Technological innovation is a primary engine of long-term economic and productivity growth, and research and development (R&D) helps fuel the innovation process. The federal government has fostered private R&D investment in several ways, including two tax incentives: (1) an option to deduct eligible research expenses as current expenses under Internal Revenue Code (IRC) Section 174(a) that expired in 2022 and (2) two versions of a tax credit for increases in qualified research expenditures (QREs) above a base amount under IRC Section 41.
The IRC Section 41 research and experimentation (R&E) tax credit entered the tax code in 1981 and became a permanent provision in 2015, after having been extended 16 times.
Although the credit is often referred to as a single credit, it actually consists of four discrete credits: (1) a regular credit (RC), (2) an alternative simplified credit (ASC), (3) a university basic research credit, and (4) an energy research credit. A taxpayer may claim one of the first two and each of the other two, if eligible. Only the first two credits are widely used. The RC is equal to 20% of a company’s current-year QREs above a base amount composed of its recent gross receipts and a ratio of QREs to gross receipts from a base period. The maximum ASC is equal to 14% of a company’s current-year QREs above a base amount equal to 50% of its average annual QREs in the past three tax years; the minimum ASC is 6% of current-year QREs for companies with no QREs in at least one of their three previous tax years.
The R&E credit is intended to encourage companies to invest more in basic and applied research and some stages of development than they would if there were no such credit. The credit reduces the after-tax cost of qualified research, which in turn lowers the user cost of capital for this purpose. In theory, a reduction in the user cost of capital would increase the number of R&D investments a company could profitably undertake.
To assess the credit’s economic impact, analysts have focused on the credit’s incentive effect for business R&D investment and its effectiveness in spurring increases in this investment. The credit’s incentive effect refers to the extent to which it encourages companies to invest more in qualified R&D than they otherwise would. One measure of this effect is how the credit affects the user cost of capital for R&D investments. The Treasury Department’s Office of Tax Analysis has estimated that, under 2016 tax law, the user cost of capital for R&D investment was 15% to 26% lower than the user cost of capital for equipment investment because of the combined effect of the R&E credit and IRC Section 174(a) expensing.
Studies of the R&E credit’s effectiveness have indicated that one dollar of the R&E credit stimulated, on average, one dollar of additional R&D investment from the 1980s to the early 1990s.
While many lawmakers endorse the use of tax incentives to boost domestic business R&D investment, there is widespread agreement that the R&E credit could be more effective than it is. Critics say that the credit’s effectiveness is diminished by several factors, including uneven and inadequate incentive effects, uncertainty about and disputes over IRS’s administration of the credit, lack of full refundability for cash-strapped start-up firms, insufficient targeting of R&D projects with relatively high social returns, and more generous R&D tax incentives in other countries. This report describes how the tax credit works, examines what is known about its economic effects, and addresses policy issues associated with the current credit.
A legislative history of the credit, a review of the debate over defining qualified research, and a description of the basic research and energy research components of the IRC Section 41 tax credit can be found in the report’s appendices.
https://crsreports.congress.gov/product/pdf/RL/RL31181