The 2017 Tax Law (P.L. 115-97) and Investment in Innovation

The 2017 Tax Law (P.L. 115-97) and Investment in Innovation

Updated April 9, 2018
The 2017 Tax Law (P.L. 115-97) and Investment in Innovation
Technological innovation refers to the often lengthy,
R&D investment. On the demand side, taxes can alter the
uncertain, and convoluted process of bringing new
incentives for individuals to form their own businesses and
technologies to the marketplace and their adoption by many
the pace at which they grow.
consumers and companies. Numerous studies have shown
that innovation serves as the primary engine of long-term
In December 2017, Congress passed a law (P.L. 115-97)
growth in real income per person, mainly by increasing the
that made significant changes in the federal tax code,
productivity of a nation’s capital stock and labor force.
including substantial cuts in business income tax rates.
Among the key players in the innovation process are large
Many of the changes went into effect on January 1, 2018.
established companies that invest substantial amounts in
One question for lawmakers concerns how these changes
research and development (R&D), small start-up (or
are likely to affect the domestic climate for investment in
entrepreneurial) firms seeking to commercialize specific
innovation in the short run. Answering the question requires
new technologies, and companies that invest in advanced
a clear understanding of how previous tax law affected that
capital assets for use in their operations.
investment.
Investment in Innovation and Federal Policy
Impact of Previous Tax Law
In a market economy, the main driver of technological
Federal tax law before the enactment of P.L. 115-97
innovation is private investment in R&D and in new capital
affected the domestic climate for technological innovation
assets that incorporate advanced technologies (e.g.,
in three primary ways. First, it offered incentives to invest
robotics). Companies making such investments seek to
in domestic R&D and in new, more advanced machinery
seize, sustain, or enlarge a competitive advantage by being
and equipment, and software. Second, previous tax law
the first to sell or use new and improved products, more
provided an incentive to produce or use domestically new
efficient production methods, and more effective ways of
technologies developed anywhere in the world. Third, it
conducting a business.
influenced the incentives for individuals to form small
entrepreneurial companies through income and capital gains
In theory, companies that engage in R&D are likely to
taxes.
invest too little in that activity, relative to its potential
economic benefits. There are two main reasons for this
One measure of the incentive effect of these tax provisions
presumed underinvestment. First, R&D (especially basic
is their impact on the marginal effective tax rates (ETRs)
research) typically generates economic benefits that are not
for investment in major asset categories. These rates show
fully captured by the firms financing the R&D investments.
the share of pre-tax returns that go to pay income taxes. As
Instead, these benefits typically spill over to other firms and
such, they take into account current income tax rates, as
consumers. In addition, the difficulties faced by many small
well as tax provisions that help shape a company’s tax
entrepreneurial firms in raising funds to undertake R&D
burden, such as deferrals, deductions, exclusions,
can further suppress private R&D investment. Economists
preferential tax rates, and credits.
consider underinvestment in R&D a market failure. As a
result, they recommend that governments try to boost
Table 1 shows estimates from the Tax Policy Center of the
private R&D investment through a variety of policy
ETRs for major classes of assets (except land) under pre-
initiatives, including research grants and tax incentives.
P.L. 115-97 tax law. The estimates were based on the
following assumptions: (1) a corporate tax rate of 35%
The vast share of domestic business R&D investment goes
(now a single rate of 21%) and a passthrough rate of 30%
into development projects. In 2015, according to a survey
(now a top rate of 29.6%); (2) a required real after-tax rate
by the National Center of Science and Engineering
of return for each asset of 6.5%; (3) an inflation rate of 3%;
Statistics, foreign- and U.S.-based businesses spent $355.8
(4) a nominal interest rate of 6.0%; and (5) a debt financing
billion on domestic R&D. Of that amount, $21.8 billion
ratio of 40% for C corporation investments and 30% for
went to basic research (6%), $56.5 billion to applied
non-corporate (or passthrough) business investments.
research (16%), and $277.6 billion to development (78%).
Such a distribution is to be expected, since the largest risk
Table 1. Marginal Effective Tax Rates for Major Asset
of failure and spillover benefits attaches to basic research,
Categories by Organizational Form (percent)
while development projects tend to have the lowest risk of
Passthrough
both outcomes.
Asset Type
Corporations
Businesses
Taxes can affect the domestic climate for innovation in
Equipment
22%
16%
several ways. On the supply side, they help determine the
after-tax cost of undertaking an additional unit of R&D
Structures
30
22
through business income tax rates and tax incentives for
