Order Code RL31181
CRS Report for Congress
Received through the CRS Web
Research Tax Credit: Current Status,
Legislative Proposals in the 109th Congress,
and Policy Issues
Updated September 22, 2006
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 in the 109th Congress,
and Policy Issues
Summary
Technological innovation makes crucial contributions to long-term economic
growth, and research and development (R&D) is the lifeblood of innovation. In
economies dominated by free markets, a large share of R&D investment is
undertaken by private firms seeking 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 its overall
economic benefits would warrant. The federal government supports R&D in a
variety of ways, including a tax credit for increases in R&D spending.
This report examines the 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
provision of the federal tax code. Since its enactment in 1981, the credit has been
extended 11 times and modified five times. In reality, the R&E tax credit has four
components: a regular credit, an alternative incremental credit (AIRC), a basic
research credit, and an energy research credit. All but the energy research credit are
incremental in that the credit applies only to qualified research spending above a base
amount. The credit expired at the end of 2005.
In effect, the research tax credit seeks to stimulate increased business R&D
investment by reducing the after-tax cost to firms of undertaking qualified research
beyond a base amount, which appears designed to approximate what a firm would
spend on R&D if there were no credit. Although most analysts and lawmakers view
research tax credits as a desirable policy instrument in theory, the current design of
the federal credit has made it a target of continuing criticism. A major concern is that
the design keeps the credit from being as effective as it might. Critics attribute this
problem to what they claim are five 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 lack of focus on
R&D projects that generate much larger social returns than private returns.
Numerous bills to extend the credit and enhance its incentive effect have been
introduced in the 109th Congress. Some examples are H.R. 1736, H.R. 4845, H.R.
5115, S. 14, S. 627, S. 2109, and S. 2357. Each would extend the credit
permanently, raise the three rates for the AIRC to 3%, 4%, and 5%, and establish
what is known as an “alternative simplified credit.” For many firms, such a credit
would be equal to 12% of spending on qualified research above 50% of their average
qualified research spending in the three previous tax years. A bill passed by the
House on July 29, 2006 (H.R. 5970) would extend the credit through the end of 2007,
increase the three rates for the AIRC, and establish the same alternative simplified
credit. It is unclear whether the Senate will vote on the measure before the end of the
current Congress.

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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Design of the Current R&E Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Regular Research Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Qualified Research Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Alternative Incremental Research Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Basic Research Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Energy Research Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Legislative History of the Research Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Effectiveness of the Research Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Policy Issues Raised by the Current Research Tax Credit . . . . . . . . . . . . . . . . . . 17
Lack of Permanence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Weak and Disparate Incentive Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Uneven Incentive Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Weak Incentive Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Non-refundable Status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Unsettled Definition of Qualified Research . . . . . . . . . . . . . . . . . . . . . . . . . 24
Lack of Focus on R&D With Large Social Returns . . . . . . . . . . . . . . . . . . . 26
Legislation in the 109th Congress to Change the Research Tax Credit . . . . . . . . 27
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 Start-up Firm . . . . . . . . . . . . . . . . . . . . . . . . 8
Table 3. U.S. Industrial R&D Spending, Federal R&D Spending, and the
Research Tax Credit, 1996 to 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Table 4. Bills in the 109th Congress to Extend or Modify the R&E
Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

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Research Tax Credit: Current Status,
Legislative Proposals in the 109th Congress,
and Policy Issues
Introduction
Economists may be notorious for their lack of consensus on some important
policy issues (e.g., 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 questions of how
technological innovation affects economic growth in the long run, and what role
governments should play in the development of new technologies, there is
surprisingly little disagreement.
Most economists subscribe to the notion that technological innovation has
accounted for a major share of long-term growth in per-capita income in the United
States.1 Technological innovation is one of those concepts that is hard to define in
a way that meets with universal acceptance. Economists with an interest in the
dynamics of economic growth generally agree that innovation 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 that can be long and convoluted. Learning-by-doing and
learning-by-using often play crucial roles in this process.
In economies dominated by free markets, technological innovation is fueled by
the efforts of competing firms to gain, sustain, or reinforce competitive advantage by
being among the first to introduce or employ new or improved products or services;
more efficient production processes; or better approaches to management, marketing
and promotion, and customer service and support. The lifeblood of innovation is
investment in research and development (R&D), whose principal output is new
scientific and technical knowledge and knowhow.
Most economists would also agree that private R&D investment is likely to be
less than adequate in the absence of government intervention. The reason is simple:
firms generally cannot capture all the economic returns to their R&D investments,
even through the aggressive use of patents, trademarks, and other instruments of
intellectual property protection. Numerous studies have found that the average social
1 Linda R. Cohen and Roger G. Noll, “Privatizing Public Research,” Scientific American,
Sept. 1994, p. 72.

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CRS-2
returns to private R&D investments greatly exceed the average private returns.2 This
finding holds true, regardless of whether a firm invests in research projects directly
related to its existing lines of business, or it focuses its resources on basic research
projects aimed at extending the boundaries of knowledge in a particular scientific
discipline 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 capture by the innovating firms and spill over to
society at large, including reverse engineering by competing firms and the purchase
of new goods and services at prices below the prices most consumers would be
willing to pay.3 When seen through the lens of conventional economic theory, these
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 technical knowledge and know-how. To remedy this failure,
most economists favor 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.
Partly in an effort to spur increased private investment in R&D, the federal
government supports R&D in a variety of direct and indirect ways. Direct support
mainly comes in the form of research performed by federal agencies and federal
grants for basic and applied research and development intended to support specific
policy goals, such as protecting the natural environment, exploring outer space,
advancing the treatment of chronic 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 to some as the research and experimentation (R&E) tax
credit. The deduction has been a permanent provision of the IRC since it was first
enacted in 1954; its main advantages are that it simplifies tax accounting for R&D
expenditures and encourages business R&D investment by imposing a marginal
effective tax rate of 0 on the returns to such investment. A similar policy objective
undergirds the research tax credit, which has always been a temporary provision of
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,
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.

