To boost innovation, tax codes cannot penalize research and development

A recurring theme in President Biden’s infrastructure package is renewing and expanding America’s investment in research and development. While there are many ideas on how the government can encourage that, not enough focus is on the barriers that exist within the tax code which make innovating in the U.S. costly and complex. 

Declining American innovation has been of concern to policymakers for decades. Since about 1980, private sector R&D investment as a share of the economy has grown considerably, while public sector R&D has declined — businesses now contribute more than two-thirds of all U.S. R&D investment.

Meanwhile, international competitors like China are making major investments in R&D to gain a competitive edge, in sectors ranging from clean energy to semiconductor development.

Unfortunately, China may keep that edge because the U.S. tax code’s provisions for R&D spending are complicated and can stand in the way of R&D investment. To fix that, there are two areas policymakers need to address. 

First, firms should be allowed to fully recoup the cost of making risky R&D investments on their tax returns. 

Currently, firms can immediately and fully deduct R&D expenses as business expenses when calculating taxable income. However, starting in 2022, R&D expenses will have to be deducted, or amortized, over five years, slowing recovery of R&D costs. This tax change is a historical anomaly: R&D expenses have been immediately deductible in the U.S. since 1954. 

R&D amortization would also be unusual from an international perspective. Other advanced countries competing with the U.S. provide an immediate deduction or even more generous tax treatment. Requiring firms to amortize R&D costs would discourage investment in risky activity and translate into reduced long-term economic output. 

Canceling the upcoming amortization of R&D expenses would benefit the U.S. economy. According to Tax Foundation estimates, this would lead to a 0.1 percent larger economy, a 0.2 percent larger capital stock, and nearly 20,000 new full-time equivalent jobs. These outcomes are a conservative estimate, because the benefits of innovation from additional R&D spending may go beyond an increase in the U.S. capital stock.

Second, policymakers should simplify tax incentives for R&D, making them more accessible for smaller firms and more likely to translate into long-lasting innovation. 

The tax code currently incentivizes R&D through the R&D tax credit. The credit can be a powerful incentive for firms to engage in new and greater innovation, but it is a complicated morass that can be overwhelming for smaller firms to claim. 

There are four types of R&D credits, and each has unique rules and restrictions. Only about 3 percent of the R&D tax credit’s benefits for increasing research activity went to small businesses according to a Small Business Administration study in 2013.

Firms often must hire auditors and interview research teams to claim the proper credit amount, diverting resources from R&D. One estimate projected that between 10 and 30 percent of the credit is often left unclaimed due to how difficult it is to document.

Lawmakers have several options to simplify the R&D credit so smaller firms can access it more easily. One way would be to define expenses eligible for that tax credit as expenses eligible for an immediate R&D deduction, eliminating the need for two separate accounting rules. Alternatively, the standard R&D credit could be eliminated altogether, and the alternative simplified credit could be bolstered, as the Government Accountability Office recommended over a decade ago.

Biden has the right instinct when focusing on ways to renew America’s advantages in innovation. Our deep talent pool, access to capital markets and entrepreneurial culture can be strengthened by ensuring the tax code does not stand in the way of risk-taking and R&D investment.

Garrett Watson is senior policy analyst at the Tax Foundation in Washington, D.C. Alex Muresianu is a policy analyst at the Tax Foundation.