Research and Experimentation Tax Credit: Current Status and Selected Isues for Congress

Research and Experimentation Tax Credit:
Current Status and Selected Issues for Congress
Updated October 6, 2008
Gary Guenther
Analyst in Business Taxation and Finance
Government and Finance Division



Research and Experimentation Tax Credit: Current
Status and Selected Issues for Congress
Summary
Technological innovation is one of the major forces driving long-term economic
growth, and research and development (R&D) serves as the lifeblood of innovation.
The federal government supports business R&D in a variety of ways, including a tax
credit for increases in R&D spending over a base amount.
This report examines the current status of the credit, summarizes its legislative
history, discusses some key policy issues it raises, and describes legislation in the

110th Congress to modify or extend it. The report will be updated as needed.


The research tax credit, which has never been a permanent provision of the
federal tax code, is due to expire at the end of 2009. Since its enactment in mid-

1981, the credit has been extended 13 times and significantly modified five times.


While the credit is often thought of as a single unified credit, it actually consists of
five discrete credits for the 2008 tax year: (1) a regular credit, (2) an alternative
incremental credit (AIRC), (3) an alternative simplified credit (ASIC), (4) a basic
research credit, and (5) an energy research credit.
The research tax credit seeks to boost business R&D investment by reducing the
after-tax cost to firms of undertaking qualified research beyond a base amount. A
key factor shaping the efficacy of the credit is the sensitivity of firms to changes in
the cost of R&D. Although most analysts and lawmakers support the use of research
tax credits to generate more business R&D investment, the design of the current
credit has been a target of some criticism. Critics contend that the credit is not as
effective as it should be because of certain flaws in its design.
At least 12 bills to extend the credit permanently have been introduced in the

110th Congress: S. 14, S. 41, S. 592, S. 833, S. 2209, S. 2884, H.R. 1712, H.R. 2138,


H.R. 2734, and H.R. 5105, H.R. 5681, and H.R. 5917. Five of the measures (S. 41,
S. 2209, S. 2884, H.R. 1712, and H.R. 5681) would also replace the regular credit,
AIRC, and ASIC with a new simplified credit.
On May 21, 2008, the House approved a bill (H.R. 6049) that would extend the
research tax credit (along with a variety of other expired or expiring tax benefits)
through the end of 2008 and offset the cost of the extensions. Consideration of the
measure in the Senate was hampered by a disagreement between Republicans and
Democrats over whether and how to offset the revenue cost of the measure. The
Senate passed an amended version of H.R. 6049 on September 23 that would extend
the same set of tax benefits. It would retroactively extend the research tax credit
through 2009, as well as raise the rate for the ASIC from 12% to 14% and repeal the
AIRC for 2009 only. Only part of the cost of the extensions would be offset.
The credit ended up being extended retroactively through 2009 as part of a
massive bill (H.R. 1424, P.L. 110-343) aimed at stabilizing and reviving financial
markets. In addition, the new law increases the rate for the ASIC from 12% to 14%
and abolishes the AIRC for the 2009 tax year only.



Contents
In troduction ......................................................1
Design of the Current R&E Tax Credit.................................3
Qualified Research Expenditures..................................3
Regular Research Credit........................................5
Alternative Incremental Research Credit............................7
Alternative Simplified Credit.....................................9
Basic Research Credit..........................................9
Energy Research Credit........................................10
Legislative History of the Research Tax Credit..........................10
Effectiveness of the Research Tax Credit..............................14
Policy Issues Raised by the Current Research Tax Credit..................17
Lack of Permanence...........................................18
Weak and Uneven Incentive Effects ..............................18
Uneven Incentive Effect....................................19
Weak or Inadequate Incentive Effect..........................20
Non-refundable Status.........................................24
Unsettled and Ambiguous Definition of Qualified Research...........24
Lack of Focus on R&D Projects With Relatively Large Social Returns...29
Legislation in the 110th Congress to Modify and Extend the
Research Tax Credit...........................................31
List of Tables
Table 1. Sample Calculations of the Regular and Alternative Incremental
R&E Tax Credits in 2007 for an Established Firm....................6
Table 2. Sample Calculations of the Regular and Alternative Incremental
R&E Tax Credits in 2007 for a Start-up Firm........................8
Table 3. U.S. Industrial R&D Spending, Federal R&D Spending, and
the Research Tax Credit, 1997 to 2005............................17



Research and Experimentation Tax Credit:
Current Status and Selected Issues for
Congress
Introduction
Economists may be notorious for their disagreements on a variety of important
policy issues. Notable examples include the long-term economic effects of large,
permanent tax cuts; the impact of illegal immigration on domestic wages; and the
best way to achieve price stability, full employment, and greater income equality.
But on the issues of the impact of technological innovation on economic growth in
the long run and the proper role of public policy in the development of new
technologies, there is relatively little discord among practitioners of what some call
the dismal science.
Most economists would agree that technological innovation has accounted for
a major share of long-term growth in real per-capita income in the United States.1
It is fair to ask what economists mean by technological innovation. After all, such
a complex idea can have different meanings among different professions.
Economists who study the dynamics of economic growth generally see innovation
as a convoluted and uncertain process that embraces the acquisition of new scientific
and technical knowledge and its application to the development of new goods and
services or methods of production through research and experimentation. Learning-
by-doing and learning-by-using often play crucial roles in this process.
In economies dominated by competitive markets, technological innovation is
driven by the unrelenting efforts of competing firms to gain, sustain, or reinforce a
decisive competitive advantage by being the first to introduce, or use, new or
improved products or services; more efficient production processes; or more effective
strategies for management, marketing and promotion, and customer service and
support. Private investment in research and development (R&D) serves as the
lifeblood of innovation.
Most economists would also agree that private R&D investment is likely to be
less than would be warranted by its economic benefits. The reason for this shortfall
lies in the nature of these benefits. Firms generally cannot capture all the returns to
their R&D investments, even in the presence of patents, trademarks, and other
instruments of intellectual property protection, and their strict enforcement.
Numerous studies have found that the average social returns to private R&D


1 Linda R. Cohen and Roger G. Noll, “Privatizing Public Research,” Scientific American,
September 1994, p. 72.

investments greatly exceed the average private returns.2 This finding holds true
whether a firm invests in research projects narrowly focused on its existing lines of
business, or in research projects aimed at extending the boundaries of knowledge in
particular scientific disciplines in ways that have no obvious or immediate
commercial applications.
Economists refer to any excess of social over private returns as the spillover
effects or external benefits of R&D. There are several channels through which the
returns from innovation may elude full capture by the innovating firms and spill over
to society at large. Among the most common channels are reverse engineering by
competing firms, migration of senior research scientists and engineers from one firm
to another, and the availability of new or newly improved goods and services at
prices lower than those most consumers would be willing to pay.3 When filtered
through the lens of conventional economic theory, the external benefits of
technological innovation take on the appearance of a market failure, in which too few
resources are allocated to the activities leading to the discovery and commercial
development of new technical knowledge and know-how. To remedy this failure,
most economists advocate the adoption of public policies aimed at boosting or
supplementing private investment in R&D, especially those investments likely to
generate relatively large external benefits, such as basic research.
Partly in an effort to stimulate increased private R&D investment, the federal
government supports R&D in a variety of direct and indirect ways. Direct support
comes mainly in the form of research performed by federal agencies and federal
grants for basic and applied research and development intended to support concrete
policy goals, such as protecting the natural environment, exploring outer space,
advancing the treatment of deadly diseases, and strengthening the national defense.
Indirect support is more diffuse. The chief sources are federal funding of higher
education in engineering and the natural sciences, legal protection of intellectual
property rights, special allowances under antitrust law for joint research ventures, and
tax incentives for business R&D investment.
Federal tax law offers two such incentives: (1) a deduction for qualified
research spending under Section 174 of the Internal Revenue Code (IRC), and (2) a
non-refundable tax credit for qualified research spending above a base amount under
IRC Section 41 — known as the research and experimentation (R&E) tax credit, the
research tax credit, the R&D tax credit, or the credit for increasing research activities.
The deduction has been a permanent provision of the IRC since it was first enacted
in 1954. Its main advantages are that the deduction simplifies tax accounting for


2 See, for example, Edwin Mansfield, “Microeconomics of Technological Innovation,” in
The Positive Sum Strategy, Ralph Landau and Nathan Rosenberg, eds. (Washington:
National Academy Press, 1986), pp. 307-325; and John C. Williams and Charles I. Jones,
“Measuring the Social Return to R&D,” Quarterly Journal of Economics, vol. 113, no. 4,
November 1998, pp. 1119-1135.
3 For a brief discussion of these channels, see Bronwyn H. Hall, “The Private and Social
Returns to Research and Development,” in Technology, R&D, and the Economy, Bruce L.
R. Smith and Claude E. Barfield, eds. (Washington: Brookings Institution and American
Enterprise Institute, 1996), pp. 140-141.

R&D expenditures and encourages business R&D investment by taxing the returns
to such investment at a marginal effective rate of 0. A similar policy objective
undergirds the research tax credit, which has been a temporary provision of the IRC
since it went into effect in July 1981. The credit is intended to stimulate more
business R&D investment than would occur in the absence of the credit by lowering
the after-tax cost of qualified research.4 But unlike the deduction, it complicates tax
compliance for firms claiming the credit. In FY2007, the combined budgetary cost
of these incentives totaled an estimated $15.5 billion, or 11.1% of the estimated
$139.1 billion spent on federal defense and non-defense R&D that year.5
This report examines the current status of the R&E tax credit, describes its
legislative history, discusses some important policy issues raised by it, and identifies
legislative proposals in the 110th Congress to extend the credit or enhance its
incentive effect. It will be updated to reflect significant legislative activity and other
developments affecting the status of the credit.
Design of the Current R&E Tax Credit
Although the research tax credit often is thought of as a single unified credit, it
has five discrete components: a regular research credit, an alternative incremental
research credit (or AIRC), an alternative simplified incremental credit (or ASIC), a
basic research credit, and a credit for energy research. Each is non-refundable, and6
with the exception of the AIRC, each is due to expire at the end of 2009. In any tax
year, business taxpayers may claim no more than the basic and energy research
credits, plus one of the following: the regular credit, the AIRC, or the ASIC. To
prevent business taxpayers from receiving two tax benefits for the same expenditures,
any research tax credit claimed must be subtracted from the amount of qualified
research expenses deducted under IRC section 174.
Qualified Research Expenditures
Ultimately, claims for the regular credit — as well as the AIRC and ASIC —
rest on the definition of qualified research expenditures (QREs). There are two
critical aspects to this definition.
One aspect deals with the nature of qualified research itself. Under IRC section
41(d), research must satisfy four criteria in order to qualify for the regular, AIRC, and
ASIC credits. First, it must involve activities that qualify for the deduction under
IRC section 174: which is to say that the activities must be “experimental” in the


