Order Code RL31181
CRS Report for Congress
Received through the CRS Web
Research Tax Credit:
Current Status, Legislative
Proposals, and Policy Issues
Updated December 22, 2005
Gary Guenther
Analyst in Business Taxation and Finance
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Research Tax Credit: Current Status,
Legislative Proposals, and Policy Issues
Summary
Technological innovation makes important contributions to long-term economic
growth, and research and development (R&D) is the lifeblood of innovation. In
economies dominated by free markets, most R&D investment is undertaken by
private firms striving to become more competitive and improve their prospects for
future growth. Because firms generally cannot capture all the returns to their R&D
investments, they are inclined to spend less on R&D than might be warranted by its
overall economic benefits. As a means of offsetting this inclination and the
economic losses it entails, the federal government supports R&D in a variety of
ways, including a tax credit for increases in R&D spending above a base amount.
This report examines the current status of the credit, summarizes its legislative
history, discusses key policy issues it raises, and describes legislation in the 109th
Congress to modify or extend the credit. It will be updated as legislative activity
warrants.
The research and experimentation (R&E) tax credit has never been a permanent
component of the federal tax code. Since its enactment in 1981, the credit has been
extended 11 times and significantly modified five times. In reality, the R&E tax
credit consists of three separate and distinct credits: a regular credit, an alternative
incremental credit (AIRC), and a basic research credit. Each is incremental in that
the credit is equal to a certain percentage of qualified research spending above a base
amount. The current credit is due to expire at the end of 2005.
The R&E tax credit seeks to stimulate increased private R&D investment by
reducing the after-tax cost to firms of undertaking qualified research above a base
amount, which is supposed to approximate what a business taxpayer would spend on
R&D in the absence of the credit. Although most analysts and policymakers view
the credit as an effective policy instrument, its current design has drawn some
criticism. A major concern, in the view of critics, is that the design prevents the
credit from being as effective as it should be. Critics say this problem arises from
what they contend are five serious (but correctable) flaws in its design: (1) its lack
of permanence; (2) its weak and disparate incentive effects; (3) its non-refundable
status; (4) its inadequate and unsettled definition of qualified research; and (5) its
poor record of targeting R&D projects that generate larger social returns than private
returns.
Four bills to extend permanently the research tax credit have been introduced
in the 109th Congress: H.R. 1454, H.R. 1736, S. 14, and S. 627. In addition, H.R.
1736, S. 14 and S. 627 would also raise the three rates for the AIRC to 3%, 4%, and
5% and establish a new alternative research tax credit known as the “alternative
simplified credit.” Moreover, the tax reconciliation measures passed by the House
(H.R. 4297) and Senate (S. 2020) would extend the credit through the end of 2006
and make the same enhancements in the credit as H.R. 1736, S. 14, and S. 627.

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Contents
Design of the Current R&E Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Regular Research Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Alternative Incremental Research Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Basic Research Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Legislative History of the Research Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Effectiveness of the Research Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Policy Issues Raised by the Current Research Tax Credit . . . . . . . . . . . . . . . . . . 16
Lack of Permanence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Weak and Disparate Incentive Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Uneven Incentive Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Weak Incentive Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Non-Refundable Status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Unsettled and Inadequate Definition of Qualified Research . . . . . . . . . . . . 23
Inefficient Targeting of R&D With Large Social Returns . . . . . . . . . . . . . . 25
Legislation in the 109th Congress to Change the Research Tax Credit . . . . . . . . 26
List of Tables
Table 1. Sample Calculations of the Regular and Alternative Incremental
R&E Tax Credits in 2003 for an Established Firm . . . . . . . . . . . . . . . . . . . . 6
Table 2. Sample Calculations of the Regular and Alternative Incremental
R&E Tax Credits in 2003 for a Startup Firm . . . . . . . . . . . . . . . . . . . . . . . . . 8
Table 3. U.S. Industrial R&D Spending, Federal R&D Spending, and the
Research Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Table 4. Bills in the 109th Congress to Extend or Modify the R&E Tax
Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

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Research Tax Credit: Current Status,
Legislative Proposals, and Policy Issues
Economists may be notorious for their disagreements over a variety of
important policy issues (e.g., the efficacy of large, permanent individual income tax
cuts as a means of stimulating sustained long-term economic growth). But on the
questions of how technological innovation affects economic growth in the long run,
and what role government should play in the commercial development of new
technologies, relatively little discord colors their views.
Most economists agree that technological innovation has accounted for a major
share of the growth in per-capita income in the United States over time.1
Technological innovation can be an elusive concept: reasonable people hold
differing views of what it is and is not. Nonetheless, among economists, a consensus
has formed around the view that innovation typically involves the acquisition of new
scientific and technical knowledge, and its application to the development of new
goods and services or methods of production through a process of experimentation.
Learning-by-doing and learning-by-using often play vital roles in this process.
In free-market economies, this process is driven largely by the efforts of
competing firms in a wide range of industries to gain, sustain, or reinforce
competitive advantage by being the first to introduce new or improved products or
services, more efficient production processes, or more effective methods of
management, marketing and promotion, and customer service and support. Central
to these efforts is public and private investment in research and development (R&D),
whose principal output is new scientific and technical knowledge and knowhow.
At the same time, most economists maintain that the level of private R&D
investment in the absence of government support is likely to be less than optimal
from the standpoint of social welfare. This is because individual firms generally
cannot capture all of the economic returns to their R&D investments, even in the
presence of patents, trademarks, and other instruments of intellectual property
protection. Numerous studies of the economic effects of technological innovation
have concluded that the social returns to private R&D investments typically greatly
exceed the private returns.2 This pattern seems to prevail whether a firm invests in
1 Linda R. Cohen and Roger G. Noll, “Privatizing Public Research,” Scientific American,
Sept. 1994, p. 72.
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,
(continued...)

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CRS-2
research projects closely related to its existing lines of business, or in basic research
projects aimed at extending the boundaries of knowledge and understanding in a
particular scientific discipline in ways that may have no obvious commercial
applications. Economists refer to this excess as the spillover effects or external
benefits of R&D. There are many channels through which the benefits from
innovation may elude capture by the innovating firm and spill over to society at large,
including reverse engineering by competing firms and the purchase of goods and
services at prices below what most consumers would be willing to pay.3 When seen
through the lens of conventional economic theory, these so-called external benefits
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
knowledge and know-how. As a means of remedying this failure, most economists
favor the adoption of public policies aimed at boosting private investment in R&D,
especially R&D targeted at projects likely to generate large external economic
benefits.
The federal government supports R&D in a variety of direct and indirect ways.
Direct support mainly takes the form of research performed by federal agencies and
federal grants for basic research, applied research, and development intended to
support specific policy goals, such as protecting the natural environment, exploring
outer space, advancing the treatment of various diseases, and strengthening national
defense capabilities. Indirect support is less focused: the chief sources are federal
financial support for 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 investment in research.
Current federal tax law offers two such incentives: (1) an expensing allowance
for qualified research spending under section 174 of the Internal Revenue Code
(IRC), and (2) a non-refundable tax credit for qualified research spending under IRC
section 41 — which is referred to by some as the research and experimentation
(R&E) tax credit. The expensing allowance, which has been a permanent component
of the IRC since it was enacted in 1954, encourages business investment in R&D by
imposing a marginal effective tax rate of 0 on a portion of the returns to such
investment. Similarly, the R&E tax credit, which has always been a temporary
provision of the IRC since its enactment in July 1981, seeks to stimulate business
R&D investment by lowering the after-tax cost of qualified R&D.4 In FY2006, the
2 (...continued)
Nov. 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.
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.