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CRS-3
the IRC since it was first enacted in July 1981: the credit seeks to stimulate increased
business R&D investment year after year by lowering the after-tax cost of qualified
R&D beyond the amount that firms would undertake in the absence of such a
subsidy.4 But the credit complicates the task of complying with tax laws and
regulations for firms claiming it. In FY2006, the combined budgetary cost of these
incentives is projected to total $10.0 billion; by contrast, federal defense and non-
defense R&D spending may reach $132.3 billion.5
This report examines the current status of the R&E tax credit, its legislative
history, some important policy issues raised by it, and legislative proposals in the
109th Congress to extend the credit or enhance its incentive effect. It will be updated
as legislative activity and other developments affecting the credit warrant.
Design of the Current R&E Tax Credit
The R&E tax credit actually has four components: a regular research credit, an
alternative incremental research credit (or AIRC), a basic research credit, and a credit
for energy research. Each is non-refundable. In any tax year, business taxpayers may
claim the basic and energy research credits, as well as either the regular credit or the
AIRC. All four credits expired on December 31, 2005.
Regular Research Credit
The regular research tax credit has been extended 11 times and revised five
times. Under IRC section 41(a)(1), it is equal to 20% of a firm’s qualified research
expenditures (QREs) above a base amount. This incremental design is intended to
encourage firms to spend more on R&D from one year to the next than they
otherwise would by lowering the after-tax cost of the added R&D spending. (By
contrast, if the credit’s design were flat, the credit would be equal to 20% of a firm’s
total spending on qualified research in a tax year.) Under such a design, the federal
government bears 20% of the cost of any qualified research above the base amount,
for firms claiming the credit.6 Given that business R&D investment hinges in part
on 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.7
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 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 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%.

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CRS-4
To grasp the links between the regular credit and business R&D investment, it
is essential to understand 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).
In principle, the base amount of the regular credit approximates the amount a
firm would spend on qualified research in the absence of the credit, or its 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.8 Second, a
firm’s base amount depends on whether the firm qualifies as 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 with fewer than three tax years with both gross receipts and
QREs from 1984 through 1988.9 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 in 1984 to 1988, capped at 16%. A start-up firm’s fixed-base
percentage is set at 3% during the firm’s first five tax years after 1993 when it invests
in qualified research. Thereafter, the percentage gradually adjusts to reflect a firm’s
actual experience so that by the its eleventh tax year, the percentage equals the firm’s
total QREs relative to its total receipts in any five tax years it chooses from 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. 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.)
Qualified Research Expenditures. Obviously, 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 aspect concerns the nature of qualified research itself. Under IRC section
41(d), research must satisfy four criteria in order to qualify for the regular or
alternative incremental research tax credits. First, the research must involve
activities that qualify for the deduction 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 intended to discover information that is “technological in nature.” Third, the
research should seek to gain new technical knowledge that is useful in the
8 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.
9 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
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 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, which also
directed the IRS to issue regulations clarifying the definition of qualified research.
In general, according to IRC section 41(d)(3), research satisfies these 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 tests for qualified research 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 seems unlikely that the regulations will
preclude further disputes between business taxpayers and the IRS over what activities
qualify for the credit.10
IRC section 41(d)(4) identifies the activities that do not qualify for the credit.
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 other critical aspect of the definition of QREs is the expenses eligible for
the credit. Under IRC section 41(b)(1), these expenses relate to both in-house
research and contract research. In the case of in-house research, qualified expenses
are limited to the wages and salaries of employees and their direct supervisors who
are engaged in qualified research, the cost of materials and supplies (but not
depreciable property) used in this research, and leased computer time used in this
research. In the case of contract research, qualified expenses cover 75% of payments
for qualified research performed under contract by nonprofit scientific research
organizations and 65% of payments for qualified research performed under contract
by other entities.
The credit does not apply to spending on the structures and equipment used in
qualified research, overhead expenses related to such research — such as heating,
electricity, rents, leasing fees, insurance, and property taxes — and the fringe benefits
10 See the discussion of concerns raised by the current definition of qualified research on
pages 24 to 26.

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CRS-6
of research personnel. As is discussed below, 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.11
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:
11 U.S. Office of Technology Assessment, The Effectiveness of Research and
Experimentation Tax Credits (Washington: 1995), p. 29.

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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.
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 have
the option of claiming the alternative incremental R&E tax credit (or AIRC), under
IRC section 41(c)(4). When a firm elects to claim 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 the regular credit. Some are concerned 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 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 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.)

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Table 2. Sample Calculations of the Regular and Alternative
Incremental R&E Tax Credits in 2003 for a Start-up 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 start-up. According to current law, a start-up 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, 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 1995 through
1999, 7.4% in 2000, 8.8% in 2001, 12.0% in 2002, and 14.7% in 2003.
Compute the base amount for 2003:
1. Calculate the average annual receipts for the four previous years (1999-2002):
$347.5 million.
2. Multiply this amount by the fixed-base percentage to determine the base amount:
$51.1 million.
Compute the regular tax credit:
1. Begin with the qualified research expenses for 2003 ($105 million) and subtract
the base amount ($51.1 million) or 50% of the qualified research expenses for
2003 ($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 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.