4 For more information on the section 174 expensing allowance, see U.S. Congress, Senate
Committee on the Budget, Tax Expenditures, committee print, 107th Cong., 2nd sess.
(Washington: GPO, 2002), pp. 55-58.
5 Office of Management and Budget, Analytical Perspectives, Fiscal Year 2006
(Washington: GPO, 2005), pp. 66 and 317.
6 As a result of the Emergency Economic Stabilization Act of 2008 (P.L. 110-343), the
AIRC is repealed for the 2009 tax year only.

laboratory sense and aimed at the development of a new or improved product or
process. Second, the research must be intended to discover information that is
“technological in nature.” Third, it should seek to gain new technical knowledge that
is useful in the development of a new or improved “business component,” which is
defined as a product, process, computer software technique, formula, or invention to
be sold, leased, licensed, or used by the firm performing the research. And fourth,
the research must entail a process of experimentation aimed at the development of
a product or process with “a new or improved function, performance or reliability or
quality.” The third and fourth tests were added by the Tax Reform Act of 1986.
According to IRC section 41(d)(3), research meets the four criteria if it seeks to
develop a new or improved function for a business component, or to improve the
performance, reliability, or quality of a business component. By contrast, research
fails to meet these criteria if its main purpose is to modify a business component
according to “style, taste, cosmetic, or seasonal design factors.”
Business taxpayers, the courts, and the IRS have clashed repeatedly over the
application of the four criteria for qualified research. Although the IRS issued final
regulations clarifying the definition of qualified research in December 2003 (T.D.
9104), further disputes between business taxpayers and the IRS over what activities
qualify for the credit appear unavoidable.7
IRC section 41(d)(4) identifies activities for which the credit may not be
claimed. Specifically, the credit does not apply to research conducted after the start
of commercial production of a “business component”; research done to adapt an
existing business component to a specific customer’s needs or requirements; research
related to the duplication of an existing business component; surveys and studies
related to data collection, market research, production efficiency, quality control, and
managerial techniques; research to develop computer software for a firm’s internal
use (except as allowed in any regulations issued by the IRS); research conducted
outside the United States, Puerto Rico, or any other U.S. possession; research in the
social sciences, arts, or humanities; and research funded by another entity.
The second critical aspect of the definition of QREs concerns the expenses
eligible for the credit. Under IRC section 41(b)(1), qualified expenses arise from
both in-house research and contract research. In the case of in-house research, the
regular, AIRC, and ASIC credits apply to the wages and salaries of employees and
supervisors engaged in qualified research, as well as the cost of materials, supplies,
and leased computer time used in this research. In the case of contract research, the
three credits apply to the full amount paid for qualified research conducted by certain
small firms, colleges and universities, and federal laboratories; 75% of payments for
qualified research performed by certain research consortia; and 65% of payments for
qualified research performed by other non-profit entities dedicated to scientific
research.


7 See the discussion of concerns raised by the current definition of qualified research in the
“Unsettled and Ambiguous Definition of Qualified Research” section of this report.

It is useful to understand which expenses related to R&D investments are
ineligible for the credits. Specifically, they do not apply to spending on depreciable
assets used in qualified research such as buildings and equipment, overhead expenses
for such research (e.g., heating, electricity, rents, leasing fees, insurance, and property
taxes), and the fringe benefits of research personnel. The exclusion of these expenses
can have important implications for the incentive effect of the credit (more on this
later). Excluded expenses may account for 27% to 50% of business R&D spending.8
Regular Research Credit
The regular research tax credit has been extended 13 times and significantly
modified five times. Under IRC section 41(a)(1), it is equal to 20% of a firm’s QREs
beyond a base amount. Such an incremental design is intended to encourage firms
to spend more on R&D than they otherwise would by lowering the after-tax cost to
business taxpayers of investing in qualified research above some normal amount by
as much as 20%.9 Given that business R&D investment appears sensitive to its cost,
a decline in the after-tax cost of R&D should spur a rise in business R&D
investment, all other things being equal.10
The base amount for the regular credit seems designed to approximate the
amount a firm would spend on qualified research in the absence of the credit. As
such, the base amount can be viewed as a firm’s normal or preferred level of R&D
investment. Two rules govern the calculation of the base amount under IRC section
41(c). First, it must be equal to 50% or more of a firm’s QREs in a tax year — a rule
that some refer to as the 50-percent rule.11 Second, the base amount depends on
whether the business taxpayer is considered an established firm or a start-up firm.
Established firms are defined as firms with gross receipts and QREs in three or more
of the tax years from 1984 through 1988. Start-up firms, by contrast, are defined as
firms whose first tax year with both gross receipts and QREs occurred after 1983, or
firms that had fewer than three tax years from 1984 to 1988 with both gross receipts
and QREs.12 The base amount for all firms, established or start-up, is the product of
a fixed-base percentage and average annual gross receipts in the previous four tax
years. An established firm’s fixed-base percentage is the ratio of its total QREs to
total gross receipts in 1984 to 1988, capped at 16%. By contrast, a start-up firm’s
fixed-base percentage is set at 3% during the firm’s first five tax years with spending


8 U.S. Office of Technology Assessment, The Effectiveness of Research and
Experimentation Tax Credits (Washington: 1995), p. 29.
9 For a variety of reasons, which will be discussed in a later section of the report, the actual
or effective rate of the credit is much lower than 20%.
10 Available studies indicate that the price elasticity of demand for R&D ranges from 0.2 to
2.0, which means that a 1% reduction in the cost of R&D would raise R&D spending
between 0.2% and 2%.
11 In other words, the expenses against which the regular research credit may be claimed can
equal no more than 50% of total QREs in a given tax year.
12 The definition of a start-up firm has changed a few times since the research credit was
enacted. Presently, it denotes a firm that recorded gross receipts and QREs in a tax year for
the first time after 1993.

on qualified research and gross receipts. Thereafter, the percentage gradually adjusts
to reflect a firm’s actual experience, so that by its eleventh tax year, the percentage
equals the firm’s total QREs relative to its total receipts in the fifth through tenth tax
years.
In general, the lower a firm’s fixed-base percentage, the better its chances of
claiming the regular credit. And a firm can expect to benefit from the regular credit
if its ratio of QREs in the current tax year to average annual gross receipts in the
previous four tax years is greater than its fixed-base percentage. (See Table 1 for a
calculation of the regular credit for a hypothetical established firm, and Table 2 for
a calculation of the regular credit for a hypothetical start-up firm.)
Table 1. Sample Calculations of the Regular and Alternative
Incremental R&E Tax Credits in 2007 for an Established Firm
($ millions)
YearGross ReceiptsQualified Research Expenses
19841005
19851508
198625012
198740015
198845016
198940018
199045018
200083545
200191550
20021,00553
20031,21560
20041,46570
20051,65085
20061,82595
20071,900100
Source: Congressional Research Service.
Calculation: Regular R&E Tax Credit
Compute the fixed-base percentage:

1. Sum the qualified research expenses for 1984 to 1988: $56 million.


2. Sum the gross receipts for 1984 to 1988: $1,350 million.


3. Divide the total qualified research expenses by the total gross receipts to
determine the fixed-base percentage: 4.0%.
Compute the base amount for 2007:

1. Calculate the average annual gross receipts for the four previous years (2003-


2006): $1,539 million.


2. Multiply this average by the fixed-base percentage to determine the base amount:


$62 million.



Compute the regular tax credit for 2007:
1. Begin with the qualified research expenses for 2007 of $100 million and subtract
the base amount ($62 million) or 50% of the qualified research expenses for

2007 ($50 million), whichever is greater: $50 million.


2. Multiply this amount by 20% to determine the regular R&E tax credit for 2007:


$10 million.
Calculation: Alternative Incremental R&E Tax Credit

1. Calculate the average annual gross receipts for the four previous years (2003-


2006): $1,539 million.


2. Multiply this amount by 1% and 1.5% and 2%: $15 million, $23 million, and $31
million.
3. Begin with the qualified research expenses for 2007 ($100 million) and subtract
1% and 1.5% and 2% (respectively) of the average annual gross receipts for

2003 to 2006: $85 million, $77 million, and $69 million.


4. Multiply the difference between $85 million and $77 million by 0.03: $0.24
million.
5. Multiply the difference between $77 million and $69 million by 0.04: $0.32
million.

6. Multiply $69 million by 0.05: $3.45 million.


7. Sum the totals from steps 4, 5, and 6 to determine the alternative incremental
R&E tax credit: $4.01 million.
Alternative Incremental Research Credit
Firms investing in qualified research that are unable to claim the regular credit
have the option of claiming the alternative incremental R&E tax credit (or AIRC),
under IRC section 41(c)(4). However, a decision to claim the AIRC does have
consequences for future tax years, and it will not be available in the 2009 tax year.
When a firm elects the AIRC in a particular tax year, it must continue to do so in
future tax years, unless the firm receives permission from the IRS to switch to
another research credit. There is some concern that such a rule deters firms from
claiming the AIRC, even though they may be better off doing so.
The definition of QREs for the AIRC is the same as the definition of QREs for
the regular credit. But that is where the similarity between the two credits ends.
Unlike the regular credit, which is equal to 20% of QREs in excess of a base amount,
the AIRC is equal to 3% of a firm’s QREs above 1% but less than 1.5% of its average
annual gross receipts in the previous four tax years, plus 4% of its QREs above 1.5%
but less than 2.0% of its average annual gross receipts in the previous four tax years,
plus 5% of its QREs greater than 2.0% of its average annual gross receipts in the
previous four tax years.
In general, firms can benefit from the AIRC if their QREs in the current tax year
exceed 1% of their average annual gross receipts during the past four tax years. In
addition, the AIRC is likely to be of greater benefit than the regular credit to business
taxpayers with relatively high fixed-base percentages, or whose research spending is
declining, or whose sales are growing much faster than their research spending. (See
Table 1 for a calculation of the AIRC for a hypothetical established firm, and Table

2 for a calculation of the AIRC for a hypothetical start-up firm.)



Table 2. Sample Calculations of the Regular and Alternative
Incremental R&E Tax Credits in 2007 for a Start-up Firm
($ millions)
YearGross ReceiptsQualified Research Expenses
19993035
20004240
20015545
20026055
200321065
200430573
200540082
200647590
2007600105
Source: Congressional Research Service.
Calculation: Regular R&E Tax Credit
Compute the fixed-base percentage:
1. By definition, the firm is a start-up. According to current law, a start-up firm’s
fixed-base percentage is set at 3% for each of the five years after 1993 when it
has both gross receipts and qualified research expenses, and then it adjusts
according to a formula over the next six years to reflect the firm’s actual
research intensity. Thus, the fixed-base percentages are 3% for 2000 through

2003, 7.4% in 2004, 8.9% in 2005, 12.0% in 2006, and 14.7% in 2007.


Compute the base amount for 2007:

1. Calculate the average annual receipts for the four previous years (2003-2006):


$347.5 million.

2. Multiply this amount by the fixed-base percentage to determine the base amount:


$51 million.
Compute the regular tax credit:
1. Begin with the qualified research expenses for 2007 ($105 million) and subtract
the base amount ($51 million) or 50% of the qualified research expenses for

2007 ($52.5 million), whichever is greater: $52.5 million.