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CRS-3
budgetary cost of these incentives is projected to total $10.0 billion, while federal
defense and non-defense R&D spending is projected to reach $132.3 billion.5
This report examines the current status of the R&E tax credit, its legislative
history, several important policy issues raised by it, and legislative proposals in the
109th Congress to extend or modify the credit.
Design of the Current R&E Tax Credit
The R&E tax credit actually consists of three separate and distinct non-
refundable credits: a regular research credit, an alternative incremental research
credit (or AIRC), and a basic research credit. In any tax year, business taxpayers may
claim the basic research credit and either the regular credit or the AIRC. All three
credits are due to expire on December 31, 2005.
Regular Research Credit
Under IRC section 41(a)(1), the regular tax credit, which has been extended 11
times and significantly revised five times, is equal to 20% of a firm’s qualified
research expenses (QREs) above 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 of this added R&D spending. (In contrast, if the credit
were flat in design, it would equal 20% of part or all of a firm’s spending on qualified
research.) Under the credit’s current design, the U.S. Treasury effectively bears up
to 20% of each additional dollar spent on R&D above a base amount.6 Assuming
that the amount spent on business R&D is sensitive to its cost, a decline in the after-
tax cost of R&D should lead to a rise in total business R&D investment, all other
things being equal.
In order to grasp the basic mechanism of the regular credit, it is useful to have
a clear understanding of how the base amount is determined under IRC section 41(c)
and which research expenses qualify for the credit under IRC section 41(b) and 41(d).
The base amount of the research tax credit is intended to approximate the
amount a firm would spend on qualified research in the absence of the tax credit.
This amount can be thought of as a firm’s normal or preferred level of R&D
investment. Two important rules govern the calculation of the base amount. First,
it must equal 50% or more of a firm’s QREs in a given tax year — a rule sometimes
referred to as the 50-percent rule.7 Second, a firm’s base amount hinges on whether
the firm is considered an established firm or a start-up firm. Established firms are
5 Office of Management and Budget, Analytical Perspectives, Fiscal Year 2006
(Washington: GPO, 2005), pp. 66 and 317.
6 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%.
7 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.

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CRS-4
defined as those with gross receipts and QREs in three or more of the tax years from
1984 through 1988. Start-up firms are firms that meet one of the following two
criteria: (1) the first tax year with both gross receipts and QREs occurred after 1983;
and (2) there were fewer than three tax years with gross receipts and QREs from
1984 through 1988.8 For all firms, the base amount 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 from 1984 to 1988, capped at 16%. By contrast, a start-up firm’s fixed-base
percentage is set at 3% during the first five tax years in which it records both gross
receipts and QREs; thereafter, the percentage gradually adjusts according to a firm’s
actual experience so that by the its eleventh tax year the percentage reflects the firm’s
total spending on QREs relative to receipts in the five previous tax years.
In general, the lower a firm’s fixed base percentage, the better its chances of
claiming the regular credit. Moreover, 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 Tables 1
and 2 for calculations of the regular credit for hypothetical established and start-up
firms.)
By now it should be clear that a key factor in claiming the regular credit (as well
as the AIRC) is the definition of QREs. In practice, there are two critical aspects to
this definition.
One is the nature of qualified research itself. Under IRC section 41(d), research
must satisfy four tests in order to qualify for the regular or alternative research tax
credits. First, the research must relate to activities that can be expensed under IRC
section 174 — which is to say that the activities must be “experimental” in the
laboratory sense and aimed at the development of a new or improved product or
process. Second, the research must be undertaken to discover information that is
“technological in nature.” Third, the research is intended to discover 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. Finally, the research must relate to activities substantially all of which
constitute a process of experimentation whose goal is 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, which also
directed the IRS to issue final regulations clarifying the definition of qualified
research. There has been considerable controversy among business taxpayers, the
courts, and the IRS over the interpretation of these tests in the real world of business
R&D. Although the IRS issued final regulations clarifying the definition of qualified
research in December 2003 (T.D. 9104), it is not clear whether they will put an end
to most of these disputes.
8 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.

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CRS-5
Certain activities fall outside the realm of qualified research, including 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,
research done to develop computer software for a firm’s internal use (except as
allowed in any regulations issued by the IRS), and research conducted outside the
United States, Puerto Rico, or any other U.S. possession.
The other key aspect of the definition of QREs is the expenses covered by the
credit. Under IRC Section 41(b), these expenses are limited to the wages and salaries
of employees engaged in qualified research, the cost of materials and supplies used
in this research, leased computer time used in this research, 75% of payments for
qualified research performed under contract by non-profit scientific research
organizations, and 65% of payments for qualified research done under contract by
certain other organizations. The credit does not apply to the cost of structures and
equipment used in qualified research, or to overhead expenses — such as heating,
electricity, rents leasing fees, insurance, and property taxes — and the fringe benefits
of research personnel. As will be seen, the exclusion of these costs has implications
for the incentive effect of the credit. In the past, QREs have accounted for anywhere
from 50% to 73% of total business R&D spending.9
9 U.S. Office of Technology Assessment, The Effectiveness of Research and
Experimentation Tax Credits (Washington: 1995), p. 29.

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CRS-6
Table 1. Sample Calculations of the Regular and Alternative
Incremental R&E Tax Credits in 2003 for an Established Firm
($ millions)
Year
Gross receipts
Qualified research expenses
1984
100
5
1985
150
8
1986
250
12
1987
400
15
1988
450
16
1989
400
18
1990
450
18
1991
550
20
1992
600
25
1993
550
23
1994
620
20
1995
700
25
1996
660
35
1997
710
30
1998
800
35
1999
835
45
2000
915
50
2001
1,005
53
2002
1,215
60
2003
1,465
70
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 2003:
1. Calculate the average annual gross receipts for the four previous years (1999-
2002): $992.5 million.
2. Multiply this average by the fixed-base percentage to determine the base amount:
$39.7 million.
Compute the regular tax credit for 2003:
1. Begin with the qualified research expenses for 2003 of $70 million and subtract
the base amount ($39.7 million) or 50% of the qualified research expenses for
2003 ($35 million), whichever is greater: $30.3 million.
2. Multiply this amount by 20% to determine the regular R&E tax credit for 2003:
$6.06 million.

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CRS-7
Calculation: Alternative Incremental R&E Tax Credit
1. Calculate the average annual gross receipts for the four previous years (1999-
2003): $992.5 million.
2. Multiply this amount by 1% and 1.5% and 2%: $9.925 million, $14.887 million,
and $19.850 million.
3. Begin with the qualified research expenses for 2003 ($70 million) and subtract
1% and 1.5% and 2% (respectively) of the average annual gross receipts for
1999 to 2002: $60.075 million, $55.113 million, and $50.150 million.
4. Multiply the difference between $60.075 million and $55.113 million by 0.0265:
$0.131 million.
5. Multiply the difference between $55.113 and $50.150 by 0.032: $0.159 million
6. Multiply $50.150 million by 0.0375: $1.881 million.
7. Sum the totals from steps 4, 5, and 6 to determine the alternative incremental
R&E tax credit: $2.17 million.
Alternative Incremental Research Credit
Firms undertaking qualified research that cannot claim the regular credit may
be able to claim the alternative incremental R&E tax credit (or AIRC) under IRC
section 41(c)(4). Under current law, however, firms are not free to claim whichever
credit is more advantageous in a given tax year. Instead, if a firm elects the AIRC,
it must continue to claim it in future tax years unless the firm receives permission
from the IRS to switch to the regular credit. There is some concern that such a rule
deters firms that may be better off under the AIRC from claiming it.
Calculating the AIRC is somewhat more complicated than calculating the
regular credit. It is equal to 2.65% 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 3.2% of its QREs
above 1.5% but less than 2.0% of its average annual gross receipts in the previous
four tax years, plus 3.75% 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
alternative credit if their QREs in the current tax year exceed 1% of their average
annual gross receipts during the past four tax years. Moreover, the AIRC is likely to
be of greater benefit than the regular credit for business taxpayers that have relatively
high fixed base percentages, or whose research spending is declining, or whose sales
are growing much faster than their research spending. (See Tables 1 and 2 for
calculations of the AIRC for hypothetical established and start-up firms.)

