The Research and Experimentation Tax Credit: Current Law and Selected Policy Issues for the 106th Congress

The Research and Experimentation Tax Credit: Current Law and Selected Policy Issues for the 106th Congress

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The Research and Experimentation Tax Credit:
Current Law and Selected Policy Issues
for the 106th Congress
Updated January 22, 2001
Gary Guenther
Analyst in Business Taxation and Finance
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

The Research and Experimentation Tax Credit: Current
Law and Selected Policy Issues for the 106th Congress
Summary
Among economists, research and development (R&D) is widely seen as a
cornerstone of technological innovation, which in turn serves as a primary engine of
long-term economic growth. Nonetheless, firms are likely to invest too little in R&D
relative to its economic benefits because it is impossible for them to appropriate all
the returns to R&D. Thus, some government support for business R&D appears to
be justified on economic grounds. However, how much support should be provided
and in what manner are policy issues that stir ongoing debate in Congress.
The federal government supports business R&D in a variety of ways, direct and
indirect. One notable indirect source of support is the research and experimentation
(R&E) tax credit, which was enacted as part of the Economic Recovery Tax Act of
1981 and recently was extended to June 30, 2004. The credit is equal to 20% of a
firm’s spending on qualified research above a base amount. Such an incremental
design is intended to give firms a robust financial incentive to keep increasing their
R&D budgets from one year to the next and to avoid rewarding firms for R&D they
would have undertaken in any event.
In its current design, the R&E tax credit appears to be a cost-effective policy
instrument for increasing business R&D investment. Some recent studies suggest that
one dollar of the credit’s revenue cost leads to a one dollar increase in business R&D
spending. Others point to the conclusion that the credit may be responsible for
somewhere between 6.5% and 13% of business R&D spending.
Nonetheless, proponents of the credit maintain that its design contains certain
flaws that reduce its effectiveness as a R&D tax subsidy. They cite three flaws in
particular. First, because of certain rules governing the use of the credit, its maximum
marginal effective rate is substantially lower than its statutory rate. Second, the credit
has never been made a permanent feature of the federal tax code. And third, the
credit confers uneven marginal benefits among firms performing qualified research and
among qualified business R&D projects without justification in standard economic
theory.
In the 106th Congress, a handful of bills has been introduced that would address
some or all these concerns. The most far-reaching is a pair of identical bills in the
House (H.R. 1682) and the Senate (S. 951) that would permanently extend the credit
and create an alternative incremental credit that is more generous at the margin than
the current credit. There is reason to believe that these proposed changes would fail
to transform the credit into what most economists regard as an optimal R&D tax
subsidy. Nonetheless, on the whole, critics of the credit view it as a form of corporate
welfare that should be curbed or abolished. They contend that it serves to reward
firms for doing what they would do in any event and often applies to R&D projects
with little or no external benefits.

Contents
Economic Rationale for the R&E Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Design of the R&E Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Regular R&E Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Alternative Incremental R&E Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Definition of Qualified Research Expenses . . . . . . . . . . . . . . . . . . . . . . . . . 8
Credit for Basic Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Expensing Allowance for Research Expenditures . . . . . . . . . . . . . . . . . . . 11
The Importance of the R&E Tax Credit Within the
Context of Federal R&D Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Incentive Effect of the R&E Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Marginal Effective Rate of the Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Effect of the Credit on After-Tax Returns
on Business R&D Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Effectiveness of the R&E Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Policy Issues Raised by the Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Lack of Permanence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Inadequate and Uneven Incentive Effect Among Firms and R&D Projects
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Ambiguous Definition of Qualified Research . . . . . . . . . . . . . . . . . . . . . . 20
Efficiency Effects of the R&E Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . 21
Proposals in the 106th Congress to Extend Permanently or Modify the R&E Tax
Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Likely Effects on Business R&D Investment of Selected Proposals in the 106th
Congress to Extend or Improve the R&E Tax Credit . . . . . . . . . . . . . . . . 25
Permanent Extension of the Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
More Favorable Tax Treatment of Research Consortia . . . . . . . . . . . . . . . 25
Recent Growth in U.S. Research Consortia . . . . . . . . . . . . . . . . . . . 26
Tax Subsidies for Research Consortia and Federal R&D Policy . . . . 27
Creation of a More Beneficial Alternative Incremental Credit . . . . . . . . . . 27
More Favorable Tax Treatment of Basic Research Expenses . . . . . . . . . . 29
Special Assistance for Smaller Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Appendix: Estimation of R&E Tax Credits Earned by a Startup Firm and An
Established Firm Under Current Law and H.R. 1682/S. 951 . . . . . . . . . . 33

List of Tables
Table 1. Sample Calculations of the Regular and Alternative Incremental R&E Tax
Credits in 1998 for an Established Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Table 2. Sample Calculations of the Regular and Alternative Incremental R&E Tax
Credits in 1998 for a Startup Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Table 3. Bills in the 106th Congress to
Extend or Improve the R&E Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . 23
Table 4. Selected Financial Data for Merck & Co. and Cephalon Inc. From 1988 to
1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Table 5. Estimated R&E Tax Credits in 1998 for Merck & Co. and Cephalon Inc.
Under Current Law and Under H.R. 1682/S. 951 . . . . . . . . . . . . . . . . . . . 35

The Research and Experimentation Tax
Credit: Current Law and Selected Policy
Issues for the 106th Congress
In recent decades, economists have gained notoriety for their disputes over a
variety of policy issues. But on one such issue, the proper role of government in the
market for research and development (R&D), they tend to agree. Most economists
subscribe to the view that R&D lays the foundation for technological innovation,
which, in turn, is an important driving force in long-term economic growth – mainly
through its impact on the productivity of capital and labor. Other key determinants
of the rate and pattern of economic growth include investment in new plant and
equipment and in worker education and training. Technological innovation embraces
a complex and varied set of activities, ranging from the discovery of new scientific or
technical knowledge to the widespread adoption of new technologies derived from
this knowledge. But it also involves elements of serendipity and ingenuity that have
little to do with the formal R&D process. The end result of this process is the
generation of new or improved goods and services and new or improved practices,
techniques, and designs for the production and distribution of goods and services.
Over time, technological innovation makes physical capital and labor more productive
and yields more benefits for the economy as a whole than the firms financing or
performing the R&D that undergirds this innovation. Economists who have studied
the sources of economic growth attribute between one-quarter and one-half of real
growth in U.S. domestic gross product since 1945 to technological innovation.1
Even though R&D plays a central role in long-term economic growth and
transformation, firms are likely to invest less in R&D on the whole than its potential
economic benefits would warrant. This is because business R&D investments
generate larger returns to society at large than to the firms financing the investments.
Studies done by the late economist Edwin Mansfield and others indicate that, on
average, the social rates of return on business R&D investments are substantially
larger than the private rates of return.2 The inability of firms to capture or appropriate
all the returns to their R&D investments provides a cogent economic rationale for
1Borrus, Michael and Jay Stowsky. “Technology Policy and Economic Growth.” Investing
in Innovation, edited by Lewis M. Branscomb and James H. Keller. Cambridge, MA, MIT
Press, 1998. P. 41.
2Mansfield, Edwin. “Contributions of New Technology to the Economy.” Technology, R&D,
and the Economy, edited by Bruce L. R. Smith and Claude E. Barfield. Washington, the
Brookings Institution and the American Enterprise Institute, 1996. P. 116-119; and Griliches,
Zvi. “The Search for R&D Spillovers.” Scandinavian Journal of Economics 94, Supplement
(3), 1992. Table 1, p. 43.