2. Multiply $52.5 million by 20% to determine the regular R&E tax credit for 2007:


$10.5 million.
Calculation: Alternative Incremental R&E Tax Credit

1. Calculate the average annual gross receipts for the four previous years (2003-


2006): $347.5 million.


2. Multiply this amount by 1%, 1.5%, and 2%: $3.5 million, $5.2 million, and $6.9
million.
3. Begin with the qualified research expenses for 2007 ($105 million) and subtract
1.0%, 1.5%, and 2.0% (respectively) of the average annual gross receipts for

2003 to 2006: $101.5 million, $99.8 million, and $98.1 million.



4. Multiply the difference between $101.5 million and $99.8 million by 0.03: $0.05
million.
5. Multiply the difference between $99.8 million and $98.1 million by 0.04: $0.07
million.

6. Multiply $98.1 million by 0.0375: $4.9 million.


7. Sum the totals from steps 4, 5, and 6 to determine the alternative incremental
R&E tax credit: $5.0 million.
Alternative Simplified Credit
The most recent addition to the array of research tax credits available under IRC
section 41 is what is known as the alternative simplified incremental credit (ASIC).
Under IRC section 41(c)(5), a business taxpayer may claim the ASIC in lieu of the
regular credit or AIRC. The ASIC is equal to 12% of a taxpayer’s QREs in the
current tax year above 50% of its average QREs in the three previous tax years; this
rate will rise to 14% for the 2009 tax year only. If a taxpayer has no QREs in any of
those years, then the credit is equal to 6% of its QREs in the current tax year. As
with the AIRC, a decision to claim the ASIC remains in effect for succeeding tax
years, unless a taxpayer gains the consent of the IRS to claim another research credit.
Basic Research Credit
Firms that enter into contracts with certain non-profit organizations to perform
basic research may be able to claim a tax credit for some of their expenditures for this
purpose under IRC Section 41(e). A primary aim of the credit is to foster
collaborative research between U.S. firms and colleges and universities. The credit
is equal to 20% of total payments for qualified basic research above a base amount,
which is known as the “qualified organization base period amount.” This amount has
little in common with the base amount for the regular R&E tax credit, except that
both amounts seem intended to approximate what firms would spend on qualified
research in the absence of such credits.13
For the purpose of the credit, basic research is defined as “any original
investigation for the advancement of scientific knowledge not having a specific
commercial objective.”


13 Calculating a firm’s base amount for the basic research credit is more complicated than
calculating its base amount for the regular credit. For the basic research credit, a firm’s base
period is the three tax years preceding the first year in which it had gross receipts after 1983.
The base amount is equal to the sum of a firm’s minimum basic research amount and its
maintenance-of-effort amount in the base period. The former is the greater of 1% of the
firm’s average annual in-house and contract research expenses during the base period, or 1%
of its total contract research expenses during the base period. For a firm claiming the basic
research credit, its minimum basic research amount cannot be less than 50% of the firm’s
basic research payments in the current tax year. The latter is the difference between a firm’s
donations to qualified organizations in the current tax year for purposes other than basic
research and its average annual donations to the same organizations for the same purposes
during the base period, multiplied by a cost-of-living adjustment for the current tax year.

The credit does not apply to qualified basic research done outside the United
States, or to basic research in the social sciences, arts, or the humanities.
In addition, the basic research credit applies only to payments for qualified basic
research performed under a written contract by the following organizations:
educational institutions, nonprofit scientific research organizations (excluding private
foundations), and certain grant-giving organizations.
Firms conducting their own basic research may not claim the credit for their
expenditures for this purpose, but the spending can be included in their QREs for the
regular credit, AIRC, or ASIC. In addition, basic research payments eligible for the
credit that fall below the base amount are treated as contract research expenses and
may be included in the QREs for any of those credits.
Energy Research Credit
Under IRC section 41(a)(3), business taxpayers may claim a tax credit equal to
20% of payments to certain entities for energy research. To qualify for the credit, the
payments must be made to a non-profit organization exempt from taxation under IRC
section 501(a) and “organized and operated primarily to conduct energy research in
the public interest.” In addition, at least five discrete entities must contribute funds
to the organization for energy research in a calendar year; none of these entities may
account for more than half of total payments to the organization for such research.
The credit also applies to the full amount (i.e., 100%) of payments to colleges
and universities, federal laboratories, and certain small firms for energy research
performed under contract. In the case of small firms performing this research, a
business taxpayer may claim a credit for the full amount of payments under two
conditions only. First, the taxpayer cannot own 50% or more of the stock of the
small firm performing the research (if the firm is a corporation), or 50% or more of
the small firm’s capital and profits (if the firm is a non-corporate entity such as a
partnership). Second, the firm performing the research must have an average of 500
or fewer employees in one of the two previous calendar years.
Because the credit is flat rather than incremental, it is more generous than the
other four components of the research tax credit.
Legislative History of the Research Tax Credit
The research tax credit entered the tax code as a temporary provision through
the Economic Recovery Tax Act of 1981 (P.L. 97-34). In adopting the credit, the 97th
Congress was looking for ways to stem a decade-long decline in spending on R&D
by the private sector as a share of U.S. gross domestic product that commenced in the
late 1960s. Around the time the credit was enacted, more than a few analysts thought
the decline contributed to a slowdown in U.S. productivity growth and a surprising
loss of competitiveness by a variety of U.S. industries in the 1970s. A majority in
Congress concluded that a “substantial tax credit for incremental research and
experimental expenditures was needed to overcome the reluctance of many ongoing



companies to bear the significant costs of staffing and supplies, and certain
equipment expenses such as computer charges, which must be incurred to initiate or
expand research programs in a trade or business.”14
The initial credit was equal to 25% of qualified research spending above a base
amount, which was equal to average spending on such research in the three previous
tax years, or 50% of current-year spending, whichever was greater. It is not clear
from the historical record why a statutory rate of 25% was chosen. But there is no
evidence that the rate was chosen on the basis of a rigorous assessment of the gap
between private and social returns to business R&D investment, or the sensitivity of
R&D expenditures to declines in their after-tax cost. Any taxpayer that claimed the
credit and was unable to apply the entire amount against its current-year federal
income tax liability was allowed to carry the unused portion back as many as three
tax years, or forward as many as 15 tax years. The credit was supposed to remain in
effect from July 1, 1981, to December 31, 1985.
Congress made the first significant changes in the original research tax credit
with the passage of the Tax Reform Act of 1986 (TRA86, P.L. 99-514). Among the
many significant changes it made in the federal tax code, the act extended the credit
through December 31, 1988, and folded it into the general business credit under IRC
section 38, thereby subjecting it to a yearly cap. In addition, the act lowered the
credit’s statutory rate to 20%, modified the definition of QREs so that the credit
applied to research intended to produce new technical knowledge deemed useful in
the commercial development of new products and processes, and created a separate
20% incremental tax credit for payments to universities and certain other nonprofit
organizations for the conduct of basic research under a written contract. The
reduction in the credit’s rate appeared not to be based on any rigorous analysis of the
credit’s effectiveness in the first five years. Rather, it seemed to flow from the
overriding goals of TRA86, which were to lower income tax rates across the board,
broaden the income tax base, and shrink the differences in tax burdens among major
categories of business assets. Firms investing in R&D already benefitted from the
option to expense qualified R&D spending under the IRC section 174 expensing
al l o wance. 15
The regular research and basic research credits were further altered by the
Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647). Specifically, the
act extended the credits through December 31, 1989. It also curtailed the overall tax
preference for private-sector R&D investment by requiring business taxpayers to
reduce any deduction they claim for research spending under IRC section 174 by half
of the total amount of any regular and basic research credits they claim. This new


14 U.S. Congress, Joint Committee on Taxation, General Explanation of the Economic
Recovery Tax Act of 1981, joint committee print, 97th Cong., 1st sess. (Washington: GPO,

1981), p. 120.


15 U.S. Congress, General Explanation of the Tax Reform Act of 1986, joint committee print,

100th Cong., 1st sess. (Washington: GPO, 1987), p.130.



rule decreased the maximum effective rate of the regular research tax credit by a
factor equal to 0.5 times a taxpayer’s marginal income tax rate.16
Continuing disappointment with the design of the original credit among
interested parties led to the enactment of additional significant changes in the regular
credit through the Omnibus Budget Reconciliation Act of 1989 (OBRA89, P.L. 101-
239). Much of the disappointment stemmed from the formula for determining the
base amount of the credit. Critics rightly pointed out that under the formula, which
was based on a three-year moving average of a firm’s annual spending on qualified
research, an increase in a firm’s research spending in one year would increase its base
amount in each of the following three years by one-third of that increase in research
spending, making it more difficult to claim the credit in those three years. Some
argued that such a design would be less cost-effective in boosting business R&D
investment than one in which a firm’s base amount was independent of its current
spending on qualified research.17
To address this concern, OBRA89 changed the formula for the base amount so
that it was equal to the greater of 50% of a firm’s current-year QREs, or the product
of the firm’s average annual gross receipts in the previous four tax years and a
“fixed-base percentage.” The act set this percentage equal to the ratio of a firm’s
total QREs to total gross receipts in the four tax years from 1984 to 1988, capped at
16%. OBRA89 also made the credit available on more favorable terms to start-up
firms, which it defined as firms without gross receipts and QREs in three of the four
years from 1984 to 1988; these firms were assigned a fixed-base percentage of 3%.
In addition, the act effectively extended the credits to December 31, 1990 (by
requiring that QREs incurred before January 1, 1991, be prorated), permitted firms
to apply the regular credit to QREs related both to current lines of business and
possible future lines of business, and required firms claiming the regular and basic
research credits to reduce any deduction they claim under IRC section 174 by the
entire amount of the credits.
In 1990 and 1991, Congress passed two bills that, among other things,
temporarily extended the credits. The Omnibus Budget Reconciliation Act of 1990
(P.L. 101-508) extended the credits through December 31, 1991, and repealed the
requirement that QREs made before January 1, 1991, be prorated. The Tax
Extension Act of 1991 (P.L. 102-227) pushed the expiration date for the credits
ahead to June 30, 1992. A major obstacle to longer extensions of the credits at the
time lay in congressional budget rules requiring that the revenue cost of lengthy or
permanent extensions be estimated over 10 fiscal years and offset with tax increases
or cuts in non-defense discretionary spending.
Although Congress passed two bills in 1992 that would have extended the
credits beyond June 30 of that year, President George H. W. Bush vetoed both for


16 For a business taxpayer in the 30% tax bracket, the rule reduced the maximum effective
rate of the regular research credit from 20% to 17.5%: .20 x [1 - (.5 x .30)].
17 See U.S. Congress, Joint Economic Committee, The R&D Tax Credit: An Evaluation of
Evidence on Its Effectiveness, joint committee print, 99th Cong., 1st sess. (Washington: GPO,

1985), pp. 17-22.



reasons that had nothing to do with the design or incentive effects of the credits. As
a result, they expired and remained unavailable from July 1, 1992, until the
enactment of the Omnibus Budget Reconciliation Act of 1993 (OBRA93, P.L. 103-