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CRS-8
Table 2. Sample Calculations of the Regular and Alternative
Incremental R&E Tax Credits in 2003 for a Startup Firm
($ millions)
Year
Gross receipts
Qualified research expenses
1995
30
35
1996
42
40
1997
56
48
1998
60
55
1999
210
65
2000
305
73
2001
400
82
2002
475
90
2003
600
105
Source: Congressional Research Service.
Calculation: Regular R&E Tax Credit
Compute the fixed-base percentage:
1. By definition, the firm is a startup. And according to current law, a startup firm’s
fixed-base percentage is fixed at 3% for each of the five years after 1993 when
it has both gross receipts and qualified research expenses. Thus, the fixed-base
percentage for 2003 is 3%.
Compute the base amount for 2003:
1. Calculate the average annual receipts for the 4 previous years (1999-2002):
$347.5 million.
2. Multiply this amount by the fixed-base percentage to determine the base amount:
$10.4 million.
Compute the regular tax credit:
1. Begin with the qualified research expenses for 2003 ($105 million) and subtract
the base amount ($10.4 million) or 50% of the qualified research expenses for
2003 ($52.5 million), whichever is greater: $52.5 million.
2. Multiply this amount by 20% to determine the regular R&E tax credit for 2003:
$10.5 million.
Calculation: Alternative Incremental R&E Tax Credit
1. Calculate the average annual gross receipts for the four previous years (1999-
2002): $347.5 million.
2. Multiply this amount by 1%, 1.5% and 2%: $3.475 million, $5.212 million, and
$6.950 million.
3. Begin with the qualified research expenses for 2003 ($105 million) and subtract
1.0%, 1.5%, and 2.0% (respectively) of the average annual gross receipts for
1999 to 2002: $101.525 million, $99.788 million, and $98.05 million.
4. Multiply the difference between $101.525 million and $99.788 million by 0.0265:
$0.046 million.

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5. Multiply the difference between $99.788 million and $98.05 million by 0.032:
$0.056 million.
6. Multiply $98.05 million by 0.0375: $3.779 million.
7. Sum the totals from steps 4, 5, and 6 to determine the alternative incremental
R&E tax credit: $3.78 million.
Basic Research Credit
Moreover, firms collaborating with certain non-profit organizations to perform
basic research may claim a tax credit for some of their expenditures for this purpose
under IRC Section 41(d). A primary aim of the basic research credit is to foster
collaborative research between U.S. industry and universities. The credit is equal to
20% of payments for contract basic research above a base amount, which has nothing
in common with the base amount for the regular R&E tax credit.10 Under IRC
section 41(e), basic research is defined as “any original investigation for the
advancement of scientific knowledge not having a specific commercial objective.”
The credit does not apply to 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 basic research performed under a written contract
by the following organizations: educational institutions, non-profit scientific
research organizations (excluding private foundations), and certain grant-giving
organizations. Payments made to joint research consortia involving a cluster of firms
or to federal laboratories for basic research are not eligible for the credit. A firm
conducting its own basic research would not be able to claim the basic research credit
for its expenditures for this purpose, but it could use these expenditures to claim the
regular research credit.
Legislative History of the Research Tax Credit
The R&E tax credit was first enacted as a temporary provision of the Economic
Recovery Tax Act of 1981 (P.L. 97-34). In establishing the credit, the 97th Congress
was seeking to reverse a decline in real spending on R&D by the private sector
relative to real U.S. gross domestic product that commenced in the late 1960s and
continued into the late 1970s. Some analysts thought this decline played a significant
role in the relatively slow productivity growth experienced by the United States and
10 Calculating a firm’s base amount for the basic research credit is much 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 recorded gross receipts
after 1983. The firm’s base amount is equal to the sum of its 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; the firm’s
minimum basic research amount must equal 50% or more of its 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.

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CRS-10
the dramatic loss of competitiveness by a range of U.S. industries in that period.
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.”11
The initial credit was equal to 25% of the excess of qualified research spending
above a base amount, which in turn was equal to average spending on this research
in the three previous tax years or 50% of current-year spending, whichever was
greater. Why a statutory rate of 25% was chosen is not clear from available primary
source material. The choice, however, does not appear to have been based on an
assessment of the gap between private and social returns to business R&D investment
or the sensitivity of R&D expenditures to declines in the cost of R&D inputs. If a
taxpayer claimed a credit but could not apply the entire amount against its current-
year federal income tax liability, the firm could carry the excess back as many as
three tax years or forward as many as 15 tax years. The credit was in effect from July
1, 1981, to December 31, 1985.
Congress made the first significant set of changes in the original credit with the
passage of the Tax Reform Act of 1986 (P.L. 99-514). The act extended the credit
through December 31, 1988 and made it part of the general business credit, thereby
subjecting it to a yearly cap. In addition, it lowered the statutory rate to 20%,
modified the definition of QREs so that the credit applied to research intended to
produce new technical knowledge that would be 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 non-profit organizations for
the conduct of basic research under a written contract. The reduction in the credit’s
rate did not seem to be based on an assessment of the credit’s effectiveness in its first
five years. Rather, it stemmed from an apparent desire on the part of Congress to
subject the credit to the overriding goals of the act — which were to lower income
tax rates across the board, broaden the income tax base, and narrow the differences
among the effective tax burdens on the returns to investment in most business assets
— and a recognition that business R&D investment also benefitted from the IRC
section 174 expensing allowance.12
The 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. In addition, it curtailed the overall tax preference for R&D by
requiring taxpayers claiming the credits to lower any deduction for qualified research
spending under IRC section 174 they claim by 50% of the combined amount of the
regular and basic research credits. This change had the effect of reducing the
11 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.
12 U.S. Congress, General Explanation of the Tax Reform Act of 1986, joint committee print,
100th Cong., 1st sess. (Washington: GPO, 1987), p.130.