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government support of R&D beyond what is needed to support the government’s
critical missions.
The federal government supports business R&D in a variety of ways, direct and
indirect.3 One salient source of indirect support is an incremental tax credit for
research expenditures. Since July 1981, firms have been able to claim a credit against
their federal income tax liabilities for spending on qualified research conducted in the
United States above a base amount under section 41 of the Internal Revenue Code
(IRC). The credit – also referred to as the research and experimentation (R&E) tax
credit – is intended to give firms a robust financial incentive to increase their R&D
investments from one year to the next. It was enacted as a temporary provision of the
Economic Recovery Tax Act of 1981, and since then it has been extended ten times
(most recently by the Ticket to Work and Work Incentives Improvement Act of 1999,
P.L. 106-170) and significantly revised five times (most recently by the Small Business
Job Protection Act of 1996). In fact, since its enactment, the credit has been
continuously available except for the period from July 1, 1995 to June 30, 1996, when
it lapsed and subsequent extensions of the credit did not retroactively cover this
period. The credit is due to expire on June 30, 2004.
This report examines the design of the current credit and some of the key policy
issues it raises. More specifically, the report discusses whether the credit is justified
on economic grounds, explains how the credit works, and summarizes what is known
about its effectiveness and incentive effect. In addition, the report describes some of
the key policy issues raised by the credit. It concludes with a discussion of legislative
proposals introduced in the 106th Congress that address these issues and an
assessment of their potential impact on business R&D investment.
Economic Rationale for the R&E Tax Credit
In theory, a properly functioning market economy can be expected to allocate
resources efficiently, which is to say in a manner that achieves the highest possible
level of social welfare. Under these circumstances, government intervention in the
economy would be likely to result in less desirable outcomes. This is not to suggest,
however, that government intervention can never improve social welfare. If any of
the stringent conditions required for markets to allocate resources efficiently fails to
materialize, then, according to standard economic theory, government intervention
might achieve higher levels of social welfare. Most economists hold that a market
economy may misallocate resources under certain conditions. One is the existence of
excessive market power on the part of buyers and sellers. Another is the failure of
markets for certain goods and services to emerge: for instance, the private market
does not offer insurance for many significant risks facing individuals, such as loss of
income because of unemployment. The presence of either condition would provide
a cogent economic justification for government intervention in the economy.
3See Library of Congress. Congressional Research Service. Industrial Competitiveness and
Technological Advancement: Debate Over Government Policy. Issue Brief 91132, by
Wendy H. Schacht, updated regularly. Washington, February 8, 2000. 14 p.

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In effect, the R&E tax credit represents government intervention in the market
for R&D, or the market for the creation and development of new technical knowledge
and knowhow. Is such intervention justified on economic grounds? The answer
depends largely on whether or not the credit addresses the conditions that contribute
to inefficient uses of economic resources. Does the market for R&D exhibit any such
conditions? In a word, yes. The market is subject to a failure that is tantamount to
the nonexistence of a market: a positive externality.4 An externality, positive or
negative, arises when one economic actor’s behavior affects the welfare of another
in a way that is not reflected in market prices.
As noted earlier, the process of technological innovation embraces a wide range
of sometimes related but often discrete activities, including the discovery of new
scientific or technical knowledge, the application of this knowledge to develop new
products and processes, and the widespread adoption of these new technologies by
consumers and firms. A critical element in the process is R&D conducted by firms.
In theory, a firm will invest in R&D up to the point where its expected after-tax return
on the investment equals its cost of capital. Yet it is thought that many firms do not
capture all the returns to their R&D investments and thus are disposed to invest less
in R&D than its social returns would warrant. The reason lies in the primary output
of R&D: new technical knowledge and knowhow. Knowledge and knowhow exhibit
the chief traits of a public good: their consumption or use is nonexcludable and
nonrival.5 As a result, it is not possible for firms that invest in R&D to prevent other
firms from exploiting its results, even in the presence of the patent protection. The
results of R&D can spill over to other firms through several channels: rival firms can
imitate new products through reverse engineering; or they can hire key R&D
personnel away from innovating firms; or researchers from an innovating firm can quit
and form a competing firm with funding from venture capitalists or banks. The
existence of those spillover effects is evidence that the social returns to R&D exceed
the private returns. In a recent paper, economists Charles I. Jones and John C.
Williams estimated that the social rate of return to R&D was two to four times greater
than the private rate of return on capital.6 And other research suggests that this is true
in the particular case of business R&D.7 Such a gap produces inefficient outcomes
4An externality is an inefficiency that arises because of the nonexistence of a market for the
costs or benefits of certain activities. It materializes when the activities of one person or firm
affect the welfare of others in ways that are not transmitted through market prices.
Externalities can be positive or negative. A positive externality occurs when an entity does
something that benefits others without receiving compensation for this welfare gain; and a
negative externality exists when one entity’s actions lowers the welfare of others without
bearing the cost of this welfare loss.
5This means that it is practically impossible to exclude someone from the benefits of newly
discovered knowledge, and that one person’s use of such knowledge does not diminish the
stock of knowledge available for others to use. For more details on the nature of public goods,
see Stiglitz, Joseph E. Economics of the Public Sector. New York, W.W. Norton & Co.,
1988. P. 119-123.
6Jones, Charles I. And John C. Williams. “Measuring the Social Return to R&D.” Quarterly
Journal of Economics, November 1998. P. 1119 to 1135.
7The late economist Edwin Mansfield estimated that the average social rate of return was more
(continued...)

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because it means that firms’ R&D investments fall short of the levels required to
achieve maximum social welfare. These spillover effects constitute a classic example
of a positive externality.
A classic remedy for such a market failure is a subsidy for the activity producing
the external benefits. In the case of business R&D, the optimal subsidy would
equalize the private and social returns to R&D investments at the level of R&D
spending that engenders the highest possible social welfare. The R&E tax credit
would play such a role if its average incentive effect were large enough to bridge the
gap between the private and social returns to R&D. So one important policy issue
raised by the credit is whether its average weighted incentive effect is capable of
elevating business R&D investment to a socially optimal level.
Ideally, the R&E tax credit would be available only for R&D projects with social
returns in excess of their private returns. Unfortunately, such a targeted use of the
credit is not feasible for two reasons. First, it is very difficult to measure accurately
the social returns to R&D; second, it is impossible to know in advance which business
R&D expenditures will produce greater social returns than private returns. In reality,
the credit is available for all qualified business research, regardless of its social returns.
As a result, there is no barrier to firms claiming R&E tax credits for R&D projects
with private rates of return that exceed social rates of return. This limitation of the
credit as an R&D subsidy raises another important policy issue: if an aim of federal
R&D policy is to stimulate investment in R&D projects with substantial spillover
effects, and assuming that public R&D spending does not displace private R&D
spending, would targeted government spending on R&D be more effective than tax
subsidies in accomplishing this goal?
Design of the R&E Tax Credit
Under IRC section 41, the R&E tax credit actually comprises three separate and
distinct credits: a regular credit, an alternative incremental credit, and a basic research
credit. They are alike in that each applies only to qualified research spending above
a base amount. Yet, as is discussed in detail below, they can differ considerably in
their marginal value to firms paying for such research. Furthermore, the R&E tax
credit is part of the general business credit (IRC section 38) and thus subject to its
restrictions. Firms that earn R&E credits in a particular tax year but cannot use them
because of these restrictions or because they lacked taxable income may carry the
unused credits back up to three years or forward up to fifteen years. The
congressional Joint Committee on Taxation estimates that in FY1999 the three credits
combined cost the U.S. government $1.6 billion in foregone tax revenues.8
7(...continued)
than twice the average private rate of return for a host of important industrial innovations:
56% versus 25%. See Mansfield, Edwin. “Microeconomics of Technological Innovation.”
The Positive Sum Strategy: Harnessing Technology for Economic Growth. Ralph Landau
and Nathan Rosenberg, eds. Washington, National Academy Press, 1986. P. 307-325.
8U.S. Congress. Joint Committee on Taxation. Estimates of Federal Tax Expenditures for
(continued...)