66) in August 1993. The act extended the credits retroactively from July 1, 1992,


through June 30, 1995. It also modified the fixed-base percentage for start-up firms.
Under OBRA93, a firm lacking gross receipts in three of the years from 1984 to 1988
was assigned a percentage of 3% for the first five tax years after 1993 in which it
reported QREs. Starting in the firm’s sixth year, the percentage was to adjust
gradually so that by its eleventh year the percentage would reflect its actual ratio of
total QREs to total gross receipts in five of the previous six tax years.
Congressional inaction allowed the credits to expire again on June 30, 1995.
They remained inactive until the enactment of the Small Business Job Protection Act
of 1996 (P.L. 104-188) in August 1996. The act retroactively reinstated the credits
from July 1, 1996, to May 31, 1997, leaving a one-year gap in the credit’s coverage
since its inception in mid-1981. It also expanded the definition of a start-up firm to
include any firm whose first tax year with both gross receipts and QREs was 1984
or later, added an alternative incremental research credit (i.e., the AIRC) with initial
rates of 1.65%, 2.2%, and 2.75%, and made 75% of payments for qualified research
performed under contract by nonprofit organizations “operated primarily to conduct
scientific research” eligible for the regular or alternative incremental credits.
The credits expired again in 1997, but they were extended retroactively from
June 1, 1997, to June 30, 1998, by the Taxpayer Relief Act of 1997 (P.L. 105-34).
A further extension of the credits to June 30, 1999, was included in the revenue
portion of the Omnibus Consolidated and Emergency Supplemental Appropriations
Act, 1998 (P.L. 105-277).
In a reprise of events in 1997, the credits expired yet again in 1999. But
Congress passed a measure late in the year reinstating them retroactively. Under the
revenue portion of the Ticket to Work and Work Incentives Improvement Act of

1999 (P.L. 106-170), the credits were extended from July 1, 1999 to June 30, 2004.


The act also increased the three rates of the AIRC to 2.65%, 3.2%, and 3.75% and
expanded the definition of qualified research to include qualified research performed
in Puerto Rico and the other territorial possessions of the United States.
On October 4, 2004, President George W. Bush signed into law the Working
Families Tax Relief Act of 2004 (P.L. 108-311), which included a provision
extending the research tax credit through December 31, 2005.
The Energy Policy Act of 2005 (P.L. 109-58) added a fourth component to the
research tax credit by establishing a credit equal to 20% of all payments for energy
research performed under contract by qualified research consortia, colleges and
universities, federal laboratories, and eligible small firms.
As a result of the Tax Relief and Health Care Act of 2006 (P.L. 109-432), the
research tax credit was extended retroactively through the end of 2007. The act also
raised the three rates for the AIRC to 3%, 4%, and 5%, and established a new
research tax credit, known as the alternative simplified credit (or ASIC). This fifth
component of the credit is equal to 12% of QREs in excess of 50% of average QREs



in the past three tax years; for business taxpayers with no QREs in any of the three
preceding tax years, the credit is equal to 6% of QREs in the current tax year.
Finally, the Emergency Economic Stabilization Act of 2008 (P.L. 110-343)
retroactively extended the credit through 2009, among other things. It also raised the
rate of the ASIC from 12% to 14% and repealed the AIRC for the 2009 tax year only.
Beginning in the mid-1990s, a cycle emerged every time the credits were about
to expire. The cycle commences when congressional and business supporters of the
credit issue public statements calling for a permanent extension of the credits and
denouncing what they see as the folly of repeated temporary extensions.18 Then the
President in office when the cycle begins expresses backing for such an extension.
In the next stage of the cycle, leaders in both houses of Congress enter into
negotiations on tax legislation that includes a permanent extension of the credit. But
in the end, Congress and the President can agree only on a relatively short extension
of the credit, stymied by the difficulty of reconciling the revenue cost of a permanent
extension with their other budget priorities.
Effectiveness of the Research Tax Credit
For analysts and lawmakers alike, the most important policy issue raised by the
research tax credit concerns how effective it has been in the more than 25 years of its
existence. There are two basic approaches to assessing the credit’s effectiveness.
Among economists, the preferred approach is to compare the social benefit from
any added R&D stimulated by the credit with the social cost of that R&D. Such an
ambitious undertaking involves comparing the returns to society of the additional
R&D spending spurred by the credit with the opportunity costs to society of the
resources represented by this added R&D. The social cost of the credit can be
thought of as the net loss of tax revenue because of the credit and the public and
private costs of administering the credit. Unfortunately, this approach to assessing
the effectiveness of the research tax credit is of limited usefulness in policymaking,
largely because it is exceedingly difficult to measure accurately the social returns to
R&D.19
As a result, economists have tended to rely on a less sweeping and rigorous
approach: estimating the additional R&D (if any) stimulated by the regular credit,
and comparing the value of that R&D with the tax revenue lost because of the credit.


18 Martin A. Sullivan, “Research Credit Hits New Heights, No End in Sight,” Tax Notes, vol.

94, no. 7, February 18, 2002, p. 801.


19 The principal barriers to measuring the social returns to R&D are developing adequate
price indices for the cost elements of R&D for specific industries, specifying the time period
in which to assess the productivity gains from R&D, and determining the depreciation rate
for a society’s stock of R&D assets. For a detailed discussion of these issues, see Bronwyn
H. Hall, “The Private and Social Returns to Research and Development,” in Technology,
R&D, and the Economy, Bruce L. Smith and Claude E. Barfield, eds. (Washington:
Brookings Institution, 1996), pp. 141-145.

Such an approach examines the direct benefits (i.e., added R&D investment) and
costs (revenue loss) of the regular credit. It presupposes that the social returns to
R&D far exceed the private returns, and that the optimal size of any tax subsidy for
R&D can be estimated. The approach also sheds light on another policy issue raised
by research tax credits: namely, whether they are more cost-effective than direct
research subsidies such as government grants or subsidized loans. If the added R&D
stimulated by the regular credit were to exceed its revenue cost, then a case could be
made that a research tax credit is a more cost-effective way to boost overall R&D
investment than direct research subsidies. But if the revenue cost of the regular credit
were greater than the added R&D it engenders, then one can argue that direct
research subsidies are more cost-effective than tax subsidies in boosting overall R&D
investment.20
What do existing studies of the regular credit’s effectiveness say about its direct
benefits and costs? For the most part, these studies are an exercise in counterfactual
analysis. They attempt to answer the following question: how much more R&D did
firms claiming the credit perform as a result of the credit? Researchers use a variety
of methods to estimate the amount of R&D that can be attributed to the regular credit.
These methods were examined in a 1995 study by economist Bronwyn Hall.21 She
found that studies based on data from 1981 to 1983 differed markedly from those
based on data from 1984 and after. More specifically, she found that the earlier set
of studies produced lower estimates of the additional R&D undertaken per dollar of
the credit than the estimates produced by the later set of studies. In light of the
strengths and weaknesses of both sets of studies, Hall concluded that the credit
contributed to a “dollar-for-dollar increase in reported R&D spending on the
margin.”22 This meant that each dollar of the credit stimulated an additional dollar
of business R&D investment.
In theory, the credit stimulates increased business R&D investment by lowering
the after-tax cost of undertaking another dollar of R&D beyond some normal (or
base) amount. It is reasonable to expect firms investing in R&D to respond to this
reduction in cost by spending more on R&D, all other things being equal. So the
critical considerations in estimating the amount of business R&D investment that is
due to the credit are the responsiveness of business R&D investment to decreases in
its after-tax cost, and the extent to which the credit lowers the after-tax cost of
business R&D.
Relatively little research has been done on how responsive business R&D
investment is to changes in its after-tax cost. The standard measure of this sensitivity
is known as the price elasticity of R&D demand. Existing studies have come up with
estimates of the long-run price elasticity ranging from -0.2 to -2.0. These results


20 This argument assumes that government research grants to the private sector do not lead
firms receiving the grants to reduce their own R&D spending by similar amounts.
21 See Bronwyn H. Hall, Effectiveness of Research and Experimentation Tax Credits:
Critical Literature Review and Research Design, report prepared for the Office of
Technology Assessment, June 15, 1995, pp. 11-13, available at [http://elsa.berkeley.edu/~
bhhall/papers/BHH95%20OT Artax.pdf].
22 Ibid., p. 18.

imply that a decline in the after-tax cost of R&D of 10% can be expected to produce
a rise in R&D spending in the long run of anywhere from 2% to 20%. In an analysis
of the President Bush’s FY2004 budget proposal, the Joint Tax Committee noted that
“the general consensus when assumptions are made with respect to research
expenditures is that the price elasticity of research is less than -1.0 and may be less
than -0.5.”23
As the main findings of Bronwyn Hall’s 1995 study (cited above) suggest, less
uncertainty surrounds the extent to which the regular credit shrinks the after-tax cost
of qualified research. Basically, one dollar of the credit reduces this cost by one
dollar. By making such a credit available, the federal government (or U.S. taxpayers)
effectively shares the cost of qualified research with the private firms financing it.
Thus, a measure of the overall reduction in the after-tax cost of domestic business
R&D investment as a result of the credit is the credit’s average effective rate, which
is measured as the ratio of the total amount of claims for the credit in a year to some
measure of domestic business R&D spending, such as QREs.
This rate can be computed for both QREs and total business R&D spending. As
Table 3 shows, the average effective rate of the credit from 1997 to 2005 was 3.3%
for industrial R&D spending and 5.3% for QRE. These rates indicate that the credit
has lowered the after-tax cost of domestic business R&D by about 3% and the after-
tax cost of qualified research by slightly more than 5%.
The gap between the rates largely reflects the differences between QREs and
industry R&D spending, as estimated by the National Science Foundation (NSF).
Aggregate QREs amounted to 63% of aggregate business R&D spending from 1997
to 2005. The NSF estimate pertains to all domestic R&D performed by firms and
funded by industry and other non-federal entities. It is based on annual surveys of
R&D in industry and covers the wages, salaries, and fringe benefits of research
personnel, and the cost of materials and supplies, overhead expenses, and
depreciation related to research activities. The estimate excludes expenditures on
plant and equipment used in research.24 By contrast, QREs represent total spending
on qualified research that is eligible for the credit. They are reported on the tax
returns business taxpayers claiming the credit and cover wages and salaries, materials
and supplies, leased computer time, and 65% to 75% of contract research funded by
these entities. Given the differences between the two sources, one would expect
industry R&D spending to be greater than QREs, as it covers a broader segment of
R&D expenses than QREs.
What can be said about the impact of the regular credit on domestic R&D? The
figures in Table 3 indicate that the credit delivered no more than a modest stimulus
to domestic business R&D investment from 1997 to 2005. Specifically, assuming


23 U.S. Congress, Joint Committee on Taxation, Description of Revenue Provisions
Contained in the President’s Fiscal Year 2004 Budget Proposal, joint committee print, JCS-thst

7-03, 108 Cong., 1 sess. (Washington, March 2003), p. 250.