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4. Multiply the difference between $101.525 million and $99.788 million by 0.0265:
$0.046 million.
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
Firms joining with certain nonprofit organizations to perform basic research
under contract may 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 are intended to approximate what firms would spend on qualified research
if there were no credits.12 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, nonprofit
scientific research organizations (excluding private foundations), and certain grant-
giving organizations. Payments made to joint research consortia involving two or
more firms, or to federal laboratories, for basic research do not qualify for the credit.

Firms conducting their own basic research may not claim the credit for their
expenditures for this purpose, but they may be added to their QREs for the regular
credit. And basic research payments eligible for the credit that do not exceed the
base amount are treated as contract research expenses and may be included in the
QREs for the regular credit.
12 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.

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CRS-10
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 nonprofit organization that is exempt from taxation
under IRC section 501(a) and “organized and operated primarily to conduct energy
research in the public interest.” In addition, a minimum of five discrete entities must
contribute to the organization for energy research in a calendar year, and none of
these entities may account for more than half of funds received by the organization
for such research.
The credit also applies to the full amount of payments to colleges and
universities, federal laboratories, and certain small firms for energy research
performed under contract. In the case of small firms, q business taxpayer may claim
the credit only under two conditions. First, the taxpayer cannot own 50% or more of
the firm’s stock (if the firm is a corporation), or capital and profits (if the firm is a
non-corporate entity such as a partnership). Second, the firm must have employed
an average of 500 or fewer individuals in one of the previous two calendar years.
Because the credit is flat rather than incremental, it is more generous than the
any of the three other components of the research tax credit.
Legislative History of the Research Tax Credit
The R&E tax credit entered the tax code as a temporary provision through 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 spending on R&D by the private sector
as a share of U.S. gross domestic product that commenced in the late 1960s and
continued through the late 1970s. Some analysts thought the decline played a
significant role in the slowdown in U.S. productivity growth and the unsettling loss
of competitiveness by a variety of U.S. industries in that decade. 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.”13
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 available information why a statutory rate of 25% was chosen. Nonetheless, the
rate does not appear to have been based on 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 the after-tax cost of R&D. Any taxpayer that claimed the
13 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.

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CRS-11
credit but could not apply the entire amount against its current-year federal income
tax liability was allowed to carry the excess back as many as three tax years or carry
it 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 changes in the original credit with the
passage of the Tax Reform Act of 1986 (P.L. 99-514). Among of host of changes in
the tax code, 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, the
act lowered the statutory rate to 20%, modified the definition of QREs so that the
credit applied to research intended to produce new technical knowledge 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 seemingly was not based on an analysis of the credit’s
effectiveness in the first five years. Rather, it reflected the intent 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 tax burdens on most business assets — and a recognition that business
R&D investment already received preferential treatment under the IRC section 174
expensing allowance.14
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 R&D investment by requiring business taxpayers to reduce any
deduction they claim for qualified research spending under IRC section 174 by half
of the total amount of any regular and basic research credits they claim. This rule had
the effect of lowering 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.
Continuing disenchantment with the design of the original credit among
interested parties led to 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 disenchantment was directed at 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 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 it more difficult to claim the credit in that
period. Some maintained that such a design 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 spending on qualified research.15
14 U.S. Congress, General Explanation of the Tax Reform Act of 1986, joint committee print,
100th Cong., 1st sess. (Washington: GPO, 1987), p.130.
15 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,
(continued...)

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CRS-12
To address this concern, OBRA89 modified the formula for the base amount so
that the amount 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
total QREs to total gross receipts in the four tax years from 1984 to 1988, with the
percentage 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 current
lines of business and to 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) further extended the credits to June 30, 1992. A major
obstacle to longer extensions of the credits — then and now — was the revenue 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 of that year, 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 suspended 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
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 reported QREs. Starting in a
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 its previous six tax years.
Congressional inaction allowed the credits to expire again on June 30, 1995.
They remained in abeyance 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 from 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 to nonprofit organizations “operated primarily to conduct scientific
research” eligible for the regular or alternative incremental credits.
15 (...continued)
1985), pp. 17-22.