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Regular R&E Tax Credit
The regular R&E tax credit is equal to 20% of a firm’s qualified research
spending above a base amount. Such an incremental design is intended to give firms
a robust financial incentive to spend more on R&D than they otherwise would,
thereby shrinking the gap between actual and socially desirable levels of business
R&D investment. The base amount is supposed to approximate a firm’s normal R&D
expenditures.
Calculating the base amount entails a series of steps, and the formula is different
for established firms and startup firms. For an established firm, which is defined as
a firm with taxable income and qualified research expenses in three of the years from
1984 to 1988, the base amount equals the product of its fixed-base percentage and its
average annual gross receipts in the four previous tax years. An established firm’s
fixed-base percentage is its ratio of total qualified research spending to total gross
receipts between 1984 and 1988 – or its research intensity in that period. (See table
1 for a sample calculation of the regular R&E tax credit for an established firm.)
For a startup firm, which is defined as either a firm with fewer than three years
of taxable income and qualified research expenses from 1984 to 1988 or a firm whose
first year with taxable income and qualified research expenses was 1984 or later, the
base amount is determined in the same manner but with one significant difference. Its
fixed-base percentage is fixed at 3% during the firm’s first five years with taxable
income and qualified research expenses after 1993; at the end of that period, the
percentage shifts gradually so that by the eleventh year with taxable income and
qualified research expenses after 1993 it equals the ratio of qualified research
spending to gross receipts in five of the previous six tax years chosen by the firm. A
consequential effect of the 3% rule is that it increases the odds that a small fledgling
firm will be able to claim the credit in a period when it is vulnerable to failure or cash
flow problems. (See table 2 for a sample calculation of the regular R&E tax credit for
a startup firm.)
Two rules for determining the base amount have a significant influence the
credit’s maximum marginal effective rate. One is that the base amount must equal
50% or more of a firm’s qualified research spending in the current tax year; hereafter
this rule will be referred to as the 50-percent rule. And the second rule is that a firm’s
fixed-base percentage cannot exceed 16%. The impact of these rules on the
maximum marginal effective rate of the credit is discussed below.
As a general rule, a firm can claim the regular R&E tax credit only if its ratio of
qualified research expenses in the current tax year to its average annual gross receipts
in the past four tax years is greater than its fixed-base percentage. This holds true
regardless of how much more a firm spends on qualified research in the current tax
year than in the base period. In the sample calculation of the regular credit shown in
table 1, the established firm’s research intensity in its base period was 4%, but it rose
8(...continued)
Fiscal Years 1999-2003 (JCS-7-98) . Washington, December 14, 1998. P. 15.

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to 5% in the period from 1994 to 1998. Thus, one desirable effect of the regular
credit is that it encourages firms to become more research-intensive.
Alternative Incremental R&E Tax Credit
Firms performing qualified research may claim an alternative incremental R&E
tax credit instead of the regular credit. This option has been available since July 1,
1996. In deciding whether to claim the alternative credit, two considerations are
paramount. One is that once a firm claims the alternative credit, it must continue to
claim it in succeeding tax years unless it receives permission from the Internal
Revenue Service (IRS) to switch to the regular credit. The other important
consideration is that the alternative credit consists of three linked rates, and the
highest one is much lower than the statutory rate of the regular credit. Specifically,
the alternative credit is equal to the sum of 2.65% of a firm’s qualified research
expenses in excess of 1% but not greater than 1.5% of its average annual gross
receipts in the preceding four tax years, and 3.2% of its qualified research expenses
in excess of 1.5% but not greater than 2.0% of this same amount, and 3.75% of its
qualified research spending that exceeds 2.0% of this same amount. By contrast, the
statutory rate of the regular credit is 20%. (See tables 1 and 2 for sample calculations
of the alternative incremental R&E tax credit for an established firm and a startup
firm.)
In general, a firm can claim the alternative credit if its qualified research expenses
in the current tax year exceed 1% of its average gross receipts in the past four tax
years. This clearly is the case for the established firm shown in table 1 and the startup
firm shown in table 2. Furthermore, firms can expect to benefit more from the
alternative credit than the regular credit if their qualified research expenses in the
current tax year are only slightly greater than their base amounts under the regular
credit. Such is not the case for the established and startup firms depicted in tables 1
and 2. The calculations in the tables prove that both firms would be better off
claiming the regular credits.

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Table 1. Sample Calculations of the Regular and Alternative
Incremental R&E Tax Credits in 1998 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
620
20
1990
700
25
1991
660
35
1992
710
30
1993
800
35
1994
835
45
1995
915
50
1996
1,005
53
1997
1,215
60
1998
1,465
70
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 1998:
1. Calculate the average annual gross receipts for the 4 previous years (1994-1997): $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 1998:
1. Begin with the qualified research expenses for 1998 of $70 million and subtract the base amount
($39.7 million) or 50% of the qualified research expenses for 1998 ($35 million), whichever is greater:
$30.3 million
2. Multiply this amount by 20% to determine the regular R&E tax credit for 1998: $6.06 million
Calculation: Alternative Incremental R&E Tax Credit
1. Calculate the average annual gross receipts for the 4 previous years (1994-1997): $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 1998 ($70 million) and subtract 1% and 1.5% and 2%
(respectively) of the average annual gross receipts for 1994 to 1997: $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
Source: Congressional Research Service