24 National Science Foundation, Division of Science Resource Statistics, The Methodology
Underlying the Measurement of R&D Expenditures: 2000 (data update) (Arlington, VA:
December 10, 2001), p. 2.

that the price elasticity of demand for R&D falls between -0.5 and -1.0, and lowers
the cost of business R&D investment by 3.3%, the credit may have raised business
R&D investment by 1.65% to 3.3% over that period.
Table 3. U.S. Industrial R&D Spending, Federal R&D Spending,
and the Research Tax Credit, 1997 to 2005
($ billions)
1997 1998 1999 2000 2001 2002 2003 2004 2005
Industrial
R&D a 133.6 145.0 160.3 180.4 181.6 177.5 183.3 188.0 204.0
Sp end i ng
Qualified
Research b 85.3 95.9 102.7 109.9 99.8 116.1 124.5 116.1 129.8
Sp end i ng
Fed e r a l
R&D c 73.5 75.3 80.3 83.1 91.2 102.0 117.4 125.3 129.9
Sp end i ng
Current-
Year 4.5 5 .3 5.3 7 .2 6.5 5 .8 5.6 5 .6 6.4
Research d
Tax Credit
Source: National Science Foundation, Division of Science Resources Statistics, InfoBrief: Increase
in U.S. Industrial R&D Expenditures Reported for 2003 Makes Up For Earlier Decline; National
Science Foundation, Division of Science Resources Statistics, Survey of Federal Funds for Research
and Development: Fiscal Years 2000, 2001, and 2002; Internal Revenue Service, Statistics of Income
Division, e-mail data transmissions.
a. Total spending on domestic industrial R&D by companies and other non-federal entities, including
nonprofit organizations and state and local governments.
b. Spending on research that qualifies for the regular and alternative incremental research tax credits
as reported by business taxpayers claiming the credit on their federal income tax returns.
c. Budget authority for Federal defense and non-defense R&D spending by fiscal year.
d. Total value of claims for the regular, incremental and basic research tax credits included on federal
income tax returns. Because of limitations on the use of the general business credit, of which
the research credit is a component, the total amount of the research credit allowed in a particular
year is likely to differ from the amount claimed.
Policy Issues Raised by the
Current Research Tax Credit
Most policy analysts and lawmakers endorse the use of tax incentives to spur
increased domestic business R&D investment. Yet the current research tax credit
seems to attract more criticism than praise. A major concern of critics is that the
credit is not as effective as it should be because of what they say are flaws in its
design. In their view, the credit will have its intended benefits only if these flaws are
corrected. Critics blame what they claim is the credit’s relatively weak incentive
effect on five shortcomings in particular: (1) the credit is not a permanent provision
of the IRC; (2) it still has weak and arbitrary incentive effects; (3) it is not refundable;
(4) the definition of qualified research remains incomplete and too ambiguous; and



(5) the credit is not targeted at R&D investments that generate greater social returns
than private returns. Each problem is examined below.
Lack of Permanence
The research tax credit is due to expire on December 31, 2009. Several
proposals to extend it permanently are being considered in the current Congress —
a step that the Bush Administration supports. The credit has never been a permanent
provision of the IRC, despite repeated attempts in Congress to extend it permanently
in the past decade.25 In fact, the credit has been extended 13 times, most recently by
the Emergency Economic Stabilization Act of 2008.
This lack of permanence is a matter of concern to many because it is thought to
weaken the credit’s incentive effect. Many R&D projects have planning horizons
extending beyond a few years. If business managers cannot count on receiving the
credit over the expected life of an R&D project, then they are unlikely to take it into
account when setting the size of annual R&D budgets. In such a situation, the credit
would have little or no influence over R&D investment decisions, defeating its
purpose. Instead of boosting R&D investment, a temporary R&D tax credit might
end up restraining it by compounding the uncertainty that characterizes projected
after-tax returns on planned R&D investments. This heightened uncertainty may
deter managers from pursuing R&D projects they would be likely to undertake if the
credit were permanent.
However, there are reasons to think that not all firms investing in R&D may be
affected in the same way by a temporary research tax credit. Firms with relatively
long R&D planning horizons and relatively high fixed costs for R&D investment
might show more sensitivity to uncertainty in the availability of a research tax credit
than firms with shorter horizons and more flexible investment costs. For example,
it is conceivable (though hard to prove) that a string of temporary credits could cause
pharmaceutical firms to expand their research budgets at a slower rate than software
firms, for the simple reason that pharmaceutical R&D projects, on average, have
longer planning horizons and require greater initial investments in plant and
equipment than do software R&D projects.
Weak and Uneven Incentive Effects
Critics maintain that another major flaw in the credit can be found in its
incentive effect. In their view, this effect varies among firms conducting qualified
research in ways that are not supported by economic theory and undermines the
credit’s purpose. The credit’s incentive effect is also thought to be too weak to induce
the increases in business R&D investment warranted by its social returns. Critics
attribute these shortcomings to the design of the regular, AIRC, ASIC, and basic
research components of the credit.


25 The R&E tax credit has been in effect for each year between July 1, 1981, and the present
except for period from July 1, 1995, to June 30, 1996, when it expired. Since July 1, 1996,
the credit has not been renewed to include this period.

Uneven Incentive Effect. The regular credit’s incentive effect appears to
vary widely among firms investing in qualified research, including those that
gradually increase their R&D investment over an extended period. Evidence for such
variation can be found in a 1996 study by economist William Cox of firms that
examined which of a large group of domestic corporations with sizable research
budgets in 1994 should have be able to claim the regular research tax credit.
The study is based on a sample of 900 publicly traded U.S.-based firms with the
largest R&D budgets, culled from a database maintained by Compustat, Inc. On the
plausible assumption that QREs for these firms in 1994 were equal to 70% of their
reported R&D spending, Cox estimated that 62.5% of the firms could be considered
established firms for the purpose of claiming the regular research tax credit, because
they had both business revenue and QREs in three of the years from 1984 to 1988;
the remainder were treated as start-up firms. Cox found that 78% of the 900 firms
in the sample (44.4% of the established firms and 33.5% of the start-up firms) could
have claimed the credit in 1994, while 22% could have claimed no credit (18% of26
established firms and 4% of start-up firms). He also found that 34% of all firms
(32.3% of established firms and 1.7% of start-up firms) had QREs greater than their
base amounts but less than twice those amounts, allowing them to claim credits with
a marginal effective rate of 13%, and that 43.8% of all firms had QREs greater than
double their base amounts, allowing them to claim credits with a marginal effective
rate of 6.5%.27 These rates measure the reduction in the after-tax cost of qualified
research as a result of the regular credit. In addition, Cox determined that some of
the most research-intensive firms could claim either no credit, or they could claim
credits with a marginal effective rate half as large as the rate of the credits that could
be claimed by firms with much lower research intensities.
The results seemed to confirm a concern raised by the current regular credit:
that it was most beneficial to firms whose research intensities had grown since their
base periods and least beneficial to firms whose research intensities had changed
little, not at all, or shrunk since their base periods. Most firms whose research
intensities had declined found themselves in that position for two reasons: (1) their
R&D spending was lower in 1994 than in their base period; or (2) their sales revenue
had grown faster than their R&D expenditures over the same period.
Critics of the regular credit say that the pattern of R&D subsidization found in
the Cox study is unfair and arbitrary, has no justification in economic theory, and
undercuts the intended purpose of the credit, which is to encourage firms to spend
more on R&D than they otherwise would. Cox concluded that the wide variation in
the marginal effective rates of the research tax credit that firms in his study could
claim suggested “that society places a higher value on adding R&D at certain firms


26 CRS Report 96-505, Research and Experimentation Tax Credits: Who Got How Much?
Evaluating Possible Changes, by William A. Cox, pp. 5-10. (The report is out of print.
Copies may be obtained from Gary Guenther (202) 707-7742, upon request.) (Hereafter
cited as Cox, Research and Experimentation Tax Credits.)
27 Their effective credit rate was lower because each firm was subject to the 50-percent rule,
which reduced the marginal effective rate of the credit on R&D spending above the base
amount by 50%.

than at others and on adding R&D of certain types than others, when little or no basis
for such different valuations exists.”28
Two rules governing the use of the regular credit explain most of its disparate
incentive effects: (1) the rule requiring the base amount for the regular credit to be
equal to 50% or more of QREs, and (2) the rule requiring established firms to use a
fixed-base period of 1984 to 1988 in computing their fixed-base percentages.
In combination, the two rules can produce strikingly disparate outcomes in the
use of the regular credit among firms spending substantial amounts on R&D. Of
particular concern to critics are firms whose research-intensity (as measured by
spending on R&D as a share of revenue) has shrunk over time. The structure of the
U.S. economy can and does change markedly in a period of 20 or so years; so it is
very likely that economic and competitive conditions in R&D-intensive industries
today bear little resemblance to the conditions that prevailed in the same industries
in the mid-to-late 1980s. Most of the firms that have stayed intact since the early
1980s and invested heavily in R&D as a share of revenue at that time presumably
face a much different competitive landscape and climate for R&D investment and
growth. In some cases, these changed circumstances have led established firms to
invest less in R&D as a share of revenues. Firms in this position may not be able to
claim the regular research credit, even if they spend relatively large sums on R&D.29
Weak or Inadequate Incentive Effect. In claiming that the regular credit’s
incentive effect is inadequate, critics are referring both to the credit rate deemed
essential to raise business R&D investment to socially optimal amounts, and to
differences between the regular credit’s statutory rate and its average marginal
effective rate. Both aspects of the regular credit’s incentive effect are examined here.
Current R&D Tax Incentives are Inadequate. Critics maintain that the
average effective rate of the regular credit is too low to boost business R&D
investment to amounts commensurate with its overall economic benefits. To lend
empirical support to this contention, they point to another study by Cox, one that
focused on the efficacy of the research tax credit.30 Cox built his analysis around the
premise that tax incentives can overcome the private sector’s inclination to invest too
little in the creation of new technical knowledge and know-how. For tax incentives
to have this effect, they must be designed so they subsidize R&D spending above and
beyond what firms would undertake on their own, and they must be large enough to
“raise private after-tax returns on R&D investments to the levels that would result


28 Cox, Research and Experimentation Tax Credits, p. 10.
29 Two examples are aerospace and semiconductor chip manufacturers. See McGee Grisby
and John Westmoreland, “The Research Tax Credit: A Temporary and Incremental
Dinosaur,” Tax Notes, vol. 93, no. 12, December 17, 2001, p. 1633.
30 See CRS Report 95-871, Tax Preferences for Research and Experimentation: Are
Changes Needed? by William A. Cox. (This report is out of print. Copies may be obtained
from Gary Guenther at (202) 707-7742, upon request.) (Hereafter cited as Cox, Tax
Preferences for Research and Experimentation.)