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Passthrough
Two other tax provisions also had a notable effect on the
Asset Type
Corporations
Businesses
domestic climate for innovation under previous tax law:
Section 199 and Section 1202.
Intellectual
0
-5
Section 199 gave companies an incentive to produce or use
Property
in the United States innovative new products and
Inventories
40
32
production processes. Under Section 199, a firm could
deduct 9% of its income from qualified domestic
Overall
26
19
production activities; the deduction was capped at 50% of
Investment
wages from those activities. The deduction lowered a firm’s
Source: Joseph Rosenberg and Donald Marron, Tax Policy and
ETR for the returns on investment in eligible activities.
Investment by Startups and Innovative Firms, February 9, 2015, Tax
Section 1202 encouraged equity investment in small
Policy Center.
corporations in a range of industries by allowing investors
to earn tax-free gains on the sale of qualified small business
It is clear from Table 1 that the federal tax code under prior
stock they held for at least five years.
law was hardly neutral in its impact on business investment.
Instead, it subsidized investments in innovation (especially
P.L. 115-97 and Investment in Innovation
by large, established firms) to a much greater extent than it
The following provisions in the new tax law could affect
did investments in other assets. For both corporations and
the domestic climate for investment in innovation in the
passthrough firms, the returns from R&D investment
short run:
(which are labeled as “intellectual property” in the table)
 Permanent reduction in the top corporate income tax
faced, by far, the lowest tax burden. The returns from
rate to 21% and the top income tax rate for passthrough
investment in equipment had the second lowest burden.
business income to 29.6%,
Four tax provisions in particular had a substantial impact on
the ETRs in Table 1: Section 174, Section 41, Section 179,
 Increase in the expensing allowance under section
and Section 168(k).
168(k) from 50% to 100% for eligible assets placed in
service between September 18, 2017 and December 31,
Under previous tax law, Section 174 allowed companies
2022,
undertaking qualified research to deduct the full amount of
qualified R&D expenditures in the year they were paid or
 Permanent increase in the Section 179 expensing
incurred. The expensing allowance applied only to wages
allowance to $1 million and the phaseout threshold to
and material costs paid or incurred in the conduct of
$2.5 million; both amounts are indexed for inflation,
research “in the experimental sense.”
 Repeal of the Section 199 deduction for domestic
The Section 41 research tax credit actually consisted of two
production income, and
non-refundable credits for investment in qualified research.
Businesses chose which one to use in computing their tax
 Repeal of the option to expense research expenditures
liability. One credit (the regular credit) was equal to 20% of
under Section 174 and a requirement that those
a company’s qualified research expenditures (QREs) above
expenditures be capitalized and amortized over five
a base amount tied to a fixed base period. The other credit
years, starting in 2022.
(the alternative simplified credit or ASC) was equal to 14%
of a company’s QREs above a base amount tied to a
The net effect of these provisions on domestic investment
moving base period. The effective rates of the two credits
in innovation is difficult to assess. Nonetheless, several
were below their statutory rates, owing to the rules
observations seem warranted. First, the cuts in the top
governing their use. Eligible small firms with insufficient
corporate and passthrough business income tax rates will
tax liability or a net operating loss (NOL) were allowed to
lower the cost of capital for investment in all kinds of
apply up to $250,000 of any unused credit in a tax year to
assets, including R&D. But the inability to expense R&D
their share of the Social Security tax for employees.
expenditures beginning in 2022 will offset some of that
reduction in the cost of capital for R&D investments.
Sections 179 and 168(k) allowed companies to accelerate
Second, full expensing of qualified assets through 2022
the recovery of the cost of qualified assets (largely
could increase the rate at which businesses invest in
machinery, equipment, and off-the-shelf software) they
productivity-enhancing technologies such as robotics.
placed in service in a tax year. The Section 179 expensing
Third, the differences between business and individual
allowance was set at $500,000 in 2017, and it began to
income tax rates, especially as they relate to business profits
phaseout when a firm’s total cost for those assets exceeded
and losses, may affect the willingness of individuals to start
$1 million; both amounts were indexed for inflation. Under
new entrepreneurial businesses. Fourth, none of the changes
Section 168(k), companies of all sizes could write off 50%
are likely to make it easier for start-up firms to raise capital
of the cost of eligible assets they placed in service in 2017.
for investment.
Gary Guenther, Analyst in Public Finance
IF10757

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The 2017 Tax Law (P.L. 115-97) and Investment in Innovation

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