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Table 2. Sample Calculations of the Regular and Alternative
Incremental R&E Tax Credits in 1998 for a Startup Firm
($ millions)
Year
Gross Receipts
Qualified Research Expenses
1990
30
35
1991
42
40
1992
56
48
1993
60
55
1994
210
65
1995
305
73
1996
400
82
1997
475
90
1998
600
105
Calculation: Regular R&E Tax Credit
Compute the fixed-base percentage:
1. By definition, the firm is a startup. And according to current law, a startup firm’s fixed-base
percentage is fixed at 3% for each of the 5 years after 1993 when it has both gross receipts and qualified
research expenses. Thus, the fixed-base percentage for 1998 is 3%.
Compute the base amount for 1998:
1. Calculate the average annual receipts for the 4 previous years (1994-1997): $347.5 million
2. Multiply this amount by the fixed-base percentage to determine the base amount: $10.4 million
Compute the regular tax credit:
1. Begin with the qualified research expenses for 1998 ($105 million) and subtract the base amount
($10.4 million) or 50% of the qualified research expenses for 1998 ($52.5 million), whichever is greater:
$52.5 million
2. Multiply this amount by 20% to determine the regular R&E tax credit for 1998: $10.5 million
Calculation: Alternative Incremental R&E Tax Credit
1. Calculate the average annual gross receipts for the 4 previous years (1994-1997): $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 1998 ($105 million) and subtract 1.0%, 1.5%, and
2.0% (respectively) of the average annual gross receipts for 1994 to 1997: $101.525 million, $99.788
million, and $98.05 million
4. Multiply the difference between $101.525 million and $99.788 million by 0.0265: $0.046 million
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
Source: Congressional Research Service
Definition of Qualified Research Expenses
The preceding discussion makes clear that a crucial consideration in claiming the
regular or alternative R&E tax credits is the definition of qualified research. Under
IRC section 41(d), research expenses must satisfy three criteria in order to qualify for
the credit. First, the expenses must relate to activities that can be expensed under IRC
section 174. That section allows a firm to deduct expenses it incurs in performing
research in the “experimental or laboratory sense” related to its business in the year
they are incurred, or to amortize them over a period of sixty months. Qualified
research under section 174 includes the development of a new product or process or
the improvement of an existing one. Second, the expenses eligible for the R&E tax
credit must pertain to research undertaken to discover information that is

CRS-9
“technological in nature” and useful in the development of a new or improved
“business component,” which is defined as a product, process, computer software,
technique, formula or invention that is to be sold, leased, licensed or used by the firm
performing the research. And third, the expenses eligible for the R&E tax credit must
relate to activities that make up a process of experimentation whose ultimate aim is
the development of a business component with “a new or improved function,
performance or reliability or quality.”
Section 41(d) also specifies that certain research activities do not qualify for the
R&E tax credit. Arguably, it is more concrete about activities that do not qualify than
those that do. At any rate, firms may not claim the credit for expenses incurred in the
following activities:
! research whose aim is to alter the style or appearance of a business component;
! research done after the start of commercial production of a new or improved
business component;
! research done to adapt a business component to a specific customer’s needs;
! research done to duplicate an existing business component -- a practice known
as reverse engineering;
! surveys or studies related to market research, management techniques, data
collection, or testing and inspection for quality control;
! the development of computer software for internal use (with some exceptions);
! research conducted outside the United States, Puerto Rico, or a U.S.
possession;
! research in the “social sciences, arts, or humanities;” and
! research funded by a grant.
Moreover, not all expenses incurred in qualified research are eligible for the
credit. Under section 41, qualified research expenses cover the wages and salaries of
employees engaged in qualified research, the costs of materials and supplies used in
qualified research, rented or leased computer time used in qualified research, 75% of
payments for qualified research performed by nonprofit scientific research
organizations that are not private foundations, and 65% of payments for qualified
research performed by certain other organizations. The credit does not apply to the
following expenses: equipment and structures used in qualified research; the overhead
related to this research, including utility costs, rent, leasing fees, administrative and
insurance costs, and property taxes; and the fringe benefits of employees engaged in
qualified research. While firms can deduct these expenses from their taxable income,
their exclusion from the calculation of the credit can diminish its incentive effect. A
recent study indicates that qualified research expenses account for anywhere from
50% to 73% of total business R&D spending as defined under current financial
accounting standards.9
In spite of its critical role in the use and incentive effect of the R&E tax credit,
the definition of qualified research has been criticized for a lack of clarity about the
9Hall, Bronwyn H. and John van Reenen. “How Effective Are Fiscal Incentives for R&D?
A Review of the Evidence.” Working Paper 7098. Cambridge, MA, National Bureau for
Economic Research, April 1999. P. 22.

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kinds of activities that qualify for the credit. The three-part test for eligible research
notwithstanding, current law and relevant IRS regulations provide little or no
guidance on such key questions as how to determine if a specific research project
discovers information that is “technological in nature,” or how to determine if a
project is part of “a process of experimentation for the purpose of (developing)....a
new or improved function, or performance, or reliability or quality.”
The Congress and IRS have taken some steps to clarify the boundaries of
qualified research, but the issue remains a source of controversy and uncertainty
within the private sector. The Tax Reform Act of 1986 mandated that the Treasury
Department issue regulations clarifying the research that qualifies for the credit. In
1989, the IRS issued final regulations for research performed between 1981 and 1986.
However, it has yet to do the same for research undertaken after 1986. In December
1998, the IRS issued proposed regulations (REG-105170-97) on the definition of
qualified research under section 41(d). In particular, it proposed that research would
meet the discovery test “only if the research activities are undertaken to obtain
knowledge that exceeds, expands, or refines the common knowledge of skilled
professionals in the particular field of technology or science and the process of
experimentation utilized fundamentally relies on principles of physical or biological
sciences, engineering, or computer science.” The IRS further proposed that “the
credit may be available where the technological advance sought by the taxpayer is
evolutionary, and, in certain circumstances, where the taxpayer is not the first to
achieve the same advance, ....and regardless of whether the taxpayer succeeds or fails
in achieving the desired advance.” But final action on these proposals is still pending.
At a public hearing on the proposed regulations held by the IRS in late April 1999,
several members of the business community voiced a variety of concerns about them
and urged the IRS to reconsider much of its proposal.10 The IRS is mulling over the
criticisms, but it is not clear when final regulations will be issued.
Credit for Basic Research
In addition to the regular or alternative incremental R&E tax credit, firms may
claim a tax credit for payments to certain organizations that perform basic research.
The basic research credit is intended in part to foster close collaboration between the
private sector and research universities. The credit is equal to 20% of basic research
payments over a base amount. Basic research payments that are less than or equal to
the base amount may be included in the research expenses eligible for the regular or
alternative credits. IRC section 41(e) defines basic research as “any original
investigation for the advancement of scientific knowledge not having a specific
commercial objective.” The credit does not apply to basic research performed outside
the United States, or to basic research in the “social sciences, arts, or humanities.”
For basic research expenditures to be eligible for the credit, the research must be
performed by the following organizations: educational institutions, nonprofit
scientific research organizations that are not private foundations, and certain grant
organizations.
10Stratton, Sheryl and Barton Massey. “Major Changes to Research Credit Rules Sought at
IRS Reg Hearing.” Tax Notes, May 3, 1999. P. 623-625.