from applying the same rate of taxation to the social rate of return from R&D.”31 A
variety of studies have concluded that the median private rate of return on R&D
investment is roughly 50% of the median social rate of return.32 Thus, assuming that
the average social pre-tax rate of return is two times the average private pre-tax rate
of return, the optimal R&D tax subsidy would double the private after-tax rate of
return to R&D investment. For example, given a corporate tax rate of 35%, after-tax
returns would equal 65% of pre-tax returns for corporations. In this case, the optimal
R&D tax subsidy would double the private after-tax returns to R&D investment by
increasing them to 130% of pre-tax returns [2 x (1 - 0.35)].
Cox’s analysis implied that the optimal average effective rate for an R&D tax
subsidy, or a combination of such subsidies (e.g., a research tax credit combined with
the treatment of research expenditures as a current business expense), was 30%. In
discussing the policy implications of this finding, Cox noted that such a rate is an
average and thus would not address the considerable variation among R&D
investments in the difference between private and social returns. So using tax
incentives to boost pre-tax returns on R&D investment by 30% across all industries
would provide excessive subsidies for projects with below-average spillover benefits
and insufficient subsidies for projects with above-average spillover benefits.
According to Cox, lawmakers should be aware that “this imprecision is unavoidable,
and its consequences are hard to assess.”33
How do existing federal tax subsidies for R&D investment compare with Cox’s
assessment of the optimal R&D tax subsidy? To determine the incentive effect of
current federal subsidies, he estimated the pre-tax and after-tax rates of return under
1995 federal tax law for a variety of hypothetical R&D projects. The projects
differed in the share of R&D expenditures devoted to depreciable assets like
structures and equipment, the share of R&D expenditures eligible for both expensing
under IRC section 174 and the regular research tax credit, and the economic lives of
the intangible assets created by the investments. Cox compared the combined effect
of expensing and the credit on after-tax returns to investment in capital-intensive,
intermediate, and labor-intensive R&D projects producing intangible assets with
economic lives of 3, 5, 10, and 20 years.34
Expensing equalizes the pre-tax and after-tax rates of return on an investment,
since it taxes the income earned by affected assets at a marginal effective rate of


31 Ibid., p. 8.
32 See, for example, Edwin Mansfield, The Positive Sum Strategy, pp. 309-311.
33 Ibid., p. 9.
34 In the case of capital-intensive projects, 50% of outlays go to structures and equipment,
35% qualify for expensing and the credit, and 15% qualify for expensing alone. In the case
of intermediate projects, 30% of outlays go to structures and equipment, 50% qualify for
expensing and the credit, and 20% qualify for expending alone. And in the case of labor-
intensive projects, 15% of outlays go to structures and equipment, 65% qualify for
expensing and the credit, and 20% qualify for expensing only.

zero.35 For the typical business R&D investment, it is likely that only part of its total
cost may be expensed under IRC section 174, as tangible depreciable assets like
structures and equipment do not qualify for such treatment. Therefore, how
expensing affects an R&D investment’s after-tax rate of return depends on two
factors: (1) the percentage of the total cost that may be expensed, and (2) the
marginal effective tax rate on income earned by the assets (including labor) eligible
for expensing.
The regular research tax credit raises the after-tax rate of return only on QREs
above a base amount. So its effect on the after-tax returns to an R&D investment
depends on both the percentage of the investment’s total cost that qualifies for the
credit and the effective tax rate on income earned by assets eligible for the credit.
Taking into account these limitations on the benefits of expensing and the
regular credit, Cox estimated that expensing and the credit together produce median
after-tax rates of return ranging from 101.0% of pre-tax returns for a hypothetical
capital-intensive project yielding intangible assets with an economic life of 20 years
to 124.7% for a hypothetical labor-intensive project yielding intangible assets with
an economic life of three years.36 As these percentages are less than 130%, he
inferred that the R&D tax subsidies in existence in 1995 did not increase private
after-tax returns to R&D investments to the “levels warranted by the spillover
benefits that are thought to be typical” for these investments.37
Significant Gap Between the Credit’s Average Effective Rate and
Its Statutory Rate. Some critics of the current research tax credit see the credit’s
incentive effect in a somewhat different light. For them, what counts most is any
difference between the regular credit’s average effective rate and its statutory rate of
20%. As noted earlier, whatever difference exists is due to three of the rules
governing the use of the credit.
One of the rules is the basis adjustment under IRC section 280C(c)(1), which
requires business taxpayers investing in qualified research to reduce whatever
deduction for research expenditures under IRC section 174 they claim by any
research tax credit they claim. This adjustment effectively taxes the credit at a firm’s
marginal income tax rate. Consequently, for business taxpayers subject to the
maximum corporate and individual tax rates of 35%, the basis adjustment decreases
the marginal effective rate of the credit from 20% to 13%. Business taxpayers have
the option of computing the regular research credit at a rate of 13% and not adjusting
any deduction taken under section 174 by the amount of the credit.
A second rule is the 50% rule, which requires that the base amount for the
regular credit equal 50% or more of a firm’s current-year QREs. The rule makes the
credit less beneficial to established firms whose ratio of current-year QREs to gross


35 See Jane G. Gravelle, “Effects of the 1981 Depreciation Revisions on the Taxation of
Income from Business Capital,” National Tax Journal, vol. 35, no. 1, March 1982, pp. 2-3.
36 Cox, Tax Preferences for Research and Experimentation, p. 15.
37 Ibid., p. 17.

income is more than double their fixed-base percentages, or more than double the

16% cap on the fixed-base percentage. It also makes the credit less attractive to start-


up firms whose current-year ratio of QREs to gross income exceeds 6% during their
first five tax years, or whose current-year ratio is more than double their fixed-base
percentages in the next six tax years. For both sets of firms, the rule further reduces
the marginal effective rate of the credit to 6.5%.
A third rule affecting this rate is the exclusion of expenditures for equipment
and structures and overhead costs from expenses eligible for the regular credit —
even though many business R&D investments involve the purchase of elaborate
buildings and sophisticated equipment, and all R&D projects entail overhead costs.
The effect of the exclusion on the marginal effective rate of the credit depends on the
overall share of an R&D investment that is ineligible for the credit. As this share
rises, the rate drops, all other things being equal. For example, if expenditures for
physical capital account for half of the cost of an R&D investment, then the marginal
effective rate of the credit for the entire investment is half of what it would be if the
entire cost were eligible for the credit. For firms subject to the 50% rule that invest
in R&D projects where physical capital represents 50% of the total cost, the marginal
effective rate of the credit could fall to 3.25%.
As these considerations suggest, the key to bolstering the regular credit’s
incentive effect is to increase its average effective rate. In essence, there are two
ways to do so. One is to keep its current statutory rate and modify one or more of the
three rules driving a wedge between the credit’s marginal effective rate and its
statutory rate. The second approach is to retain these rules but increase the credit’s
statutory rate.
Cox analyzed the effect of both options on after-tax rates of return for the same
set of hypothetical R&D investments discussed above. In the case of labor-intensive
R&D projects, he estimated that 1995 research tax preferences produced median
after-tax returns that were 124.7% of pre-tax returns for projects yielding intangible
assets with an economic life of three years, and 115.5% for projects yielding
intangible assets with an economic life of 20 years. Repealing the basis adjustment
for the credit caused median after-tax returns to increase to 146.0% of pre-tax returns
for assets with a three-year economic life, and 130.1% for assets with a 20-year
economic life.38 Increasing the statutory rate of the credit to 25% but retaining
existing rules (including the basis adjustment) led to similar results: median after-tax
returns for assets with a three-year economic life were an estimated 133.9% of pre-
tax returns, and an estimated 121.9% for assets with a 20-year economic life.39 As
one might expect, increasing the rate to 25% and removing the basis adjustment led
to the biggest boost in the ratio of after-tax returns to pre-tax returns: 165.8% for
assets with a three-year economic life, and 143.4% for assets with a 20-year
economic life.
Assuming that the optimal R&D tax subsidy would raise after-tax returns to

130% of pre-tax returns, Cox’s analysis suggested that keeping the regular credit’s


38 Ibid., p. 27.
39 Ibid., p. 27.

statutory rate at the current level of 20% but removing or relaxing the three rules
governing the credit’s use might be the best policy option for significantly boosting
the credit’s incentive effect.
Non-refundable Status
The research tax credit is non-refundable, which means that only firms with
sufficiently large income tax liabilities may benefit from the full amount of the credit
claimed in a tax year. In addition, the credit is a component of the general business
credit (GBC) under IRC section 38, and therefore subject to its limitations. For firms
undertaking qualified research, a key limitation is that the GBC cannot exceed a
taxpayer’s net income tax liability, less the greater of its tentative minimum tax under
the alternative minimum tax or 25% of its regular income tax liability above $25,000.
Unused GBCs may be carried forward 20 years or back one year. Although there are
some advantages to having an inventory of tax credits to apply against future or past
tax liabilities, the advantages do not necessarily outweigh the disadvantages for all
firms investing in R&D. In the case of firms with sizable net operating losses, there
is no certainty that stored credits can be used before they expire. In addition, the time
value of money means that a business taxpayer is better off using the full amount of
a tax credit today, rather than five or 10 years from now.
Critics of the credit’s design contend that its non-refundable status poses a
special problem for small, fledgling research-intensive firms. In recent decades,
numerous commercially successful technological innovations have originated with
such firms. Many of these firms spend substantial sums on R&D during their first
few years, despite experiencing large financial losses. In the view of critics, the
credit’s lack of refundability diminishes the typical small start-up firm’s chances of
survival or growth, as the firm cannot count on the credit to reduce its cost of capital
for R&D investments. Some critics advocate making the credit wholly or partially
refundable for firms under a certain asset, employment size, or age, as a means of
both solving this problem and improving the domestic climate for technological
innovation.40
Unsettled and Ambiguous Definition of Qualified Research
Another important policy issue raised by the current research tax credit relates
to the activities that qualify for it. At its core, the issue concerns the definition of
qualified research and how the IRS and business taxpayers apply it in the real world
of business R&D.
Critics argue that the statutory definition in IRC section 41(d) and IRS
regulations implementing it are vague and incomplete. This lack of clarity and
finality, in their view, often paves the way for protracted and costly disputes between
business taxpayers and the IRS over the validity of claims for the credit. Critics say


40 For further discussion of the possible benefits to small firms of making the credit wholly
or partially refundable, see Scott J. Wallsten, “Rethinking the Small Business Innovation
Research Program,” in Investing in Innovation, Lewis M. Branscomb and James H. Keller,
eds. (Cambridge, MA: MIT Press, 1998), pp. 212-214.

that these disputes can curtail the stimulative effect of the credit by denying the full
benefit of credits claimed by some firms investing in R&D, and by deterring some
other firms investing in R&D from claiming the credit on the grounds that its
potential benefits are dwarfed by the costs associated with IRS scrutiny of claims for
the credit.
Under the original credit, which was in effect from 1981 through 1985, research
expenditures qualified for the credit if they were also eligible for expensing under
IRC section 174. There were three exceptions to this general rule: no credit could
be claimed for research conducted outside the United States, research in the social
sciences or humanities, and any portion of research funded by another entity. Section

174 allows business taxpayers to deduct all “research or experimental expenditures”


incurred in connection with their trade or business, but it does not define these
expenditures.
The IRS filled this gap by issuing regulation 1.174-2(a), which defined research
or experimental expenditures. According to the regulation, these expenditures refer
to “research and development costs in the laboratory sense” and generally include
“all such costs incident to the development or improvement of a product.”
Expenditures can be considered R&D costs in the “experimental or laboratory sense
if they fund activities intended to discover information that would eliminate
uncertainty concerning the development or improvement of a product.” Uncertainty
exists in the R&D process when the information available to researchers does not
indicate how to proceed in developing a new product or improving an existing one.
According to the regulation, the proper focus in determining whether research
expenditures qualify for expensing under section 174 is the “nature of the activity to
which the expenditures relate, not the nature of the product or improvement being
developed.”
Responding to a concern that business taxpayers were claiming the credit for
activities that had more to do with product development than genuine technological
innovation, Congress tightened the definition by adding three tests through the Tax
Reform Act of 1986 (TRA86).41 Under the act, qualified research still had to involve
activities eligible for expensing under section 174. But such activities also had to
satisfy the following criteria:
!they were directed at discovering information that “technological in
nature” and useful in the development of a new or improved
business component of the taxpayer;
!they constituted “elements of a process of experimentation;”
!and they were intended to improve the function, performance,
quality or reliability of a business component.42


41 See P.L. 99-514, Section 231.
42 U.S. Congress, Joint Committee on Taxation, General Explanation of the Tax Reform Act
of 1986, JCS-10-87 (Washington: GPO, 1987), pp. 132-134.