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CRS-13
The credits yet again expired 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),
which President Clinton signed in October 1997. In the following year, the revenue
portion of the Omnibus Consolidated and Emergency Supplemental Appropriations
Act, 1998 (P.L. 105-277) further extended the credits from July 1, 1998, to June 30,
1999.
In a reprise of 1997, the credits expired again in 1999, and Congress passed a
bill 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 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.
Finally, 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 to
qualified consortia, colleges and universities, federal laboratories, and eligible small
firms for contract energy research.
Beginning in the mid-1990s, a cycle emerged every time the credits were about
to expire, one that seems to have persisted to the present. The cycle starts with
supporters of the credit in Congress and among influential business groups calling
for a permanent extension of the credits and issuing stern denunciations of what they
see as the folly of repeated temporary extensions.16 In the next stage of the cycle,
leaders in both houses of Congress undertake serious negotiations on tax legislation
that often includes a permanent extension of the credit. But in the end, Congress and
the President agree to extend the credit one or two years, stymied by a recurring
inability to reconcile the revenue cost of such an extension with their budget
priorities.
Effectiveness of the Research Tax Credit
Perhaps the most important policy issue raised by the credit concerns how
effective it has been in the 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 engendered by the credit with the social cost of that R&D. Such a
comparison involves measuring the returns to society of the added R&D spending
and the social cost of all other possible public uses of this R&D (e.g., corporate
16 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-14
income tax rate cut, deficit reduction, increased federal spending on higher education,
or pollution abatement). 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 cannot be used because of difficulties in measuring the social returns to
R&D.17
As a result, economists have been forced to rely on a second, less sweeping
approach: estimating the additional R&D (if any) stimulated by the credit and
comparing the value of that R&D to the tax revenue lost because of the credit. Such
an approach rests on two assumptions: (1) that the social returns to R&D far exceed
the private returns and (2) that it is possible to determine the optimal size of the
subsidy for R&D.
An interesting policy question raised by this approach concerns whether the
subsidy should be offered as a tax credit or as a direct payment (e.g. research grant
or subsidized loan). If the value of the added R&D engendered by the credit were to
exceed the credit’s revenue cost, then it may be the case that the tax credit is a more
cost-effective way to boost private R&D investment than direct payments. But if the
revenue cost were to exceed the value of the added R&D, then it may be more cost-
effective for the federal government to pass up the credit in favor of direct
payments.18
Nonetheless, the question of whether the credit is more desirable than direct
payments as a means of boosting business R&D investment cannot be answered
solely on the basis of such a narrow comparison of cost and benefit. There are
circumstances in which a ratio of less than one does not necessarily mean that direct
payments are preferable to the credit as an R&D subsidy, and there are circumstances
in which a ratio of more than one does not necessarily mean that the credit is
preferable to a direct payment. On the one hand, if the average social returns to
business R&D investment are much higher than the average private returns, then it
is possible for social welfare to be enhanced through the use of the credit even though
the revenue cost of the credit exceeds the value of the added research it induces. 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 greater than the average private returns,
then use of the credit might encourage firms to engage in too much R&D from the
perspective of social welfare, even if the added R&D induced by the credit were to
exceed its revenue cost. In this case, social welfare might be enhanced more if the
17 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.
18 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-15
federal government were to use the tax revenue lost to 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? For the most part, the studies are an exercise in counterfactual analysis.
They seek to answer the following question: how much more R&D did firms
undertake as a result of the credit than they would have undertaken if there were no
credit? Researchers use a variety of methods to estimate the amount of R&D
undertaken with and without the credit. These methods were examined in a 1995
study by economist Bronwyn Hall.19 She found that studies based on data from 1981
to 1983 differed markedly from those based on data from years after 1983. More
specifically, she found that the former set of studies generated estimates of the
additional R&D undertaken per dollar of the credit that were considerably lower than
the estimates offered by the latter set of studies. Taking into consideration the
strengths and weaknesses of both sets of studies, Hall concluded that the credit (as
of 1995) led to a “dollar-for-dollar increase in reported R&D spending on the
margin.”20 This meant that it had a benefit-to-cost ratio of one. (In other words, each
dollar of the credit stimulated one additional dollar of 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. Firms can be expected to respond to this reduction in cost by spending
more on R&D, all other things being equal. So the critical considerations in
determining the share of business R&D investment in a year that can be attributed 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 average after-tax cost of
conducting R&D.
Little research has been done on how responsive business R&D investment is
to changes in its after-tax cost — as measured by the price elasticity of R&D
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 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.”21
19 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].
20 Ibid., p. 18.
21 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.

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CRS-16
Much less doubt surrounds the impact of the credit on the after-tax cost of
qualified research: basically, one dollar of the credit reduces this cost by one dollar.
In offering such a credit, the federal government (or U.S. taxpayers) effectively is
sharing the cost of qualified research. Consequently, 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 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 QRE.
From the figures in Table 3, this rate can be computed for both QRE and
industry R&D spending. In 1996 to 2003, the average effective rate of the credit was
3.3% for industry R&D spending and 5.5% for QRE. This implies that the credit
lowered the after-tax cost of domestic business R&D by 3.3% and the after-tax cost
of qualified research by 5.5% 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,
total QRE was about 60% of business R&D spending from 1996 to 2003. The NSF
estimate aims to measure all R&D 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.22 By contrast, QRE is the sum of spending on
research eligible for the credit, as reported by firms claiming the credit on their tax
returns, and covers wages and salaries, materials and supplies, leased computer time,
and 65% or 75% of contract research funded by these firms. One would expect
industry R&D spending to be greater, because it covers a broader array of R&D
expenses than QRE.
What can be said about the overall impact of the credit on domestic R&D? The
figures in Table 3 indicate that the credit delivered a modest stimulus to domestic
business R&D investment from 1996 to 2003. Specifically, assuming that the price
elasticity of demand for R&D is between -0.5 and -1.0 and the average effective rate
of the credit is .033, the credit might have boosted business R&D investment by
1.65% to 3.3% over that period.
22 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-17
Table 3. U.S. Industrial R&D Spending, Federal R&D Spending,
and the Research Tax Credit, 1996 to 2003
($ billions)
1996
1997
1998
1999
2000
2001
2002
2003
Industry
R&D
121.0
133.6
145.0
160.3
180.4
181.6
177.5
183.3
Spendinga
Qualified
Research
38.3
85.3
95.9
102.7
109.9
99.8
116.1
124.5
Spendingb
Federal
R&D
70.6
73.5
75.3
80.3
83.1
91.2
102.0
117.4
Spendingc
Current-
Year
Research
2.2
4.5
5.3
5.3
7.2
6.5
5.8
5.6
Tax
Creditd
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
Although most policy analysts and lawmakers back the use of tax incentives to
spur increased domestic business R&D investment, the research tax credit authorized
by IRC Section 41 seems to attract more criticism than praise. A major concern is
that the credit is less effective than it might be because of what critics see as flaws
in its present design. In their view, the credit will yield its intended benefits only if
these problems are fixed. Critics cite five problems in particular: (1) the credit is not
a permanent provision of the IRC; (2) it has weak and arbitrary incentive effects; (3)
it is not refundable; (4) the definition of qualified research is inadequate and remains
unsettled; and (5) the credit appears to subsidize R&D investment that generates
greater private returns than social returns. Each problem is examined in turn below.