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CRS-11
maximum effective rate of the regular research tax credit by a factor equal to 0.5
times a taxpayer’s marginal income tax rate.
Mounting dissatisfaction with the design of the original credit culminated in the
enactment of further important changes in the regular credit through the Omnibus
Budget Reconciliation Act of 1989 (OBRA89, P.L. 101-239). Much of the concern
was directed at the formula for determining the base amount of the credit. Critics
rightly pointed out that under the formula — which involved a three-year moving
average of a firm’s annual spending on qualified research — an increase in a firm’s
research spending from one year to the next would increase its base amount in each
of the following three years by one-third of the increase in research spending, making
the credit harder to claim in that period. Some maintained that such an arrangement
would be less cost-effective in spurring continuous increases in business R&D
investment than one in which a firm’s base amount is independent of its investment
behavior.13 To address this concern, OBRA89 modified the formula for determining
a firm’s base amount so that it was equal to the greater of 50% of its current-year
QREs or the product of the firm’s average annual gross receipts in the previous four
tax years and its “fixed base percentage.” This percentage was set equal to the ratio
of a firm’s combined QRE’s to combined gross receipts in the four tax years from
1984 to 1988; the percentage was capped at 16%. OBRA89 also made the credit
available on more favorable terms to start-up firms, which it defined as firms that did
not have 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 to both current lines of business and lines of business they might want to
enter, and required firms claiming the regular and basic research credits to reduce any
deduction they claim under IRC section 174 by the entire combined 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) further extended the credits to June 30, 1992. A major
obstacle to longer extensions of the credits in this period was the budgetary cost of
doing so in the midst of rising federal budget deficits.
Although Congress passed two bills in 1992 that would have extended the
credits beyond June 30, President George H. W. Bush vetoed both for reasons that
had nothing to do with the credit. As a result, the credits expired and remained in a
state of suspension 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, firms lacking
13 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.

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CRS-12
gross receipts in three of the years from 1984 to 1988 were assigned a percentage of
3% for the first five tax years after 1993 in which it had QREs. Starting in the firm’s
sixth year, the percentage gradually adjusted according to a formula so that by their
eleventh year the percentage reflected their actual ratio of QREs to gross receipts in
five of their previous six tax years.
Congressional inaction resulted in another expiration of the credits on June 30,
1995. They remained suspended 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 it went into effect 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 to non-profit organizations “operated primarily to
conduct scientific research” eligible for the regular or alternative incremental credits.
The credits expired in 1997 before they were extended retroactively from June
1, 1997 to June 30, 1998 by the enactment of the Taxpayer Relief Act of 1997 (P.L.
105-34) in October 1997. And the revenue portion of the Omnibus Consolidated and
Emergency Supplemental Appropriations Act of 1998 (P.L. 105-277) further
extended the credits from July 1, 1998 to June 30, 1999.
In a reprise of 1997, the credits again expired in 1999 before Congress passed
a bill later 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 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.
Beginning in the mid-1990s, a cycle began to emerge every time the credits were
about to expire, one that seemed to persist through the end of the decade. As one
analyst has noted, the cycle would start with supporters of the credit in Congress and
influential business lobbyists clamoring for a permanent extension of the credit and
denouncing what they saw as the inexcusable folly of repeated temporary
extensions.14 Then leaders in both houses of Congress would begin serious
negotiations on tax legislation that included a permanent extension. But in the end,
Congress and the President would agree to limit the extension to one or two years.
The main barrier to a permanent extension never has been staunch opposition to the
credit on the part of Congress or the President, but what has proven to be the
14 Martin A. Sullivan, “Research Credit Hits New Heights, No End in Sight,” Tax Notes, vol.
94, no. 7, Feb. 18, 2002, p. 801.

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CRS-13
insuperable difficulty of reconciling the revenue cost of such an extension with the
clashing budget priorities of the President and congressional leaders.
Effectiveness of the Research Tax Credit
A policy question posed by the credit concerns how effective the research tax
credit has been in the 22 or so years of its existence. There are two basic approaches
to coming up with a plausible answer to this important question.
Among economists, the preferred approach to assessing the credit’s
effectiveness is to compare the potential social benefit from any added R&D
generated by the credit with the credit’s potential social cost. Making such a
comparison involves measuring the marginal return to society of the added R&D
spending and the marginal returns to society of using the social cost of the credit for
other public purposes (e.g., corporate income tax rate cut, deficit reduction, or
pollution abatement). The social cost of the credit is equivalent to the net loss of tax
revenue because of the credit and the public and private costs of administering the
credit, and the latter benefits can be thought of as the social opportunity cost of the
credit. Unfortunately, this approach to assessing the effectiveness of the research tax
credit cannot be pursued because of certain insurmountable barriers to measuring the
social returns to R&D.15
As a result, economists have been forced to rely on a second approach:
estimating the additional R&D (if any) stimulated by the credit and comparing that
amount to the tax revenue lost because of the credit. Such an approach rests on two
implicit assumptions: (1) that the social returns to R&D far exceed the private
returns; and (2) that the optimal size of the subsidy for R&D is known. Under these
assumptions, the principal policy question to be addressed is whether the subsidy
should be offered as a tax credit or as a direct payment (e.g. research grant or
subsidized loan). A ratio of greater than one suggests that the tax credit is a more
cost-effective way to achieve a certain desired level of R&D subsidy than a direct
payment; but if the ratio turns out to be less than one, then it would be more cost-
effective for the federal government to fund R&D projects directly.16
Such a benefit-to-cost ratio is only loosely connected to the magnitude of the
gap between the social and private returns to R&D investment. This point can be
illuminated by considering the circumstances in which a ratio of less than does not
necessarily mean that the research credit is undesirable as a R&D subsidy, and in
15 The barriers to measuring the social returns to R&D include 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.
16 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.

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CRS-14
which a ratio of greater than one does not necessarily mean that the credit is a
desirable option. On the one hand, if the average social returns to business R&D
investment are much higher than the average private returns, it is possible for social
welfare to be enhanced through the use of the credit even if the revenue cost of the
credit exceeds the added research it brings forth. In this case, the credit could be
considered a desirable and effective policy instrument for raising business R&D
investment. On the other hand, if the average social returns to business R&D
investment are only slightly higher than the average private returns, then use of the
credit might encourage firms to engage in too much R&D, even if the amount of
R&D induced by the credit exceeds its revenue cost. In this case, social welfare
might be greater if the federal government were to use the tax revenue lost because
of the credit for purposes with greater social returns, and the credit could be seen as
a less than desirable policy instrument.
What do existing studies of the credit’s effectiveness say about its benefit-to-
cost ratio? In essence, these studies are an exercise in counterfactual analysis. They
seek to answer the question: “how much more R&D did firms undertake as a result
of the credit than they would have undertaken if there had been no credit?” Because
this added R&D cannot be observed or directly measured, researchers resort to a
variety of methods of estimating the amount of R&D undertaken with and without
the credit. These methods were examined in detail in a 1995 study by economist
Bronwyn Hall.17 She found that the studies based on data from 1981 to 1983 differed
markedly from those based on data from years after 1983. The earlier studies came
up with estimates of the amount of additional R&D undertaken per dollar of the
credit that were considerably lower than those of the later studies. Taking into
consideration the strengths and weaknesses of both sets of studies, Hall concluded
that there seemed to be no doubt that the credit (as of 1995) led to a “dollar-for-dollar
increase in reported R&D spending on the margin.”18 This meant that the benefit-to-
cost ratio was one. (In other words, each dollar of the credit claimed induced one
additional dollar of R&D.) She also noted that the available evidence suggested that
it took some time for firms to adjust their R&D budgets to the credit, so the response
was somewhat weaker in the early years of its existence.
In theory, the credit seeks to stimulate increased business R&D investment by
lowering the after-tax cost of undertaking another dollar of R&D beyond some
normal (or base) amount. Thus, two key considerations in evaluating the
effectiveness of the credit are (1) the responsiveness of business R&D investment to
decreases in its after-tax cost, and (2) the extent to which the credit lowers the after-
tax cost of conducting R&D. Combining the two factors makes it possible to
estimate how much greater business R&D spending might be because of the credit.
There is little empirical evidence on how responsive business R&D investment
is to shifts in its marginal after-tax cost, as measured by the price elasticity of R&D
17 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://emlab.berkeley.edu
/users/bhhall/papers/BHH95%200Artax.pdf].
18 Ibid., p. 18.