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Determining the base amount for the basic research credit is a complicated
procedure. A firm’s base period is the three tax years preceding the first year in which
it recorded taxable income after 1983. And a firm’s base amount is equal to the sum
of its “minimum basic research amount” and its “maintenance-of-effort amount” in the
base period. The minimum basic research amount is equal to the greater of 1% of a
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; and a firm’s
minimum basic research amount must equal 50% or more of its basic research
payments in the current tax year. The maintenance-of-effort amount is the difference
between a firm’s donations in the current tax year to qualified organizations (e.g.,
universities) for purposes other than basic research and its average annual donations
to the same organizations during the base period for the same purposes, multiplied by
the cost-of-living adjustment for the current tax year.
Expensing Allowance for Research Expenditures
As noted above, under IRC section 174, firms engaging in R&D may deduct
their qualified research expenses from taxable income in the year when they are
incurred, or they may amortize the expenses over 60 months. Without such a
provision, firms would be required to recover their R&D expenses through
depreciation allowances that reflect the economic lives of the assets created through
the R&D; in the case of patents acquired by a firm, that period would encompass the
twenty years after a patent is filed. The expensing allowance was enacted in 1954,
and, unlike the R&E tax credit, it benefits nearly every firm that conducts R&D. The
allowance applies to all R&D costs except the structures and equipment used in R&D;
the costs of R&D equipment must be recovered over three years and those of R&D
buildings over fifteen years at the rates permitted under current depreciation
schedules. Expensing represents a significant R&D subsidy because it has the effect
of taxing the returns to the share of an R&D investment that is expensed at a marginal
effective rate of zero. The congressional Joint Committee on Taxation estimates that
in FY1999 the expensing allowance cost the U.S. government $1.9 billion in forgone
revenues.11
A firm that claims the R&E tax credit must subtract the value of the credit from
the R&D expenditures it deducts under section 174. This has the effect of making the
credit part of taxable income. Such a basis adjustment diminishes the marginal
effective rate of the credit.
The Importance of the R&E Tax Credit Within the
Context of Federal R&D Policy
The R&E tax credit is one of many tools employed by the federal government
to spur technological innovation. Important direct policy tools include the funding
of basic and applied research in a variety of academic disciplines; the protection of
11Joint Committee on Taxation. Estimates of Federal Tax Expenditures for Fiscal years
1999-2003. P. 15.

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intellectual property rights through patents, copyrights, and trademarks; efforts to
facilitate the creation of joint research ventures involving firms and federal research
laboratories; and grants for specific technology development projects. In addition,
federal policies in the areas of environmental protection, technical standards,
procurement, taxation, business regulation, antitrust law, and foreign trade and
investment can indirectly shape the domestic climate for technological innovation.
Nonetheless, the application of these tools is not always coordinated, and sometimes
they appear to work at cross-purposes.12
Within the broad spectrum of federal support for R&D, the credit has played a
relatively minor role in dollar terms since its inception in July 1981. This can be
readily seen by comparing the cost of the credit (measured in equivalent federal
outlays) to total federal spending on R&D.13 In FY 1998, according to estimates by
the U.S. Office of Management and Budget, the outlay equivalent of the credit totaled
$3.3 billion, or 4.3% of federal R&D outlays that year. From FY 1993 through FY
1997, the outlay equivalent of the credit averaged 2.5% of federal R&D spending.
Incentive Effect of the R&E Tax Credit
The incentive effect of the R&E tax credit denotes the financial incentive it offers
firms to spend an additional dollar on R&D. Basically, there are two ways to assess
this effect. One is to analyze the credit’s impact on the after-tax price of R&D. The
credit lowers the cost to firms of performing research beyond their base amounts.
This cost reduction presumably induces firms to spend more on qualified research, and
the magnitude of the increase hinges on how responsive firms are to declines in the
after-tax price of R&D. Another way to assess the credit’s incentive effect is to
measure its impact on the profitability of business R&D investments. The credit
lowers the marginal effective tax rate on the returns to the R&D investments that
qualify for it, which is to say that the credit increases the after-tax rate of return on
the share of a R&D investment that qualifies for it relative to alternative uses of that
capital. In this way, it is meant to encourage firms to invest more in R&D than they
otherwise would. So how much of a subsidy to R&D does the credit represent?
Marginal Effective Rate of the Credit
The credit is equal to 20% of a firm’s spending on qualified research above its
base amount. In reality, however, the marginal effective rate of the credit on R&D
12Congressional Research Service. Industrial Competitiveness and Technological
Advancement: Debate Over Government Policy. Issue Brief 91132, by Wendy H. Schacht.
Washington, February 8, 2000. 14 p.
13The outlay equivalent of the R&E tax credit is the federal dollars that would have to be spent
to give firms the same after-tax benefits provided by the credit. In effect, it estimates how
much the federal government would have to spend to duplicate the added research stimulated
by the credit. See Office of Management and the Budget. Budget of the United States
Government, Fiscal year 2000: Analytical Perspectives. Washington, U.S. Govt. Print.
Off., 1999. P. 116-117.

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expenditures above this amount turns out to be much lower than 20%. This reduction
is due largely to three rules governing the use of the credit.
One such rule is the requirement that any credit must be subtracted from the
research outlays that are expensed; hereafter this rule will be referred to as the basis
adjustment. It has the effect of taxing the credit at a firm’s statutory income tax rate.
As most corporate income is taxed at a rate of 35%, this adjustment reduces the
maximum marginal effective rate of the credit for many firms from 20% to 13% (20%
x [1-.35]). Essentially, the basis adjustment treats the credit as a price reduction for
a portion of research expenses. As a result, the value of the credit cannot be
deducted.
Another rule that can dilute the marginal effective rate of the credit was
mentioned earlier: the 50-percent rule. Under this rule, a firm’s base amount cannot
be less than 50% of its qualified research expenses in the current tax year. For a firm
whose current spending on R&D relative to gross income (i.e., its research intensity)
is more than double its fixed-based percentage, which is equivalent to its base-period
research intensity, this rule further lowers the top marginal effective rate of any credit
it can claim to 6.5% (and the price reduction for research above the base amount from
20% to 10%).
And further diminishing the incentive effect of the credit is a rule that excludes
the cost of R&D equipment, structures, and overhead (including the fringe benefits
of R&D personnel) from qualified research expenses. How this exclusion affects the
credit’s marginal effective rate depends on the share of an R&D investment that is
ineligible for the credit.
A firm’s past R&D investments can also diminish the incentive effect of the R&E
tax credit, although this feedback effect is likely to be very small in most instances.
To the extent a firm’s current R&D investments boost its future gross receipts by
making it more competitive in domestic or foreign markets, they could set the stage
for smaller R&E tax credits in the future. Such a scenario would materialize if a
firm’s current R&D projects eventually lead to increased gross receipts in a future
period, and if the added receipts boost the firm’s base amounts for the calculation of
the R&E tax credit, and if the firm’s spending on qualified research grows at a slower
rate than its gross receipts between the present and that future period. The likely
outcome would be that the firm ends up claiming smaller credits because of past
research successes. Although such a feedback effect would make it harder over time
for a firm to claim the credit, the effect is smaller than it was under the original credit,
which was revised in 1989 mainly to remedy this problem.14
14The original credit, which was enacted as a temporary provision of the Economic Recovery
Tax Act of 1981, was equal to 25% of the amount by which spending on qualified research
in the current tax year exceeded average qualified research expenditures in the previous three
years. Shortly after the credit went into effect in July 1981, its formula became a target of
criticism. A key problem with the formula, in the view of analysts who studied it, was that
it tended to undercut the incentive effect of the credit over time. This stemmed from the use
of a moving base that depended in part on a firm’s current spending on qualified research. For
example, if a firm raised its spending on qualified research by $100 in 1983, it not only earned
(continued...)