The act defined a business component as “a product, process, computer software,
technique, formula, or invention” held for sale or lease, or to be used by a taxpayer
in its trade or business. It also specified that research aimed at developing new or
improved internal-use software could qualify for the credit only if it met the general
requirements for the credit, was intended to develop software that was innovative and
not commercially available, and involved “significant economic risk.”
In light of the significant changes made by the act, there was a pressing need for
the IRS to issue final regulations clarifying the meaning and limits of the three new
tests for qualified research. But for reasons that are not entirely clear in hindsight,
the IRS did not issue proposed regulations (REG-105170-97) on the tests until
December 1998.
Among other things, they set forth guidelines for determining whether or not a
business taxpayer investing in R&D has discovered information that is “technological
in nature” and “useful in developing a new or improved business component of the
taxpayer” through a “process of experimentation that relates to a new or improved
function, performance, reliability, or quality.” The IRS proposed that research would
meet what became known as the discovery test if it were intended to obtain
“knowledge that exceeds, expands, or refines the common knowledge of skilled
professionals in the particular field of technology or science.” At the same time, the
agency noted that such a standard did not necessarily mean the credit would be
denied in the case of business taxpayers who made technological advances in an
“evolutionary” manner, or business taxpayers who failed to achieve the desired
result, or business taxpayers who were not the first to achieve a certain technological
advance. In addition, the IRS proposed that research would meet the experimentation
test if it were to draw upon the “principles of physical or biological sciences,
engineering, or computer science (as appropriate)” to evaluate “more than one
alternative designed to achieve a result where the means of achieving the result are
uncertain at the outset.” Such an evaluation should involve developing, testing, and
refining or discarding hypotheses related to the design of new or improved business
components.
The release of the proposed regulations unleashed a wave of criticism from the
business community. Much of the dissent focused on the proposed guidelines for
discovering technological information. A widely voiced complaint was that the
common knowledge test violated the intent of Congress and would prove
burdensome and unworkable for tax practitioners because it was too subjective.
Most tax practitioners and business taxpayers who commented on the proposal urged
the IRS to scrap the test.43
After reviewing the many critical comments it received, along with recent case
law and the legislative history of the research tax credit, the IRS issued what it
described as a final set of regulations (T.D. 8930) on the definition of qualified
research in late December 2000. While differing somewhat from the proposed
regulations, the final regulations retained the common knowledge test for


43 Sheryl Stratton and Barton Massey, “Major Changes to Research Credit Rules Sought at
IRS Reg Hearing,” Tax Notes, May 3, 1999, pp. 623-624.

determining whether or not the information gained through research was
technological in nature and useful in the development of a new or improved business
component. But they further clarified the application of the test by noting that the
“common knowledge of skilled professionals in a particular field of science or
engineering” referred to information that would be known by such professionals if
they were to investigate the state of knowledge in a field of science or engineering
before undertaking a research project. The final regulations also carved out a safe
harbor for patents by affirming that a business taxpayer would be presumed to have
passed the common knowledge test if the taxpayer could prove it had been awarded
a patent for a new or improved business component. Moreover, they set down new
standards for determining when the development of computer software for internal
use qualified for the credit. Specifically, research on internal-use software was
eligible for the regular credit or AIRC only if it satisfied the general requirements for
the credits, entailed “significant economic risk,” and led to the development of
innovative software that was not commercially available.
The final regulations seemed to arouse as much opposition within the business
community as the proposed regulations that preceded them. A principal bone of
contention was the IRS’s insistence on retaining the controversial discovery test.
Many tax practitioners also complained that a number of the provisions in the final
regulations were not included in the proposed regulations, precluding public
comment on those provisions.44
These criticisms spurred the IRS to take an unusual procedural step. About one
month after the release of the regulations, the Treasury Department published a
notice (Notice 2001-19) retracting them. The notice also requested further comment
“on all aspects” of the suspended regulations, promised that the IRS would carefully
review all questions and concerns raised about them, and committed the IRS to issue
any changes to the final regulations in proposed form for additional comment.45
In December 2001, the IRS delivered on this promise by releasing more
proposed regulations (REG-112991-01). They departed in some important ways
from previous guidance. Among other things, the regulations jettisoned the
requirement set forth in T.D. 8930 that qualified research seek to discover
“knowledge that exceeds, expands, or refines the common knowledge of skilled
professionals in a particular field of science or engineering.” They also revised the
definition of a process of experimentation so that it was seen as a “process designed
to evaluate one or more alternatives to achieve a result where the capability or the
method of achieving that result, or the appropriate design of that result is uncertain
as of the beginning of the taxpayer’s research activities.” The determination of
whether a taxpayer engaged in such a process should be made on the basis of relevant
facts and circumstances. In addition, the proposed regulations defined internal-use
software as software that is developed not to be sold, leased, or licensed to third
parties and specified that internal-use software is eligible for the credit only if it is


44 David L. Click, “Treasury Discovers Problems With New Research Tax Credit
Regulations,” Tax Notes, March 12, 2001, p. 1531.
45 Sheryl Stratton, “Treasury Puts Brakes on Research Credit Regs; Practitioners Applaud,”
Tax Notes, vol. 90, no. 6, February 5, 2001, pp. 713-715.

intended to be novel in its design or applications. Tax practitioners and business
taxpayers generally welcomed the proposed changes.46
On December 30, 2003, the IRS published still another set of final regulations
(T.D. 9104) clarifying the definition of qualified research and other matters related
to the credit.47 Some analysts viewed them as an attempt by the IRS to follow strictly
congressional intent in altering the definition of qualified research in TRA86.
The regulations specified that information is technological in nature if the
process of experimentation used to discover it relies on the principles of the physical
or biological sciences, engineering, or computer science. They did not retain the
discovery test included in T.D. 8930, but affirmed that taxpayers can be deemed to
have discovered information that is technological in nature by using “existing
technologies.... and principles of the physical or biological sciences, engineering, or
computer science.” Such a discovery would not hinge on whether a taxpayer
succeeds in its quest to develop a new or improved business component. At the same
time, having a patent for a business component would be considered “conclusive
evidence that a taxpayer has discovered information that is technological in nature
that is intended to eliminate uncertainty concerning the development or improvement
of (such a) component.”
In addition, T.D. 9104 sheds additional light on what constituted a “process of
experimentation.” Basically, the regulations noted that such a process had three
critical elements. First, the actual outcome must be uncertain at the outset. Second,
the process must allow researchers to identify more than one approach to achieving
a desired outcome. And third, researchers must use certain scientific methods to
evaluate the efficacy of these alternatives (e.g., modeling, simulation, and a
systematic trial-and-error investigation). The regulations stressed that a process of
experimentation is evaluative in nature, and therefore “often involves refining
throughout much of the process the taxpayer’s understanding of the uncertainty the
taxpayer is trying to address.” A taxpayer’s relevant facts and circumstances should
be considered in determining whether it has engaged in such a process.
Although the regulations clarified a number of important issues regarding the
definition of qualified research, they did not address several other issues that are
important to many firms.
One such issue concerns the circumstances under which spending on the
development of internal-use software can be deemed eligible for the credit. In
proposed regulations issued in 2001, the IRS stated that any costs incurred to develop
such software were eligible for the credit only if the software was intended to be


46 For more details on the latest set of proposed regulations and reactions to them in the
business community, see David Lupi-Sher and Sheryl Stratton, “Practitioners Welcome New
Proposed Research Credit Regulations,” Tax Notes, December 24, 2001, vol. 93, no. 13, pp.

1662-1665.


47 Alison Bennett, “IRS Issues Final Research Credit Rules With Safe Harbor For Qualified
Activities,” Daily Report for Executives, Bureau of National Affairs, December 23, 2003,
p. GG-2.

unique or novel and to differ in a “significant and inventive” way from previous
software. But in the absence of further guidance on the meaning of “significant and
inventive,” disputes between IRS examiners and business taxpayers over the validity
of claims for the credit involving internal-use software are more likely than not. One
analyst has noted that since the release of the final regulations, the IRS has
interpreted the definition of significant and inventive in a way that imposes the same
requirements on the development of internal-use software as the discovery test that
the regulations eliminated.48
Another unresolved issue is the eligibility of research aimed at achieving
significant cost reductions. Cost reduction is not identified in the statute as a purpose
of qualified research, but the research required to lower costs can be as challenging
as research done to improve a business component’s reliability or performance.
Some have pointed out that research that allows a product or process to deliver the
same performance at a reduced cost represents an improvement in performance.49
Yet another unresolved issue with widespread reach is the definition of gross
receipts for an affiliated group of companies. How these receipts are characterized
helps determine a business taxpayer’s base amount for the credit. Contradictory
rulings by the IRS on this issue have caused considerable confusion for some U.S.-
based multinational corporations with majority-owned foreign subsidiaries.50
Lack of Focus on R&D Projects With
Relatively Large Social Returns
In the minds of some critics, another key policy issue raised by the credit relates
to its efficacy in spurring increased business investment in R&D projects yielding
relatively large spillover benefits — or the credit’s “bang for the buck.” They
question whether an additional dollar of the credit leads to more investment in R&D
with relatively high social returns than does an additional dollar of direct government
spending on basic or applied research.
For many analysts and lawmakers, an advantage of the credit over direct
research spending is that private companies, and not the federal government, decide
which R&D projects are subsidized. Under current federal tax law, firms claim the
credit for projects they decide to fund, and the federal government bears some of the
cost.51 The credit, used in combination with the expensing of research spending,
enables market forces to determine which projects are pursued and which are


48 Christopher J. Ohmes, David S. Hudson, and Monique J. Migneault, “Final Research
Credit Regulations Expected to Immediately Affect IRS Examinations,” Tax Notes, February

23, 2004, p. 1024.