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CRS-18
Lack of Permanence
The R&E tax credit expired on December 31, 2005, and a variety of bills are
being considered in the current Congress to extend the credit retroactively. It has
never been a permanent provision of the IRC, despite repeated attempts in Congress
to extend it permanently in the past decade.23 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 because it is thought to diminish
the credit’s incentive effect. As critics of the design of the current credit are wont to
point out, many R&D projects have planning horizons extending beyond a year or
two. They also point out that if business managers cannot count on receiving the
credit over the expected life of an R&D project, then it is unlikely to influence
decisions on the size of annual R&D budgets, even if a credit exists when the
decisions are made. Instead of boosting R&D investment, a temporary R&D tax
credit could end up restraining it by compounding the considerable uncertainty that
typically surrounds projected after-tax returns on planned R&D investments. This
added uncertainty may convince managers not to pursue R&D projects they would
be inclined to undertake if the credit were permanent.
Nonetheless, not all firms investing in R&D are likely to be equally affected by
a temporary research tax credit. Those with relatively long R&D planning horizons
and relatively high fixed R&D investment costs can be expected to be more sensitive
to uncertainty in the availability of the credit than those with shorter horizons and
more flexible investment costs. For example, the R&D investment plans of
pharmaceutical firms could be affected more by a temporary research tax credit than
those of 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 do software R&D projects.
Weak and Disparate Incentive Effect
Critics maintain that another major problem with the credit lies 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 that thwart the credit’s purpose.
The incentive effect is also thought to be too weak to produce the levels of business
R&D investment warranted by its overall returns. Critics attribute these
shortcomings to the design of the regular and alternative incremental credits.
Uneven Incentive Effect. The regular credit’s incentive effect appears to
vary widely among firms investing in qualified research, including those that steadily
increase their R&D investment over an extended period. Evidence for such variation
can be found in a 1996 study by economist William Cox that looked at the firms with
sizable research budgets in 1994 that could have claimed the regular R&E tax credit.
23 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-19
The starting point for the study was a sample of 900 publicly traded U.S.-based
firms with the largest R&D budgets culled by Cox from a database maintained by
Compustat, Inc. On the defensible assumption that combined QREs for these firms
in 1994 were equal to 70% of their reported R&D spending, Cox determined that
62.5% of the firms could be considered established firms 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 R&E tax credit in 1994, while 22% could have claimed no credit (18% of
established firms and 4% of start-up firms).24 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, enabling them to claim credits with a marginal effective
rate of 6.5%.25 These rates measure the reduction in the after-tax cost of qualified
research because of the credit. In addition, Cox discovered that some of the most
research-intensive firms could claim either no credit or credits with marginal
effective rates half as large as the rates of the estimated credits claimed by firms with
much lower research intensities.
The results indicated that the credit 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 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 say that such a pattern of R&D
subsidization is unfair and arbitrary, has no justification in economic theory, and
contravenes the intended 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 competitiveness
and the prospects for future growth in the U.S. economy. Cox noted that the widely
varying marginal effective rates of the research credit that R&D-performing firms
included in his study could claim “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.”26
There are two basic reasons for the credit’s disparate incentive effects: the rule
requiring the base amount for the regular credit to be equal to no less than 50% of
24 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.)
25 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%.
26 Cox, Research and Experimentation Tax Credits, p. 10.

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CRS-20
QREs, 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 economic or competitive conditions in most 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 different set of incentives to invest in R&D.
In some cases, these incentives have led to much lower research intensities. Firms
in this position cannot claim the R&E tax credit, even though they still spend
substantial sums on R&D.27
Weak Incentive Effect. In claiming that the credit’s incentive effect is too
weak, critics have in mind some estimate of the credit rate necessary to raise business
R&D investment to socially optimal levels, as well as differences between the regular
credit’s statutory rate and its average marginal effective rate. Both aspects of this
alleged weakness are examined here.
Current R&D Tax Incentives are Inadequate. Some maintain that the
average effective rate of the credit is too low to boost business R&D investment to
levels 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 R&E tax credit.28 Cox built his analysis around the premise that tax
incentives can overcome the private sector’s disposition to invest too little in the
creation of new technical knowledge and know-how. For this to happen, the
incentives must be designed so they target spending on R&D 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 from applying the
same rate of taxation to the social rate of return from R&D.”29 A variety of
researchers have concluded that the median private rate of return on R&D investment
is roughly 50% of the median social rate of return.30 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 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)], thereby
subsidizing private pre-tax returns by 30%.31
27 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.
28 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.)
29 Ibid., p. 8.
30 See, for example, Edwin Mansfield, The Positive Sum Strategy, pp. 309-311.
31 Cox, Tax Preferences for Research and Experimentation, pp. 7-8.