CRS-14
The marginal effective rate of the credit is equivalent to the reduction in the
after-tax price of an additional dollar of qualified research. Once the rate has been
determined, all that is needed to estimate the additional R&D stimulated by the credit
is a measure of the tax price elasticity of R&D. This elasticity shows the percentage
change in R&D spending that would result from a 1% decrease in the price of R&D.
Available studies that attempt to estimate the tax price elasticity for R&D come to
basically the same conclusion: the tax price elasticity of U.S. R&D spending during
the 1980s was around unity (1.0), maybe higher.15 To estimate the R&D spending
induced by the credit, all that is necessary is to multiply the estimated elasticity by the
weighted average marginal effective rate of the credit. Assuming that the current tax
price elasticity of R&D is unity, it is possible that the credit raises business R&D
investment somewhere between 10% and 20%. But considering that the price
responsiveness of R&D demand is unlikely to remain constant over long periods, such
an estimate may be far off the mark in 2000.
Effect of the Credit on After-Tax Returns on Business R&D
Investments
The incentive effect of the credit can also be analyzed from the perspective of its
impact on the returns to business R&D investments. As Bill Cox of CRS made clear
in a 1995 report, this impact depends on three factors: (1) the share of an R&D
investment that qualifies for the credit; (2) the economic life of the technology assets
created by the investment; and (3) the marginal effective tax rate on the income
earned from these assets. In essence, the decision to invest in the creation of new
technical knowledge or knowhow is an investment decision entailing the expenditure
of funds in the present to create intangible economic assets that might yield profits
sometime in the future. As with any investment decision, the decision to invest in
R&D should be based in part on the user cost of capital, which is the amount needed
to return the amount invested in an asset and pay a competitive return on that capital.
Part of the user cost of capital is the income taxes paid on the returns to the intangible
assets created through R&D, less depreciation allowances and credits. In effect, the
R&E tax credit raises after-tax returns on the shares of R&D investments that qualify
for it by reducing the user cost of capital. A key question is by how much does it
reduce this cost.
14(...continued)
a tax credit of $25 for that year but it also increased its base amount for the credit by $33.33
in each of the next three years, thereby reducing the maximum credit it could earn in that
period by a total of $25 ([$33.33 x 0.25] x 3).
Congress attempted to eliminate this flaw in the design of the credit by passing the
Omnibus Budget Reconciliation Act of 1989 (OBRA89). Among other things, the Act altered
the formula for calculating the credit so that the base amount was independent of a firm’s
current R&D spending. It established the current formula where a firm’s base amount is
equal to a product of its fixed-base percentage and its average annual gross income in the
previous four years.
15Hall, Bronwyn H. How Effective Are Fiscal Incentives for R&D? A Review of the
Evidence. P. 21.

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In his 1995 report, Cox estimated the effects of the two main tax preferences for
R&D – the R&E tax credit and the expensing allowance for qualified research
expenditures – on the rates of return for a host of hypothetical research projects. He
divided the projects into three groups based on the share of each project’s total cost
accounted for by depreciable structures and equipment: capital-intensive projects
(50% of outlays), intermediate projects (30% of outlays), and labor-intensive projects
(15% of outlays). In addition, the groups differed in the share of outlays that qualified
for both expensing and the credit: 35% in the case of capital-intensive projects; 50%
in the case of intermediate projects; and 65% in the case of labor-intensive projects.
And within each group, Cox assumed that the economic lives of the technology assets
produced by the projects lasted three, five, ten, or twenty years.
In Cox’s analysis, the impact of the credit can be inferred from the difference
between the ratios of after-tax returns to pre-tax returns for the projects under
expensing alone and under both expensing and the credit. As one would expect, he
found that the credit augmented the effect of expensing on the returns to the shares
of R&D investments that qualified for both tax subsidies. In the case of capital-
intensive projects, the weighted average ratio under expensing alone was 91.3% for
all economic lives; when the credit was included, the weighted average ratio rose for
all economic lives, ranging from 101.0% for projects with 20-year economic lives to
106.0% for projects with 3-year economic lives.16 For intermediate projects, Cox
estimated that under expensing alone the weighted average ratio of after-tax returns
to pre-tax returns was 94.8%, regardless of the economic life of the project; but under
both expensing and the credit, the weighted average ratio was higher for all economic
lives, ranging from 108.7% for projects with 20-year economic lives to 115.8% for
projects with 3-year economic lives. And for labor-intensive projects, the ratio under
expensing alone was 97.4% for all economic lives, but the inclusion of the credit again
increased the ratios for all economic lives, ranging from 115.5% for projects with 20-
year economic lives to 124.7% for projects with 3-year economic lives. In short, the
R&E tax credit boosted the after-tax returns relative to pre-tax returns for all
hypothetical R&D projects by margins ranging from 11% for 20-year capital-intensive
projects to 28% for 3-year labor-intensive projects.
What do these striking results say about the credit’s incentive effect? The
optimal R&D subsidy strives to increase the returns to R&D investments that firms
would not make without the subsidy. Furthermore, in theory, the optimal R&D
subsidy equalizes the private and social returns on these additional R&D investments.
If the subsidy is delivered through the tax code, then the focus of concern necessarily
shifts to after-tax returns to R&D investments. The optimal R&D tax subsidy would
try to elevate after-tax returns to R&D investments beyond what firms would
undertake without the subsidy to the levels that would result from taxing the social
returns to R&D at the same rate. For example, let us assume that the average pre-tax
social return to R&D is double the average pre-tax private return, as a number of
studies have suggested. Then at a corporate tax rate of 35%, the optimal R&D tax
subsidy would seek to raise after-tax returns to business R&D investments to 130%
16For a summary of Cox’s estimates of the effects of expensing and the R&E tax credit on the
rates of return to R&D investments, see Cox, William A. Tax Preferences for Research and
Experimentation: Are Changes Needed? Table 1 (p. 15) and the Appendix (p. 33).

CRS-16
of the pre-tax returns. Because after-tax returns would be 65% of the pre-tax returns
without the tax subsidy, the optimal tax subsidy would attempt to boost after-tax
returns to a level that is double pre-tax returns.
In Cox’s analysis, the two tax subsidies had the largest impact on labor-intensive
R&D projects yielding technology assets with a 3-year economic life. Specifically,
they boosted after-tax returns to 124.7% of pre-tax returns in the case of the median
project. (Without the R&E credit, after-tax returns were less than pre-tax returns by
2.6%.) By contrast, the two tax subsidies had the smallest impact on capital-intensive
projects with a 20-year economic life: they raised after-tax returns to 101% of pre-
tax returns. These results suggest that even in the best of circumstances, the current
R&E tax credit may not be large enough to bridge the gap between after-tax private
and social returns to business R&D investments. At the same time, because the social
returns to R&D that qualifies for the credit cannot be known when the credits are
claimed, it is unclear by how much the marginal effective rate of the credit should be
increased. What is clear is that the credit confers varying marginal benefits on R&D
projects, and, more specifically, it might provide excessive subsidies to projects with
below-average external benefits and inadequate subsidies to projects with above-
average external benefits.
Effectiveness of the R&E Tax Credit
An issue separate from the incentive effect of the R&E tax credit is its
effectiveness. The credit’s effectiveness signifies its efficacy in raising business R&D
investment in a way that enhances economic welfare relative to alternative uses of the
capital. Ideally, the credit’s effectiveness would be assessed by comparing the social
benefits from the added R&D stimulated by the credit with the social opportunity
costs of the tax revenue forgone because of the credit. Under such an approach, the
credit would be deemed effective if the social benefits arising from the R&D
stimulated by credit outweigh the social benefits arising from alternative uses (e.g.,
increased federal spending on defense, education, or health care) of the revenue cost
of the credit. However, no such analysis appears to have been done, and it is unlikely
that one ever will be undertaken because of the formidable difficulties in measuring
the social returns to R&D. Among the main difficulties are coming up with adequate
price indexes for the cost components of R&D in different industries, establishing a
reasonable time frame for measuring the productivity gains from R&D, and devising
reasonable measures of the rate of depreciation for R&D capital stocks.17
Consequently, some analysts have focused on a more limited and manageable
objective: estimating the amount of research expenditures induced by one dollar of
the credit, or the credit’s cost-effectiveness. Such an approach implicitly assumes that
the spillover benefits of R&D are large enough to justify a subsidy such as the R&E
tax credit. The central policy issues tackled by this approach are whether the current
R&E tax credit is a cost-effective R&D subsidy, and whether other policy tools (e.g.,
17Office of Technology Assessment. The Effectiveness of Research and Experimentation Tax
Credits. P. 21-22.