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CRS-15
spending. The few available studies have come up with estimates of the long-run
price elasticity ranging from -0.2 to -2.0. These results implied that a decline in the
after-tax cost of R&D of 1% can be expected to yield a rise in R&D spending in the
long run of anywhere from 0.2% to 2%. Seeking to shed further light on the price
sensitivity of the demand for R&D, a recent analysis by 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.”19
The effectiveness of the credit also depends on the extent to which it reduces the
after-tax cost of R&D. The simple truth for firms able to claim the credit is that one
dollar of the credit reduces the after-tax cost of QRE by one dollar. By offering a tax
credit for qualified research, the federal government (or U.S. taxpayers) effectively
shares the cost of this research. Consequently, a measure of the overall reduction in
the after-tax cost of domestic R&D arising from the credit is the credit’s average
effective rate, which can be approximated by the ratio of the total amount of claims
for the credit in a year to some measure of domestic business research spending, such
as QRE.
From the figures in Table 3, this rate can be computed for both QRE and
industry R&D spending. In 1996 to 2001, the average effective rate of the credit was
3.3% for industry R&D spending and 5.8% for QRE. This implies that the credit
lowered the after-tax cost of industrial R&D performed in the United States by 3.3%
and the after-tax cost of research that qualified for the credit by 5.8% over that
period.
The gap between the rates reflects the differences between QRE and industry
R&D spending as estimated by the National Science Foundation (NSF). On average,
QRE was about 58% of industry R&D spending from 1996 to 2001. The NSF
estimate is intended to measure all R&D both performed in the United States 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, as well as the cost of materials and supplies, overhead expenses,
and depreciation related to research activities; expenditures on plant and equipment
used in research are excluded, however.20 By contrast, QRE is the sum of spending
on research eligible for the credit reported by firms claiming the credit on their tax
returns and covers only wages and salaries, materials and supplies, leased computer
time, and 65% or 75% of contract research funded by these firms. Thus, it is no
surprise that QRE is significantly less than industry R&D spending.
What can be said about the overall impact of the credit on domestic R&D? The
figures in Table 3 suggest that the credit exerted a modest stimulus on domestic
19 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-
7-03, 108th Cong., 1st sess. (Washington, March 2003), p. 250.
20 National Science Foundation, Division of Science Resource Statistics, The Methodology
Underlying the Measurement of R&D Expenditures: 2000 (data update) (Arlington, VA:
Dec. 10, 2001), p. 2.

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CRS-16
business R&D investment from 1996 to 2000. More specifically, assuming the price
elasticity of R&D spending is between -0.5 and -1.0 and the average effective rate of
the credit is .033, it is possible that the credit boosted business R&D investment
between 1.65% and 3.3% over that period.
Table 3. U.S. Industrial R&D Spending, Federal R&D Spending,
and the Research Tax Credit
($ billions)
1996
1997
1998
1999
2000
2001
Industry R&D Spendinga
121.0
133.6
145.0
160.3
180.4
181.6
Qualified Research Spendingb
38.3
85.3
95.9
102.7
109.9
99.8
Federal R&D Spendingc
67.6
69.8
72.1
75.3
72.9
79.9
Current-Year Research Tax
Creditd
2.2
4.5
5.3
5.3
7.2
6.5
Source: National Science Foundation, Division of Science Resources Statistics, U.S. Industrial R&D
Expenditures and R&D-to-Sales Ratio Reach Historical Highs in 2000; 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
non-profit organizations and state and local governments.
b. Spending on research that qualifies for the research tax credit as reported by business taxpayers
claiming the credit on their federal income tax returns.
c. Federal obligations for defense and non-defense R&D 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
Although there appears to be a broad consensus among economists and
policymakers that tax incentives are a desirable way to boost business R&D
investment, the current research tax credit has drawn plenty of criticism. A major
concern is that the credit is less effective than it could or should be because of its
present design. Critics argue that the credit will produce its intended benefits only
if certain perceived flaws in its design are remedied. They cite five such flaws in
particular: (1) a lack of permanence, (2) weak and arbitrary incentive effects, (3)
non-refundable status, (4) an inadequate and unsettled definition of qualified
research, and (5) its tendency to target R&D that generates significant private returns
but relatively meager social returns.

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CRS-17
Lack of Permanence
The current R&E tax credit is due to expire on December 31, 2005. It has never
been a permanent fixture of the IRC, despite repeated attempts in Congress to extend
it permanently in the past decade.21 In fact, the credit has been extended 11 times,
most recently by the Working Families Tax Relief Act of 2004 (P.L. 108-311).
This lack of permanence is a matter of concern to critics because it is thought
to diminish the credit’s incentive effect. Many R&D projects have planning horizons
extending beyond a year or two. Some analysts have pointed out that if business
managers cannot count on receiving the credit throughout the life of a R&D project,
then it is unlikely they will factor it into their decisions on the size of annual R&D
budgets. In the view of these analysts, instead of boosting R&D investment, a
temporary incremental R&D tax credit may have the unintended effect of restraining
it somewhat by compounding the considerable uncertainty that typically surrounds
the projected after-tax returns on planned R&D investments. This added uncertainty
may deter managers from undertaking R&D projects they would pursue if the credit
were permanent.
It should be noted, however, that not all firms investing in R&D may be affected
equally by an impermanent research credit. In general, those with longer R&D
planning horizons and relatively high fixed R&D investment costs can be expected
to be more sensitive to uncertainty in the duration of the credit than those with
shorter horizons and more flexible investment costs. For example, some analysts
believe that pharmaceutical firms may be affected more by a temporary research tax
credit than software firms, simply because pharmaceutical R&D projects tend to have
much longer planning horizons and require much greater initial investment in plant
and equipment and staff training than software R&D projects.
Weak and Disparate Incentive Effect
Another problem with the credit, in the view of many of its critics, lies in its
incentive effect. They maintain that the effect varies among firms conducting
qualified research in ways that have no basis in economic theory and appear to run
counter to the purpose of the credit. In addition, according to the same critics, the
effect seems too weak to produce socially optimal levels of business R&D
investment. They trace the roots of this dual problem to the design of the current
regular credit.
Uneven Incentive Effect. The regular credit’s incentive effect appears to
vary widely among firms investing in qualified research, including those that increase
their qualified research expenditures over an extended period. Evidence for such
variation comes from a 1996 CRS report by economist William Cox that analyzed
the results of an estimation of which firms with sizable research budgets in 1994
could have claimed the regular R&E tax credit that year.
21 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.