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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
expensing of research expenditures), was around 30%. In sorting through the policy
implications of this finding, Cox noted that such a rate is an average and thus does
not take into consideration the fact that the gap between private and social returns
varies considerably among R&D projects and may shift over time. As a result, using
the tax code 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.”32
How do existing federal tax subsidies for R&D investment compare with Cox’s
estimate of the optimal R&D tax subsidy? To assess the incentive effect of current
federal 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 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 R&E 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.33
Expensing has the effect of equating the pre-tax and after-tax rates of return on
an investment, as it taxes the income earned by affected assets at a zero marginal
effective rate.34 For the average business R&D investment, it is likely that only part
of the cost may be expensed under IRC section 174, as the cost of tangible depreciable
assets like structures and equipment does not qualify for such treatment. Therefore,
the effect of expensing on an R&D investment’s after-tax rate of return depends on
both the percentage of the total cost that is eligible for expensing and the effective tax
rate on income earned by assets eligible for expensing.
At the same time, the R&E 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 R&D investment
depends on both the percentage of a project’s cost that qualifies for the credit and the
effective tax rate on income earned by assets eligible for the credit.
32 Ibid., p. 9.
33 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.
34 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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CRS-22
After allowing for these limitations on the benefits of expensing and the research
tax credit, Cox estimated that expensing and the credit together give rise to 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.35 The 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.36
Significant Gap Between Average Effective Rate of the Credit and
Its Statutory Rate. Some critics of the current research tax credit view the credit’s
incentive effect from a different perspective. To them, the critical consideration is any
difference between the credit’s average effective rate and its statutory rate of 20%.
Such a difference would arise from three of the rules governing the use of the credit
discussed earlier.
One of the rules is the basis adjustment under IRC section 280C(c)(1), which
requires business taxpayers claiming the credit to reduce any deduction for research
expenditures under IRC section 174 by the amount of the credit they claim. The
adjustment has the effect of taxing the credit at a firm’s marginal income tax rate.
Consequently, 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%.
Business taxpayers have the option of computing the regular research credit at a rate
of 13%, instead of reducing any deductions taken under section 174 and computing
the credit at the rate of 20%.
A second rule is the 50% rule, which requires that the base amount for the credit
not be less than 50% of a firm’s current-year QREs. The rule affects established firms
whose ratio of current-year QREs to gross income is more than double their fixed-base
percentages, or more than double the 16% cap on the fixed-base percentage. It also
affects 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%.
Yet another rule lowering this rate is the exclusion of expenditures for equipment
and structures and overhead costs from expenses eligible for the credit — even though
many business R&D investments involve the purchase of elaborate buildings and
sophisticated equipment, and all R&D projects have overhead costs. The effect of the
exclusion on the marginal effective rate of the credit depends on the share of an R&D
investment that is ineligible for the credit: as this share rises, the rate falls, 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 that invest in R&D projects where physical capital represents 50%
35 Cox, Tax Preferences for Research and Experimentation, p. 15.
36 Ibid., p. 17.

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CRS-23
of the total cost and are subject to 50% rule, the marginal effective rate of the credit
could drop to 3.25%.
The key to bolstering the credit’s incentive effect is to increase its average
effective rate. 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 to increase the credit’s statutory rate.
Cox assessed the impact 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 existing R&D tax preferences yielded median after-
tax returns that were 124.7% of pre-tax returns for projects producing intangible assets
with an economic life of three years, and 115.5% for projects producing intangible
assets with an economic life of 20 years. Getting rid of 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.37 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 121.9% for assets with a 20-year economic life.38 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 suggests that leaving the credit’s 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 enhancing the credit’s
incentive effect.
Non-refundable Status
The R&E tax credit is non-refundable, which means that only firms with
sufficiently large income tax liabilities may benefit from it. In addition, the credit is
a component of the general business credit (GBC) 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 tax liabilities, the disadvantages may outweigh the advantages.
For smaller, newly created 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
37 Ibid., p. 27.
38 Ibid., p. 27.

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CRS-24
money means that a business taxpayer is better off using a tax credit now rather than
five or 10 years from now.
Critics of the credit’s design say 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 have spent substantial sums on R&D, even though they lost large
sums of money in their first few years of existence. In the view of critics, the credit’s
lack of refundability diminishes the typical small start-up firm’s prospects for survival
or growth because it cannot count on the credit as a possible source of funding for
R&D investments. They argue that making the credit wholly or partially refundable
for firms under a certain asset or employment size and age would strengthen the
domestic climate for technological innovation.39
Unsettled Definition of Qualified Research
Another policy issue raised by the current research tax credit relates to the
definition of qualified research. More specifically, firms investing in R&D face
continuing uncertainty over how the IRS will interpret final regulations on the
definition of qualified research issued in December 2003, and when the IRS will
address certain key issues left unresolved by those regulations. Critics say this
double-edged uncertainty undermines the effectiveness of the credit and inflates the
cost of compliance with it. Lasting doubt about which research projects do and do not
qualify for the credit may deter some firms from claiming it and may encourage others
to re-label or repackage certain ordinary business expenses to make them eligible for
the credit. Additionally, a lack of clarity over where the line is drawn between
research that does and does not qualify for the credit sets the stage for costly,
prolonged legal disputes between business taxpayers and the IRS over which claims
for the credit are valid.
From 1981 through 1985, research that could be expensed 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. In response to mounting concerns that business
taxpayers were claiming the credit for activities that had little to do with technological
innovation, Congress tightened the definition by adding two tests through the Tax
Reform Act of 1986.40 Under the act, qualified research still had to satisfy the criteria
for qualified research under IRC section 174. But it also was required 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. And “substantially all” of the research had to
involve a process of experimentation aimed at developing a new or improved
39 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.
40 See P.L. 99-514, Section 231.