CRS-17
government funding or performance of R&D) could spur the same increase in R&D
investment at a lower cost.
What do existing studies reveal about the cost-effectiveness of the R&E tax
credit? For policymakers, the most useful studies are those that use industry data
from 1985 and after to analyze the responsiveness of business R&D spending to the
decrease in the tax price of research caused by the credit.18 On the whole, those
studies concluded that from the mid-1980s to the early 1990s, firms responded to the
credit by raising their R&D spending between one and two dollars for every dollar of
the credit claimed.19 While these studies have flaws that limit their reliability, they do
suggest that the current credit can be considered a cost-effective policy tool for
boosting business R&D investments.20 For instance, assuming that the one dollar of
the credit generated one additional dollar of business R&D spending in 1996, the most
recent year for which detailed corporate income tax return data are available, the
credit may have raised business R&D investment by as much as $2.2 billion in that
year. Assuming this estimate is reasonable, then it can be maintained that the credit
was responsible for about 2% of U.S. business R&D spending in 1996, which totaled
an estimated $121 billion.
Policy Issues Raised by the Credit
In the minds of most economists, the R&E tax credit can be justified on
economic grounds. Moreover, available evidence suggests that it is capable of
boosting business R&D investment in a cost-effective manner. But this is not to imply
that, in its current state, it is an ideal policy instrument, or that it sparks no
controversy. Some believe that it should be reduced or eliminated on principle. And
supporters of the credit find fault with it for the following reasons: 1) its lack of
permanence; 2) its weak and uneven incentive effect across the range of R&D projects
and across firms performing qualified research; 3) its ambiguous definition of qualified
research; and 4) its relative efficiency in boosting business R&D investment. Each
policy issue is discussed in detail below.
Lack of Permanence
The R&E tax credit, which recently was extended from July 1, 1999 to June 30,
2004, has never been a permanent fixture of the federal tax code. In the view of some
18For a summary of these studies, see Office of Technology Assessment. The Effectiveness
of Research and Experimentation Tax Credits. P. 28.
19See Hall, Bronwyn H. and John van Reenen. How Effective Are Fiscal Incentives for R&D?
A Review of the Evidence. NBER Working Paper No. 7098. Cambridge, MA, National
Bureau of Economic Research, April 1999; Coopers & Lybrand L.L.P. Economic Benefits
of the R&D Tax Credit. Washington, January 1998. P. 15-16; and Office of Technology
Assessment. The Effectiveness of Research and Experimentation Tax Credits. Table 3, p.
28.
20Office of Technology Assessment. The Effectiveness of Research and Experimentation Tax
Credits. P. 29-30.

CRS-18
analysts, this lack of permanence limits the credit’s efficacy because it subtly
encourages business managers to ignore or downplay the credit when considering
whether (or by how much) to expand their R&D budgets.
Basically, there are two reasons for this subtle effect. One is that uncertainty
about future tax policy toward R&D compounds the uncertainty that inevitably
surrounds the expected returns on prospective R&D projects, and this heightened
uncertainty may deter business managers from pursuing R&D projects that they
would pursue if they could count on the credit being available in three, five, ten or
fifteen years. A second reason is the high adjustment costs that R&D entails. In
general, adjustment costs are the hidden costs firms confront when they alter their
output in response to temporary conditions. In the case of R&D, the adjustment costs
become a pressing managerial issue when R&D budgets are cut. A substantial share
of the typical business R&D budget is composed of the wages and salaries of R&D
personnel. For the most part, these employees are costly to train and difficult to
replace when they resign or are let go. Moreover, R&D scientists and engineers
represent valuable assets for their employers largely because of the specialized
knowledge and knowhow they possess. When a group of them leaves one firm and
is hired by another or forms a competing firm, they unavoidably transfer their
knowledge and knowhow to their new employers. Technology transfers of this sort
could end up benefitting the new employers or firms at the expense of the former
employers.21 Adjustment costs such as these make firms reluctant to cut their R&D
budgets during periods of declining or stagnant revenues. By the same token, the
adjustment costs associated with R&D may be large enough to deter business
managers from undertaking R&D projects that are expected to earn acceptable after-
tax rates of return in the presence of the R&E tax credit but carry a significant risk of
earning unacceptable after-tax rates of return if the credit were to expire and not be
renewed at some future date.
These considerations suggest that permanently extending the credit could make
it a more effective policy instrument for boosting business R&D investment.
Inadequate and Uneven Incentive Effect Among Firms and
R&D Projects
Another key policy issue raised by the current R&E tax credit is its apparently
inadequate (or suboptimal) and uneven incentive effect among firms performing
qualified research and among qualified research projects. In this context, an
inadequate incentive effect denotes a marginal benefit from the credit that is less than
the amount that would be needed to boost business R&D investment to levels
warranted by its potential spillover benefits; by contrast, an uneven incentive effect
signifies a marginal benefit from the credit that varies from one firm to the next or
from one R&D project to the next, with no clear economic justification for the
variation.
21Himmelberg, Charles P. and Bruce C. Peterson. “R&D and Internal Finance: Panel Study
of Small Firms in High-Tech Industries.” The Review of Economics and Statistics, February
1994, p. 41.

