incentives. In addition, R&D benefits from other tax advantages, notably immediate deductibility of spending on equipment, wages, and other current expenditures along with a special low tax rate on net income derived from exports of commercialized R&D. Altogether, federal and state tax support accounts for 9.5 percent of R&D spending.
This is, however, quite low relative to tax-support levels in other countries. The United States ranks 24th out of 34 in a comparison group consisting of all Organization for Economic Cooperation and Development (OECD) member countries with a population of more than four million, plus Brazil, Russia, India, and China (BRIC). China’s R&D tax subsidy, for example, is 2.7 times more generous than the United States’. Slightly more than doubling the federal credit rates would raise the federal-state subsidy rate to 15.5 percent, which would be slightly below the median for the comparison group (excluding the United States), and still well below China.
Moreover, starting in 2022, because of provisions in the Tax Cuts and Job Creation Act of 2017, the United States is on track to be one of the few countries not to allow expensing of current R&D costs. Letting this change go ahead, and assuming state governments follow the federal lead, would reduce the subsidy rate to 2.8 percent from 9.5 percent and bring the U.S. ranking down to 32nd. In addition, eliminating the favorable tax treatment of net exports of commercialized R&D, as some have proposed, would drop the subsidy rate to 1.8 percent, while leaving the United States’ international ranking at 32nd.
The international comparison, coupled with a benefit-cost analysis, suggests U.S. tax support for R&D is too low. The analysis in this paper confirms that substantial increases in U.S. tax support for R&D would improve overall economic performance, including innovation, productivity, and international competitiveness. A fiscally responsible target would be to increase the overall subsidy rate to 15.5 percent from 9.5 percent. This could be done by eliminating the 2017 repeal of the expensing of R&D costs, while slightly more than doubling the effective rates for the ASC and the RC through some combination of higher statutory rates and design changes. In addition, there is an advantage in using more than one instrument to achieve the target support level. As a result, the favorable tax treatment of foreign-derived intangible income (FDII), which indirectly supports R&D by reducing the tax rate on income from commercialized R&D products that are exported, should be expanded to cover income derived from commercialized R&D products sold domestically. Such a change would raise the R&D subsidy rate by about 2 percentage points while encouraging the retention in America of commercialization activity and the associated taxable income.