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CRS-18
The starting point for the analysis was a sample of 900 publicly traded U.S.-
based firms with the largest R&D budgets retrieved from a database maintained by
Compustat, Inc. On the reasonable assumption that the 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 sake of claiming the credit
because they had both business revenue and QREs in three of the years from 1984
to 1988; the remainder were considered start-up firms. What is more, he found that
78% of the 900 firms in the sample (44.4% of the established firms plus 33.5% of the
start-up firms) could have claimed the R&E tax credit in 1994, while 22% could have
claimed no credit (18% of established firms plus 4% of start-up firms).22 A total of
34% of all firms (32.3% of established firms plus 1.7% of start-up firms) were
estimated to have QREs greater than their base amounts but less than twice these
amounts; as a result, they could have claimed credits with a marginal effective rate
of 13%. And 43.8% of all firms had QREs greater than double their base amounts,
enabling them to claim credits with a marginal effective rate of 6.5%.23 These rates
measure the reduction in the after-tax cost of qualified research because of the credit.
In addition, Cox found that some of the most research-intensive firms were able to
claim either no credit or credits with a marginal effective rate that was half of the rate
of the estimated credits claimed by firms with much lower research intensities.
The results showed that the credit was most beneficial to firms whose research
intensities had grown since their base periods and least beneficial to whose research
intensities had changed little or not at all or had shrunk since their base periods.
Firms whose research intensities had diminished found themselves in that position
for two reasons: (1) their R&D spending was lower in 1994 relative to their base
period; or (2) their sales revenue had grown faster than their R&D expenditures over
the same time span.
Critics of the current research credit maintain that such a pattern of R&D
subsidization is unfair and arbitrary, has no justification in economic theory, and
undercuts the central purpose of the credit, which is to encourage firms to spend more
on R&D than they otherwise would in an effort to bolster their international
competitiveness. Cox noted that the widely varying marginal effective rates of the
research credit realized by R&D-performing firms “imply that society places a higher
value on adding R&D at certain firms than at others and on adding R&D of certain
types than others, when little or no basis for such different valuations exists.”24
Two primary causes of the credit’s disparate incentive effects are the 50% rule
and the rule requiring established firms to use a fixed base period of 1984 to 1988 in
computing their fixed-base percentages. This period bears no relationship to current
22 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.)
23 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%.
24 Cox, Research and Experimentation Tax Credits, p. 10.

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CRS-19
economic or competitive conditions in a number of industries. As a result, many of
the firms that have existed since the early 1980s and invested heavily in R&D relative
to revenue back then now face a vastly altered set of incentives to invest in R&D; in
some cases, the new set of incentives has resulted in much lower research intensities.
Firms in this position could not expect to claim the R&E tax credit, even though they
still spend substantial sums on R&D.25
Weak Incentive Effect. In claiming that the credit’s incentive effect is too
weak, critics have in mind both the credit rate necessary to raise business R&D
investment to socially optimal levels and the difference between the regular credit’s
statutory rate and its average marginal effective rate. Both aspects of this policy issue
are discussed here.
Some critics maintain that the typical marginal effective rate of the credit is too
low to boost business R&D investment to levels commensurate with its potential
spillover benefits. Another CRS report by Cox on the R&E tax credit examined this
issue in depth.26 In his view, tax incentives can rectify the private sector’s
predisposition to invest too little in the creation of new technical knowledge and
know-how. For this to happen, the incentives must be designed so that they apply
only to R&D investments in excess of what firms would undertake in the absence of
a subsidy, and they must be large enough to “raise private after-tax returns on R&D
investments to the level that would result from applying the same rate of taxation to
the social rate of return from R&D.”27 As Cox correctly noted, various researchers
have concluded that the median private rate of return on R&D investment is roughly
50% of the median social rate of return.28 Thus, assuming that the average social pre-
tax rate of return is double the average private pre-tax rate of return, the optimal
R&D tax subsidy would seek to double the private after-tax rate of return to R&D
investment. For example, at a corporate tax rate of 35%, after-tax returns would
equal 65% of pre-tax returns for firms organized as corporations. In this case, the
optimal R&D tax subsidy would double the private after-tax returns to R&D
investment by elevating them to 130% of pre-tax returns [2 x (1 - 0.35)], in effect
subsidizing private pre-tax returns by 30%.29
Cox’s analysis seems to imply that the optimal average effective rate for a R&D
tax subsidy or a combination of such subsidies (e.g., a research tax credit combined
with expensing of research expenditures) is around 30%. But this implication comes
with a caveat: namely, the gap between private and social returns varies
25 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, Dec. 17, 2001, p. 1633.
26 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.)
27 Ibid., p. 8.
28 See, for example, Edwin Mansfield, The Positive Sum Strategy, pp. 309-311.
29 Cox, Tax Preferences for Research and Experimentation, pp. 7-8.

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CRS-20
considerably among R&D projects and may shift over time. One implication of this
variability and instability is that a R&D tax subsidy rate of 30% would provide
excessive subsidies for projects with below-average spillover benefits and
insufficient subsidies for projects with above-average spillover benefits.
Policymakers should be aware that “this imprecision is unavoidable, and its
consequences are hard to assess.”30
How do existing tax subsidies for R&D investment compare with Cox’s
estimate of the optimal R&D tax subsidy rate? Cox provided an answer. To assess
the incentive effect of these subsidies, he estimated the pre-tax and after-tax rates of
return under then-current tax law for a variety of hypothetical R&D projects. The
projects differed according to the proportion of R&D expenditures for depreciable
assets like structures and equipment, the proportion of R&D expenditures eligible for
both expensing under IRC section 174 and the R&E tax credit, and the economic
lives of the intangible assets arising from the investments. Cox was seeking to
compare the combined effect of expensing and the credit on after-tax returns to
investment in capital-intensive, intermediate, and labor-intensive R&D projects
yielding intangible assets with economic lives of three, five, 10, and 20 years.31
Expensing has the effect of equalizing the pre-tax and after-tax rates of return
on an investment, as it imposes an effective marginal tax rate of zero on the income
earned by affected assets.32 In other words, if the full cost of an asset is expensed, its
after-tax returns are equal to 100% of pre-tax returns. But only part of the full cost
of an R&D investment qualifies for expensing, as it does not apply to tangible
depreciable assets like structures and equipment. As a result, the effect of expensing
on a R&D investment’s after-tax rate of return depends on both the proportion of the
total cost accounted for by structures and equipment and the effective tax rate on
income from those assets.
At the same time, the R&E tax credit, which magnifies the tax benefits of
expensing, raises after-tax returns only on qualified research expenditures above a
base amount for those firms able to claim it; the credit has no effect on the returns to
other research expenditures. So its effect on after-tax returns to R&D investment
depends on both the share of a project’s cost accounted for by structures, equipment,
and overhead items and the effective tax rate on income from those depreciable
assets.
After allowing for these limitations on the incentive effects of expensing and the
research tax credit, Cox estimated that in the presence of these tax incentives, median
30 Ibid., p. 9.
31 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.
32 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, Mar. 1982, pp. 2-3.