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CRS-25
function, performance, or quality for a product or process. The act also directed the
IRS to issue regulations clarifying and implementing the new tests.
Nearly 12 years passed before the IRS issued proposed regulations on the
definition of qualified research in December 1998. Its release provoked a storm of
controversy. Two key issues addressed by the proposal were how to identify
information that is technological in nature and what it means to discover such
information. Most of the comments on the proposed regulations received from tax
practitioners and business taxpayers were critical of positions staked out by the IRS.
In response, the agency made some changes in the proposal and issued what was
intended to be a final set of regulations in December 2000 (T.D. 8930). But about a
month later, the Treasury Department published a notice (Notice 2001-19) retracting
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.41 In December 2001, the IRS fulfilled the pledge by releasing
a another set of proposed regulations (REG-112991-01). Tax practitioners generally
responded favorably to the proposal.42
On December 30, 2003, the IRS published final regulations (T.D. 9104) in the
Federal Register clarifying the definition of qualified research.43 The regulations
made some important changes to previous guidance, while reassuring business
taxpayers that the IRS would not challenge positions taken by them if they were
consistent with previous regulations.
Under T.D. 9104, information is considered technological in nature if the process
used to discover the information draws on the principles of the physical or biological
sciences, engineering, or computer science. In addition, the regulations state that
taxpayers do not need 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” for it to be
considered technological in nature.
The regulations also explain what it means to engage in a “process of
experimentation.” Basically, such a process has three elements. First, the outcome
of a process of experimentation must be uncertain at the outset. Second, the process
must enable researchers to identify a variety of alternative approaches to achieving a
desired outcome. And third, the researchers must use certain scientific methods for
41 Sheryl Stratton, “Treasury Puts Brakes on Research Credit Regs; Practitioners Applaud,”
Tax Notes, vol. 90, no. 6, Feb. 5, 2001, pp. 713-715.
42 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.
43 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.

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CRS-26
evaluating these alternatives (e.g., modeling, simulation, and a systematic trial-and-
error investigation).
Although the regulations clarified a number of important questions, they did not
address an issue that is important to many firms: whether or not research to develop
internal-use software is 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 unique or novel and to differ in a
“significant and inventive” way from previous software. Not surprisingly, the
meaning of “significant and inventive” has been a subject of contentious debate
between IRS examiners and taxpayers ever since. The regulations offer no guidance
on this question.
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.44
Lack of Focus on R&D With Large Social Returns
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 its “bang for the buck.” Critics 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
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 ends up bearing some of the
cost.45 The tax subsidy enables market forces to determine which projects are pursued
and which are jettisoned. Supporters of the credit 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 some critics of the credit say that it does a poor job of targeting R&D
projects with large external benefits. While there are no known data to test this claim,
it seems plausible. In general, business managers and owners are driven to seek the
highest possible return on investment. Consequently, in selecting R&D projects to
pursue, they are likely to 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 reflected in domestic industrial R&D spending: in 2001,
44 Annette B. Smith, “Continuing Uncertainty on Research Credit Definition of Gross
Receipts,” Tax Adviser, vol. 35, no. 7, July 1, 2004, p. 407.
45 Joseph E. Stiglitz, Economics of the Public Sector (New York: W.W. Norton, 2000),
p. 348.

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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.46 Such an allocation creates 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 only to basic research, and altering the basic
research credit so that it applies to all basic research undertaken by a business taxpayer
and offers a higher statutory rate than the regular R&E tax credit.
In deciding 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.47 This preponderance is neither surprising nor unjustified, given that
most firms are reluctant to invest more in basic research than applied research or
development because of the difficulty of capturing all or most of the returns on
investment in basic research and the greater uncertainty surrounding those returns.
Legislation in the 109th Congress
to Change the Research Tax Credit
The research tax credit has enjoyed strong bipartisan support since its inception,
and there is no reason to think that this support has weakened in the current Congress.
Numerous bills that would permanently extend the research tax credit have been
introduced in the 109th Congress, most notably H.R. 1454, H.R. 1736, H.R. 2665,
H.R. 4845, H.R. 5058, H.R. 5115, S. 14, S. 627, S. 2109, S. 2199, S. 2357, and S.
2720. Three of these measures (H.R. 1454, H.R. 1736, and S. 627) focus solely on
46 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.
47 See Brandon Shackelford, “U.S. R&D Continues to Rebound in 2004,” InfoBrief, NSF06-
306 (Arlington, VA: Jan. 2006), p. 3.

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altering the existing credit; H.R. 1736 and S. 627, which are companion bills, have
garnered substantial bipartisan backing.48 The other bills have broader aims and
would modify the credit as a key element of strategies aimed at achieving goals as
varied as improving the domestic climate for technological innovation (S. 2199 and
S. 2720), reducing U.S. dependence on foreign sources of oil (H.R. 2665), and
encouraging an increased flow of equity capital into biomedical research corporations
(H.R. 5115).
Many of the bills that would permanently extend the credit would also change its
design with the intent of enhancing its effectiveness. For example, H.R. 1736, H.R.
2665, H.R. 4845, H.R. 5115, S. 14, S. 627, S. 1020, S. 2109, and S. 2357 would raise
the three rates for the AIRC to 3%, 4%, and 5%. Most of these bills (H.R. 1736, H.R.
4845, H.R. 5115, S. 14, S. 627, S. 1020, S. 2109, and S. 2357) would also establish
a second 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 QREs in the three previous tax years; for firms that did not
have qualified research expenditures in at least one of the preceding three tax years,
the credit would be equal to 6% of qualified research expenditures in the current tax
year. In addition, S. 2199 would raise the statutory rates for the regular and basic
research credits from 20% to 40%, and S. 14, S. 2199, S. 2357 would make 100% of
payments made to private research consortia for qualified research eligible for a 20%
tax credit. S. 2720 would break new ground by scrapping the current research credit
starting in 2008 and replacing it with a credit equal to 20% of QREs above 50% of a
firm’s average QREs in the three previous tax years (the credit would be 10% of all
QREs in the current tax year for firms with no QREs in one or more of the three
previous tax years) and making 80% of contract research expenses and 100% of
payments for basic research conducted by certain organizations eligible for the credit.
Recent legislative activity in the 109th Congress suggests that it is more likely to
pass a temporary extension of the credit rather than a permanent one. Two measures
with a provision extending the credit have been considered by either the House or
Senate: H.R. 4297, the tax reconciliation bill, and H.R. 5970, the so-called “trifecta
bill.”
In the case of H.R. 4297, the version passed by the House would have extended
the expired credit through the end of 2006, whereas the version passed by the Senate
would extended it through the end of 2007. In addition, both versions would have
increased the rates of the AIRC to 3%, 4%, and 5% and established the same
alternative simplified credit described above. The conference committee formed to
reconcile differences between the two versions of H.R. 4297 agreed to remove the
provision extending and modifying the credit (along with a number of other popular
expired tax benefits, such as the work opportunity tax credit and the deduction for
state and local sales taxes) from the version that was enacted (the Tax Increase
Prevention and Reconciliation Act of 2005, P.L. 109-222). Two considerations lay
behind this decision: (1) a $70 billion cap on total revenue losses from FY2006
through FY2010 under the FY2006 budget resolution approved by the House and
48 As of April 25, 2006, H.R. 1736 had 127 cosponsors (52 Democrats and 75 Republicans),
and S. 627 had 47 cosponsors (20 Democrats and 27 Republicans).