49 Michael D. Rashkin, Research and Development Tax Incentives: Federal, State, and
Foreign (Chicago: CCH Inc., 2003), p. 87.
50 Annette B. Smith, “Continuing Uncertainty on Research Credit Definition of Gross
Receipts,” Tax Adviser, vol. 35, no. 7, July 1, 2004, p. 407.
51 Joseph E. Stiglitz, Economics of the Public Sector (New York: W.W. Norton, 2000),
p. 348.

jettisoned. Supporters of the credit believe that such an approach is more likely to
promote greater diversity in the search for new technical knowledge and knowhow
with profitable commercial applications than a direct subsidy such as federal R&D
grants.
But some critics of the credit say that it does an exceptionally poor job of
targeting R&D projects with large external benefits. While there are no known
studies investigating this claim, it seems plausible. In general, business managers
and owners seek the highest possible return on their investments. Consequently, in
selecting R&D projects to pursue, it makes sense that they would assign a higher
priority to projects likely to earn substantial profits for their firms in the short run
than to projects likely to expand the frontiers of knowledge in a scientific field but
to yield relatively meager returns in the short run. Such a predisposition is more than
a matter of speculation. It is reflected in domestic industrial R&D spending: in 2001,
according to data published by the National Science Foundation, U.S. industry spent
a total of $184.9 billion on R&D, of which 5% went to basic research, 22% to
applied research, and 73% to development.52 This allocation reinforces the
impression that the credit is mainly subsidizing R&D projects with relatively modest
social returns.
Some would modify the credit to give firms a stronger incentive to invest in
basic research than in applied research or development. Among the options are
redefining qualified research so that it applies to what is regarded as basic research
only, and altering the basic research credit so that it offers a higher statutory rate than
the regular R&E tax credit to basic research undertaken by a business taxpayer.
In considering whether to modify the credit to make it a more effective tool for
stimulating business investment in R&D projects with relatively high social returns,
lawmakers should keep in mind that the federal government has long served as the
primary source of funding for basic research performed in the United States. In 2004,
the federal government funded 62% of this research, compared to shares of 16% for
industry, 13% for colleges and universities, and 9% for other nonprofit
organizations.53 This preponderance is neither surprising nor unjustified. Most firms
are disinclined to invest more in basic research than applied research or development
for the simple reasons that it is much more difficult to capture all or most of the


52 National Science Foundation, Division of Science Resource Studies, National Patterns
of Research and Development: 2003, NSF 05-308 (Arlington, VA: 2005), tables B-4 to B-6,
pp. 74, 76, and 78. For industry, the NSF defines basic research as “original investigations
for the advancement of scientific knowledge ... which do not have specific commercial
objectives, although they may be in fields of present or potential interest to the reporting
company;” applied research as “research projects which represent investigations directed
to the discovery of new scientific knowledge and which have specific commercial objectives
with respect to either products or processes;” and development as “the systematic use of the
knowledge or understanding gained from research directed toward the production of useful
materials, devices, systems or methods, including design and development of prototypes and
processes,” but excluding quality control, routine product testing, and production.
53 See Brandon Shackelford, “U.S. R&D Continues to Rebound in 2004,” InfoBrief, NSF06-

306 (Arlington, VA: January 2006), p. 3.



returns on investment in basic research and the returns on this investment are more
uncertain.
Legislation in the 110th Congress
to Modify and Extend the Research Tax Credit
The research tax credit has enjoyed strong bipartisan support since its inception,
and there is no indication that this support has waned in the current Congress.
A major concern raised by any legislative initiative to extend the credit longer
than a year or two or bolster its efficacy has been the revenue cost of doing so. This
concern has taken on new influence now that the federal government is running an
exceptionally large budget deficit, and the House and Senate are operating under a
so-called “pay-as-you-go” budget rule that requires any increases in discretionary
spending or tax cuts to be offset by revenue increases or reductions in discretionary
spending.
To date, at least 19 bills to extend the research tax credit have been introduced
in the 110th Congress: S. 14, S. 41, S. 592, S. 833, S. 2209, S. 2552, S. 2884, S.

2886, S. 3098, H.R. 1424, H.R. 1712, H.R. 2138, H.R. 2734, H.R. 3996, H.R. 5105,


H.R. 5681, H.R. 5917, H.R. 6049, and H.R. 6552. All but S. 592, S. 2552, S. 3098,
H.R. 1424, H.R. 3996, H.R. 6049, and H.R. 6552 would extend the credit
permanently.
In addition, S. 41 (which Senate Finance Committee Chairman Max Baucus
introduced on January 4, 2007), H.R. 1712 (which Representative Eddie Bernice
Johnson introduced on March 27), and S. 2209 (which Senator Orrin Hatch
introduced on October 19) would make the following changes in the credit as of
January 1, 2008:
!replace the current regular, AIRC, and ASIC credits with an
alternative simplified credit equal to 20% of QREs above a
base amount of 50% of average QREs in the three previous
tax years — or 10% of QREs for business taxpayers with no
QREs in at least one of the three previous tax years;
!increase the share of payments for contract research eligible
for the credit from 65% to 80%;
!simplify the basic research credit so that it is equal to 20% of
payments for contract basic research performed by educational
institutions, certain scientific research organizations, and
certain grant institutions; and
!require the IRS to complete a study for the House Ways and
Means Committee and the Senate Finance Committee of
taxpayer compliance with the record keeping requirements for
the credit; the study should be completed within one year of



the enactment of the provisions of S. 41 and focus on the
extent to which business taxpayers maintain adequate records
to justify claims for the credit and the burdens imposed on
such taxpayers and the IRS by failures to comply with those
requirements.
The Baucus/Johnson proposal has attracted support from several advocacy groups
representing the interests of the private sector, including the National Association of
Manufacturers.
S. 2886 and H.R. 2138 would make fewer changes in the credit, but they still
could have a significant impact on its effectiveness. The bills would replace the
current simplified credit with the same new simplified credit proposed in S. 41, S.
2209, and H.R. 1712. They would also retain the current regular credit but abolish
the AIRC.
S. 2209, S. 2884, and H.R. 5681 would make the same changes in the credit as
S. 41/H.R. 1712, but they would phase in the new simplified credit from 2007 to

2010.


Several initiatives to extend the current research credit through the end of 2008
were considered in the first session of the 110th Congress, but none was enacted.
Chairman Charles Rangel of the Ways and Means Committee introduced one such
measure: H.R. 3996. A primary aim of the bill was to provide temporary relief from
the alternative minimum tax (AMT) for millions of individual taxpayers in 2007.
The version of H.R. 3996 passed by the House contained revenue raisers intended to
offset its revenue cost. Republican leaders in the Senate objected to most of them
because they saw them as unacceptable tax increases. The version of the bill signed
into law in December 2007 (P.L. 110-166) only increased the exemption amounts for
the AMT in 2007 — without offsetting the estimated revenue cost of doing so.
On May 21, 2008, the House approved a bill (H.R. 6049) that would
retroactively extend for one year a variety of individual and business tax benefits
preferences that expired at the end of 2007, or are due to expire at the end of 2008,
and establish a set of tax incentives for the production and use of renewable energy.
If enacted, the measure would extend the research tax credit through the end of 2008.
The estimated revenue cost over 10 years of extending the credit for that period is
$8.8 billion. H.R. 6049 also contains three revenue raisers intended to offset the total
revenue cost of the bill: (1) taxation of the deferred compensation paid to individuals
by offshore companies; (2) a nine-year delay in the implementation of a worldwide
interest allocation rule; and (3) a 37.75% increase in the estimated tax payments of
corporations with at least $1 billion in assets in the third quarter of 2013.
Senate consideration of a similar bill was hampered by a disagreement between
Republicans and Democrats over whether and how to offset its revenue cost. The
Democratic leadership appears to back the revenue raisers included in H.R. 6049, but
the Republican leadership is opposed to that option. A bill (S. 3098) supported by
the Republican leadership would extend the research tax credit and certain other
expired or expiring tax preferences through 2009, without offsetting the bill’s
revenue cost. On September 23, the Senate passed an amended version of H.R. 6049



that would extend the same set of expired or expiring tax benefits and exempt about
21 million individual taxpayers from paying the AMT in 2008. It would offset none
of the cost of the AMT patch and only part of the cost of the extensions. Among
other things, the bill would retroactively extend the research tax credit through 2009,
as well as raise the rate for the ASIC and repeal the AIRC for 2009 only.
The House responded to the Senate’s passage of H.R. 6049 by passing on
September 26 another bill to extend the same tax benefits. It would offset the cost
of the extensions. Among other things, it would retroactively extend the research tax
credit through 2009 but make no other changes in its design.
Congressional supporters of the credit achieved one of their objectives through
the enactment of H.R. 1424 (the Emergency Economic Stabilization Act of 2008,
P.L. 110-343) on October 3. The massive bill, which was aimed at stabilizing and
reviving financial markets, included a provision extending the research tax credit
through 2009 and raising the rate for the ASIC from 12% to 14% and repealing the
AIRC for the 2009 tax year only.
Several other legislative initiatives would modify the credit to encourage
increased investment in specific research activities. Specifically, H.R. 3264 would
try to boost investment in domestic biomedical research by making 100% of
payments for contract research done by so-called biomedical research corporations
eligible for the credit and 100% of payments for contract basic research done by such
corporations eligible for the basic research credit; H.R. 5917 would allow domestic
partnerships formed to conduct research on new technologies for improving the gas
economy of motor vehicles to claim a refundable research tax credit for their
spending for this purpose; and H.R. 6552 would establish an enhanced tax credit for
research targeted at developing clean burning fuels.
In addition, the enacted version of a bill (H.R. 3221, P.L. 110-289) to revitalize
the housing sector contains a provision that allows corporations to receive a portion
of any research tax credits or corporate alternative minimum tax credits they are
carrying forward from previous tax years in lieu of any bonus depreciation
allowances they could claim in 2008. The outstanding credits they receive cannot
exceed a taxpayer’s “bonus depreciation amount” for that year, which is defined as
20% of any excess (if any) of the total amount of depreciation for the year determined
without the bonus depreciation allowance and the total amount of depreciation with
the allowance; this amount would be capped at the lesser of $30 million or 6% of the
combined credits carried forward from tax years before 2006. Any credit received
under this provision is refundable.
In his budget proposal for FY2009, President Bush backs a permanent extension
of the research tax credit and expresses a willingness to work with Congress to
improve its incentive effect.54


54 Department of the Treasury, General Explanations of the Administration’s Fiscal Year

2009 Revenue Proposals (Washington: Feb. 2008), p. 113.



A key consideration for Congress in deciding whether to extend the credit
permanently or enhance its incentive effect is the projected revenue cost of doing so.
Recent and projected federal budget deficits have heightened concern over this cost.
The reinstatement of a “pay-as-you-go” budget rule in the current Congress is a
response to that concern, even if it raises another obstacle to the passage of
legislation addressing perceived problems with the current credit. The Bush
Administration estimates that a permanent extension of the credit would entail a
cumulative revenue loss of $133.1 billion from FY2009 through FY2018.55 This loss
would likely be larger if a permanent extension were coupled with changes in the
design of the credit intended to improve its efficacy, like those proposed in S.

41/H.R. 1712.



55 Ibid., p. 131.