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after-tax rates of return ranged from 101.0% of pre-tax returns for a capital-intensive
project yielding intangible assets with an economic life of 20 years to 124.7% for a
labor-intensive project yielding intangible assets with an economic life of three
years.33 These results led him to conclude that existing R&D tax subsidies 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.34
By contrast, critics tend to view the credit’s incentive effect from the perspective
of the difference between its average effective rate and its statutory rate of 20%. This
difference stems from three of the rules governing the use of the credit discussed
earlier. One of the rules is the basis adjustment, which requires that any credit
claimed be subtracted from the deduction for research expenditures under IRC
section 174. The adjustment has the effect of taxing the credit at a firm’s marginal
income tax rate. At the maximum corporate and individual tax rates of 35%, the
basis adjustment lowers the marginal effective rate of the credit from 20% to 13%.
A second rule is the so-called 50% rule, which requires that a firm’s base amount for
the credit be equal to 50% or more of its current-year qualified research expenses.
The firms affected by this rule are established firms whose ratios of current-year
qualified research spending to gross income are more than double their fixed-base
percentages or whose current-year ratios are more than double the 16% cap on the
fixed-base percentage, and start-up firms whose current-year ratios exceed 6% or are
more than double their ratios during the transitional period. For these firms, the rule
further reduces the marginal effective rate of the credit to 6.5%. Yet another rule
affecting this rate is the exclusion of outlays for R&D-related equipment, structures,
and overhead from expenses eligible for the credit, even though these outlays are a
component of the total cost of most R&D projects. The effect of the rule on the
marginal effective rate of the credit depends on the proportion of the cost of an R&D
investment that is ineligible for the credit: as this share rises, the credit’s marginal
effective rate decreases. For example, if expenditures for physical capital and
overhead constitute 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.
Would increasing the credit’s average effective rate lead to a significant
improvement in its incentive effect? Again, Cox’s 1995 report points to an answer.
Fundamentally, there are two ways to increase the credit’s marginal effective rate.
One is to retain its current statutory rate but to modify one or more of the three rules
causing the credit’s marginal effective rate to fall short of its statutory rate. The
second approach is to retain these rules but to increase the credit’s statutory rate.
Cox assessed the impact of both approaches 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 under existing R&D tax preferences,
median after-tax returns 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. If the basis adjustment
33 Cox, Tax Preferences for Research and Experimentation, p. 15.
34 Ibid., p. 17.

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for the R&E tax credit were eliminated, median after-tax returns increased 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.35 A similar gain in the credit’s incentive effect also
resulted from increasing the statutory rate of the credit to 25% but retaining existing
rules such as the basis adjustment: median after-tax returns for assets with a
three-year economic life were an estimated 133.9% of pre-tax returns and 121.9% for
assets with a 20-year economic life.36 But increasing the rate to 25% and removing
the basis adjustment led to the biggest boost in after-tax returns relative 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.
If it is true that the optimal R&D tax subsidy produces after-tax returns equal
to 130% of pre-tax returns, then Cox’s analysis suggests that leaving the credit’s
statutory rate at the current level of 20% but removing or relaxing the rules governing
the credit’s use may be the best available option for enhancing the credit’s incentive
effect.
Non-Refundable Status
The R&E tax credit is non-refundable, which means that only firms with
positive federal income tax liabilities may benefit from it in the same year in which
it is claimed. In addition, the credit is part of the general business credit (GBC) and
therefore subject to its limitations. For firms investing in 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 GBC’s may be carried
forward 20 years or carried back one year. While having tax credits to apply against
future tax liabilities is desirable in some ways, there is no certainty the credits will
be used before they expire.
Critics of the current credit say that the credit’s non-refundable status is an
important policy issue because of its implications for the viability of small research-
intensive firms. In recent decades, a number of successful technological innovations
have originated with small start-up firms. Many such firms spend substantial sums
on R&D even though they lose money in their first few years of existence. In the
view of critics, the credit’s non-refundability decreases their chances for survival
because it effectively removes the credit as a possible source of needed funding for
R&D projects. Of course some small start-up firms do end up growing into large,
innovative, and profitable enterprises, but only if they can raise enough capital to
survive during the crucial early years. If the credit were made wholly or partially
refundable, any firm investing in qualified research would have more funds to invest
in R&D, regardless of tax status.37
35 Ibid., p. 27.
36 Ibid., p. 27.
37 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
(continued...)

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CRS-23
Unsettled and Inadequate Definition of Qualified Research
Yet another policy issue raised by the current R&E tax credit is lingering
uncertainty among firms conducting R&D over how the IRS will implement final
regulations it issued in December 2003 on the definition of qualified research and
significant gaps in those regulations. Critics point out that this uncertainty
undermines the efficacy of the credit and inflates the cost of administering it.
Persistent questions about what research does and does not qualify for the credit may
deter some firms from claiming it and may encourage others to re-classify certain
activities to make them eligible for the credit. And the uncertainty sets the stage for
costly, time-consuming legal disputes between business taxpayers and the IRS over
whether claims for the credit are valid.
From 1981 through 1985, research that qualified for expensing under IRC
section 174 also qualified for the credit, with three exceptions: the credit did not
apply to research conducted outside the United States, research in the social sciences
or humanities, or research funded by another entity. Responding to numerous
complaints that this definition was being interpreted too broadly by business
taxpayers, Congress tightened the definition in the Tax Reform Act of 1986 by
adding two tests.38 Under the act, qualified research still had to satisfy the criteria for
qualified research under section 174. But in addition, the research had to serve the
purpose of discovering information that is technological in nature and useful in the
development of a new or improved product, process, or some other kind of
intellectual property with commercial applications. What is more, “substantially all”
of the research had to be part of a process of experimentation aimed at developing a
new or improved function, performance, or quality for a product or process. The act
also directed the Treasury Department to issue regulations clarifying the new tests.
Nearly 12 years passed before the IRS issued proposed regulations on the
definition of qualified research in December 1998. A key issue addressed by the
proposal was what it meant to discover information “which is technological in
nature.” Most of the comments on the proposed regulations received from tax
practitioners and business taxpayers were highly critical of a number of the positions
taken by the IRS. In response, the agency released a revised final set of regulations
in December 2000 (T.D. 8930). But about a month later, the Treasury Department
issued a notice (Notice 2001-19) suspending those regulations, requesting further
comment “on all aspects” of them, promising a careful review of all questions and
concerns raised about the suspended regulations, and pledging to issue any changes
to the final regulations in proposed form for additional comment.39 In December
2001, the IRS fulfilled the pledge by releasing a another set of proposed regulations
(REG-112991-01) addressing some of the chief concerns expressed about the
37 (...continued)
Research Program,” in Investing in Innovation, Lewis M. Branscomb and James H. Keller,
eds. (Cambridge, MA: MIT Press, 1998), pp. 212-214.
38 See P.L. 99-514, Section 231.
39 Sheryl Stratton, “Treasury Puts Brakes on Research Credit Regs; Practitioners Applaud,”
Tax Notes, vol. 90, no. 6, Feb. 5, 2001, pp. 713-715.

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withdrawn regulations. Tax practitioners generally responded favorably to the
proposal.40
On December 30, 2003, the IRS published final regulations (T.D. 9104) in the
Federal Register clarifying the definition of qualified research.41 The regulations
made some important changes to previous guidance, although they also made it clear
that the IRS shall not challenge positions taken by taxpayers that were consistent with
the final regulations issued in previous years.
Under T.D. 9104, information is considered technological in nature if the
process of experimentation used to discover the information draws on the principles
of physical or biological sciences, engineering, or computer science. In addition, the
regulations specified that it is no longer necessary for taxpayers to demonstrate that
the information “exceeds, expands, or refines the common knowledge of skilled
professionals in the particular field of science or engineering in which the taxpayer
is performing the research” in order for the information to be considered
technological in nature.
The regulations also clarified the meaning of a process of experimentation.
Basically, the process must embrace three elements. The first is uncertainty about
the outcome. The second is the identification of a variety of alternative approaches
to eliminating this uncertainty. And the third element is the use of certain methods
for evaluating these alternatives (e.g., modeling, simulation, and a systematic trial-
and- error investigation).
One lingering source of uncertainty in the definition of qualified research not
addressed in the regulations was the eligibility for the credit of expenditures to
develop internal-use software. In proposed regulations issued in 2001, the IRS stated
that costs incurred to develop such software were eligible for the credit only if the
software was intended to be unique or novel and to differ in a “significant and
inventive” way from previous software. The meaning of “significant and inventive”
has been a source of controversy between IRS examiners and taxpayers. The final
regulations offer no guidance on this question.
The definition of gross receipts for an affiliated group of companies also
remains uncertain. Such a definition is critical to the determination of a business
taxpayer’s base amount for the credit. Contradictory rulings by the IRS on this
matter have caused confusion for some U.S.-based multinational corporations with
majority-owned foreign subsidiaries.42
40 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, Dec. 24, 2001, vol. 93, no. 13, pp. 1662-
1665.
41 Alison Bennett, “IRS Issues Final Research Credit Rules With Safe Harbor For Qualified
Activities,” Daily Report for Executives, Bureau of National Affairs, Dec. 23, 2003, p. GG-
2.
42 Annette B. Smith, “Continuing Uncertainty on Research Credit Definition of Gross
(continued...)