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Senate; and (2) a resolve on the part of the leadership of the House and Senate to
include in H.R. 4297 certain tax provisions (e.g., an extension through 2008 of the
current 15% tax rates on capital gains and dividends) that would be unlikely to pass
in the Senate without the protections the offered by the budget reconciliation process.
Conferees reportedly agreed to include an extension of the expired tax provisions in
a “trailer” bill that could be attached to a pension reform bill (H.R. 4) then in
conference.49
A trailer bill (better known as the trifecta bill) emerged about two months after
President Bush signed H.R. 4297 into law in May 2006 in the form of H.R. 5970. The
bill would combine an extension of various expired tax provisions with an increase
in the federal minimum wage and a reduction in the estate tax. One of its provisions
would retroactively extend the research tax credit through 2007, raise the rates of the
AIRC to 3%, 4%, and 5%, and create an “alternative simplified credit” equal to 12%
of a firm’s QREs in excess of 50% of its average QREs in the three previous tax years
(or 6% of QREs in the current tax year for firms without QREs in each of the three
previous tax years). The increase in the rates for the AIRC and the creation of the new
alternative credit would take effect in 2007. After a brief debate, the House passed
the measure by a vote of 230 to 180 on July 29, 2006. In the Senate, a procedural
motion to end debate on H.R. 5970 and proceed to a vote fell four votes short of
passage on August 3. It now appears unlikely that the Senate will reconsider the bill
before it adjourns near the end of September for the mid-term elections.50 As a result,
there is growing concern among proponents of the credit that it will not be renewed
before the end of the current Congress.
The Bush Administration favors a permanent extension of the research tax credit
and has expressed a willingness to work with Congress to improve its incentive
effect.51
An important consideration (some would say an insurmountable barrier in the
current fiscal climate) for Congress in deciding whether to extend or enhance the
credit is the projected revenue cost of doing so. Recent and projected federal budget
deficits have heightened concern over this cost and are making it difficult to enact
legislation addressing perceived problems with the current credit. The Bush
Administration estimates that a permanent extension of the credit would entail a
revenue loss of $86.4 billion from FY2007 through FY2016.52 Obviously, the revenue
loss would be greater if a permanent extension were coupled with changes in the
design of the credit intended to improve its incentive effect.
49 Wesley Elmore, “Congress Sends $70 Billion Tax Cut to President’s Desk,” Tax Notes,
vol. 777, no. 7, May 15, 2006, pp. 743-745.
50 Kurt Ritterpusch and Jonathan Nicholson, “Estate Tax Cut Dead Before Elections But
Extenders to Remain as Sweetner,” Daily Report for Executives, BNA, Sept. 22, 2006, p.
G-2.
51 Department of the Treasury, General Explanations of the Administration’s Fiscal year
2007 Revenue Proposals (Washington: Feb. 2006), p. 131.
52 Ibid., p. 131.

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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, H.R. 1736,
Permanently extends the regular, alternative incremental, basic
H.R. 2665, H.R. 4845,
research, and energy research credits.
H.R. 5058, H.R. 5115, S.
14, S. 627, S. 2109, S.
2199, and S. 2357
House-Passed Version of
Extends the regular, alternative incremental, basic research, and
H.R. 4297
energy research credits through the end of 2006.
Senate-Passed Version of
Extends the regular, alternative incremental, basic research, and
H.R. 4297, H.R. 5970, and
energy research credits through the end of 2007.
S. 1020
H.R. 1736, H.R. 2665, the
Raises the three rates of the alternative incremental credit to 3%,
House- and Senate-Passed
4%, and 5%.
Versions of H.R. 4297,
H.R. 4845, H.R. 5115,
H.R. 5970, S. 14, S. 627,
S. 1020, S. 2109, and S.
2357
H.R. 1736, the House- and
Creates an alternative simplified credit equal to 12% of qualified
Senate-Passed Versions of
research expenses in excess of 50% of the taxpayer’s average
H.R. 4297, H.R. 4845,
qualified research expenses in the three previous tax years, and
H.R. 5115, H.R. 5970, S.
6% of qualified research expenses in the current tax year for
14, S. 627, S. 1020, S.
taxpayers with no qualified research expenses in at least one of the
2109, and S. 2357
three previous tax years.
S. 14
Makes 100% of payments to certain small firms, universities, and
federal laboratories for contract research eligible for the credit.
Senate-Passed Version of
Makes the full amount of payments to tax-exempt private research
H.R. 4297, S. 14, S. 2199,
consortia with at least five contributing members eligible for what
and S. 2357
is now a 20% research credit.
Source: Congressional Research Service.

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