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Inefficient Targeting of R&D With Large Social Returns
Another concern about the credit relates to its efficacy in spurring increased
investment in R&D projects yielding large spillover benefits, or its “bang for the
buck.” Some critics question whether an additional dollar of the credit leads to more
investment in R&D with relatively high social returns, on average, than an additional
dollar of direct government spending on basic or applied research.
For many, an advantage of the credit over direct spending is that private
companies, not the federal government, choose which R&D projects end up receiving
the subsidy. Firms claim the credit for projects they decide to fund, and the federal
government ends up covering as much as 20% of the cost above a base amount.43
The tax subsidy permits market forces to determine which projects are funded, and
many believe that such an approach is more likely to promote valuable diversity in
the search for new technical knowledge and knowhow than a direct subsidy such as
federal R&D grants.
But others say that the current credit does a poor job of targeting R&D projects
with large external benefits. While there are no data to verify this claim, it does have
a modicum of plausibility. Business managers and owners are motivated to earn the
highest possible return on investment for their firms. Consequently, in selecting
R&D projects to pursue, they are likely to assign a higher priority to projects with
favorable odds of generating substantial profits for their firms than to projects likely
to yield greater social returns than private returns. Such a predilection is apparent in
recent data on domestic industrial R&D expenditures. In 1999, according to data
collected by the National Science Foundation, U.S. industry spent a total of $160.3
billion on R&D, of which 9% went to basic research, 20% to applied research, and
71% to development.44 This distribution raises the distinct possibility that the credit,
to the extent that it is claimed, mainly subsidizes R&D projects with relatively
modest social returns. Some would modify the design of the credit to give firms a
stronger incentive to invest in basic or applied research than development activities.
Options include re-defining qualified research so that it encompasses basic and
applied research only and altering the basic research credit so that it applies to basic
42 (...continued)
Receipts,” Tax Adviser, vol. 35, no. 7, July 1, 2004, p. 407.
43 Joseph E. Stiglitz, Economics of the Public Sector (New York: W.W. Norton, 2000),
p. 348.
44 National Science Foundation, Division of Science Resource Studies, Research and
Development in Industry: 1999, NSF 02-312 (Arlington, VA: 2002), table A-28, p. 86. 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.

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research undertaken by a business taxpayer and has a higher statutory rate than the
regular R&E tax credit.
In evaluating this criticism, it is important to keep in mind that the federal
government has long served as a major source of funding for basic research
performed in the United States. In 1997, for example, the federal share of spending
for this purpose was 52%, compared to 28% for industry. The federal role partly
reflects a broad recognition among policy analysts and lawmakers that firms are
likely to invest less in basic research than applied research or development because
of the greater uncertainty surrounding the expected returns on investment in basic
research.
Legislation in the 109th Congress to Change the
Research Tax Credit
The research tax credit has enjoyed broad bipartisan support since its inception,
and there is no evidence that this support has waned in the current Congress.
Four bills to extend permanently the research tax credit have been introduced
in the 109th Congress: H.R. 1454, H.R. 1736, S. 14, and S. 627. Two of them have
attracted substantial bipartisan backing: H.R. 1736 and S. 627.45 Moreover, the tax
reconciliation bills passed by the House (H.R. 4297) and the Senate (S. 2020) would
extend the current credit by one year, through the end of 2006.46
In addition, H.R. 1736, H.R. 4297, S. 14, S. 627, and S. 2020 would raise the
three rates for the AIRC to 3%, 4%, and 5%. The three bills would also establish a
new alternative research tax credit — known as the “alternative simplified credit” —
that would be equal to 12% of a firm’s spending on qualified research in a tax year
above 50% of its average qualified research expenditures in the three previous tax
years; for firms that did not have qualified research expenditures in one or more of
the preceding three tax years, the credit would be equal to 6% of qualified research
expenditures in the current tax year. Finally, under S. 14, payments for contract
research made to certain small firms, universities, and federal laboratories would be
eligible for the credit; and S. 2020 would make payments made to private research
consortia eligible for the credit.
In its budget request for FY2006, the Bush Administration proposes a
permanent extension of the research tax credit.
An important consideration (some would say insuperable barrier) in deciding
whether to extend or enhance the credit is the projected revenue cost of doing so. A
large and growing federal budget deficit has raised concern over this cost and is
45 As of April 18, 2005, there were 11 co-sponsors of the bill: five Democrats and six
Republicans.
46 There are significant differences between the two bills that will need to be resolved
through a conference committee before a bill can be sent to the President for his signature.

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making it more difficult for Congress to pass legislation addressing perceived
problems with the current credit. The Bush Administration estimates that a
permanent extension of the credit would result in a revenue loss of $76.225 billion
from FY2006 through FY2015. Obviously, the projected revenue loss would be
greater if the design of the credit were altered to improve its incentive effect.
Table 4 summarizes the provisions of bills in the 109th Congress that would
modify the credit.
Table 4. Bills in the 109th Congress to Extend or Modify
the R&E Tax Credit
Bill Number
Provisions Related to the Credit
H.R. 1454
Permanently extends the regular, alternative incremental, and basic research
credits.
H.R. 4297
Extends the regular, alternative incremental, and basic research credits one
and S. 2020
year, through the end of 2006.
S. 14
Extends the regular, alternative incremental, and basic research credits
permanently.
—
Raises the three rates of the alternative incremental credit to 3%, 4%, and 5%.
—
Creates an alternative simplified credit equal to 12% of qualified research
expenses in excess of 50% of the taxpayer’s average qualified research
expenses in the three previous tax years, and 6% of qualified research expenses
in the current tax year for taxpayers with no qualified research expenses in one
or more of the three previous tax years.
—
Modifies the credit so that it applies to payments to research consortia, which
are defined as tax-exempt organizations dedicated to the conduct of research
that are not private foundations and have at least five “unrelated” paying
members, not one of which accounts for more than 50% of the total research
budget for the organization in a calendar year.
—
Makes 100% of amounts paid to eligible small firms, universities, and federal
laboratories for contract research eligible for the credit.
H.R. 1736,
Permanently extends the regular, alternative, and basic research credits.
H.R. 4297,
—
S. 627, and
Raises the rates of the alternative incremental credit to 3%, 4%, and 5%.
S. 2020
—
Creates an alternative simplified credit equal to 12% of qualified research
expenses above 50% of the taxpayer’s average qualified research expenses in
the three previous tax years, and 6% of qualified research expenses in the
current tax year for taxpayers with no qualified research expenses in one of
more of the three previous tax years.
S. 2020
Makes 100% of amounts paid to private research consortia eligible for the
credit.
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Source: Congressional Research Service

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