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As was noted earlier, the optimal R&D tax subsidy would seek to elevate the real
after-tax private returns to R&D investments to the levels that would result from
taxing their real social returns at the same rate. Some studies have indicated that the
median private rate of return on business R&D is about one-half the median social
rate of return.22 Assuming this estimate is correct, then, in theory, the optimal R&D
tax subsidy might seek to double after-tax private rates of return to business R&D
investments in the absence of a subsidy. Because most corporate income is taxed at
a rate of 35%, the optimal R&D tax subsidy would arguably try to increase after-tax
private returns to a level equal to 130% of pre-tax returns [2 X (1-.35)]; without the
subsidy, after-tax returns would equal 65% of pre-tax returns. It is likely, however,
that the relationship between private and social returns varies markedly among R&D
projects. This implies that a subsidy rate that is optimal for projects with average
spillover benefits would end up oversubsidizing projects with below-average
spillovers and undersubsidizing projects with above-average spillovers. At any rate,
as Cox suggested in a 1995 study discussed earlier, a R&D tax subsidy rate of 130%
of pre-tax private returns might offer policymakers a reasonable standard for
evaluating the efficiency effects of current R&D tax subsidies.
Cox discovered in the 1995 study cited earlier that the weighted average ratios
of after-tax returns to pre-tax returns under the expensing allowance and the R&E tax
credit for the hypothetical R&D projects he examined ranged from 101% for capital-
intensive projects yielding technology assets with a 20-year economic life to 124.7%
for labor-intensive projects yielding technology assets with a 3-year economic life.
This result raised the possibility that the combined effect of current R&D tax subsidies
was insufficient to raise business R&D investment to levels commensurate with its
potential social benefits. It also raised the possibility that an increase in the maximum
marginal effective rate of the R&E tax credit may be justified on economic grounds.
How much the credit rate should be increased was not clear from Cox’s analysis.
That the R&E tax credit’s incentive effect varies among firms performing
qualified research in ways that cannot be justified on economic grounds is evident
from another CRS report by Bill Cox, this one issued in 1996. Using data on net
income and R&D spending reported to the Securities and Exchange Commission by
publicly traded companies, Cox estimated the number of companies from a sample of
about 900 U.S.-based companies with research budgets ranging from the gargantuan
to the lilliputian that could claim the R&E tax credit in 1994. He found that 78% of
the firms in the sample could claim the credit. And of those, he found that 56%
received credits with a maximum effective rate of 6.5% and the remaining 44%
received credits with a maximum effective rate of 13%. The firms in the former group
had a lower rate because they were subject to the 50-percent rule. Furthermore, his
analysis showed that some of the most research-intensive firms could claim either no
credit or a credit with a maximum effective rate that was half as large as the rate
received by firms with lower research intensities. These results were not surprising
in light of the design of the credit, which gives firms a significant financial incentive
to spend more on research relative to sales in the present than in their base periods.
22See, for example, Mansfield, Edwin. “Microeconomics of Technological Innovation.” The
Positive Sum Strategy, edited by Ralph Landau and Nathan Rosenberg. Washington,
National Academy Press, 1986. P. 309-311.

CRS-20
In practice, the credit rewards firms whose research intensity has grown since their
base periods, but it may offer no rewards to firms whose research-intensities have
stagnated or declined since their base periods. Such a haphazard and seemingly
arbitrary pattern of subsidization cannot be defended on the grounds of economic
efficiency because there is no evidence linking a firm’s research intensity to the social
returns to its R&D investments. Suggested remedies include abolishing or relaxing
the 50-percent rule, making the credit refundable – especially for firms that are having
difficulty raising funds in debt and equity markets – establishing a moving base period,
and permitting all expenses related to qualified research (including overhead and
capital expenditures) to qualify for the credit.
Ambiguous Definition of Qualified Research
Yet another problem with the current R&E tax credit is the current definition of
qualified research. The definition is ambiguous to the point that it either deters firms
from claiming the credit or compounds the administrative cost of the credit both for
firms performing qualified research and for the IRS. In order to qualify for the credit,
research expenses must satisfy three criteria: (1) they must relate to activities that are
eligible for expensing under IRC section 174; (2) they must also relate to research
done to discover information that is “technological in nature” and useful in the
development of a new or improved “business component” (i.e., product, process,
computer software, technique, formula, or invention); and (3) they must relate to
activities that constitute a process of experimentation whose intended aim is the
development of a business component with “a new or improved function, performance
or reliability or quality.” A costly ambiguity enters the picture when executives at
firms that want to claim the credit are unsure whether specific research expenses meet
the often vague criteria. For example, how is one to determine whether a specific
research project passes the discovery test or whether it is part of a “process of
experimentation” whose ultimate aim is to develop a product or process with a “new
or improved function, or performance, or reliability or quality?” Lingering uncertainty
over which research activities qualify for the credit has spawned numerous disputes
between the IRS and firms over the amounts of the credit that are claimed. While
there are no reliable estimates of the cost to either firms or the IRS of administering
the credit, a 1995 report by the Office of Technology Assessment made clear that the
legal disputes entail considerable costs for both sides.23
Under the Tax Reform Act of 1986, the IRS was given the task of issuing final
regulations clarifying the definition of qualified research. In December 1998, the
agency issued proposed regulations that have generated considerable comment and
criticism from some representatives of the business sector. Given the contentiousness
of the definition of research that qualifies for the credit, it is unclear whether the IRS
can issue final regulations that will satisfy all concerned parties.
23Office of Technology Assessment. The Effectiveness of Research and Experimentation Tax
Credits. P. 15 and 17.

CRS-21
Efficiency Effects of the R&E Tax Credit
A chief economic rationale for the R&E tax credit is that firms invest too little
in R&D because they cannot appropriate all the returns to it. This raises the question
of whether the credit is the most efficient means of elevating business R&D
investment to the socially optimal level. The credit, of course, is but one of a variety
of direct and indirect policy instruments used by the federal government to support
commercial R&D. If it can be shown that one (or more) of these other instruments
can boost business R&D spending to the same extent at a lower opportunity cost or
of achieving a higher level of business R&D investment at the same opportunity cost,
then a case can be made for replacing the credit with the more efficient policy
instrument. Unfortunately, there appears to be no body of research that addresses this
issue.
In the current state of knowledge, policymakers who must make decisions about
the size and composition of federal R&D support are sometimes limited to what is
known about the strengths and weaknesses of the alternative R&D policy tools. Most
economists concur that this much can be ascertained about the effectiveness of the
R&E tax credit and direct federal R&d spending. First, there is some evidence that
the credit is as cost-effective as direct government spending on R&D in raising
business R&D investment. In other words, one dollar in revenue cost of the credit is
thought to raise this investment as much as an additional dollar of federal research
grants. One reason for this is that government R&D spending might not crowd out
privately financed R&D spending.24
Second, government R&D spending and the R&E tax credit both appear to have
drawbacks that limit their efficiency. The preceding discussion has made clear that
R&E tax credit exerts an uneven incentive effect on R&D projects and on firms
performing or financing qualified research; that the credit appears to offer firms too
weak an incentive to raise business R&D investment to socially optimal levels; and
that the credit cannot be targeted at projects with the highest ratio of social returns
to private returns. In addition, some critics contend that the R&E tax credit is a
wasteful subsidy because there are no clear guidelines on the research that qualifies
for it and this uncertainty can have the effect of rewarding firms for research with no
external benefits and research that they would have done in any event.25 Similarly, it
has been pointed out that government R&D spending can have certain effects that
may diminish its efficiency effects: 1) a lessening of private-sector competition to
develop technologies targeted for government funding; 2) funding decisions that are
guided more by political considerations than the potential economic merits of the
research; 3) government management of research projects that may lack the flexibility
24Stoneman, Paul. The Economic Analysis of Technology Policy. New York, Oxford
University Press, 1987. P. 203-204; and David, Paul A., Bronwyn H. Hall and Andrew A.
Toole. Is Public R&D A Complement Or Substitute For Private R&D? A Review of the
Econometric Evidence. Working Paper 7373. Cambridge, MA, National Bureau of
Economic Research, October 1999. P.6.
25U.S. Congress. House of Representatives. Committee on the Budget. Unnecessary
Business Subsidies. Hearing, Serial No. 106-5. Washington, U.S. Govt. Print. Off., 1999.
Prepared statement of Robert McIntyre, p. 316.

CRS-22
and creativity dictated by the uncertainty inherent in R&D efforts; and 4) the inability
of government program managers and politicians to identify research projects with
promising spillover benefits.26
Third, the two policy instruments differ in their targeting. The R&E tax credit
applies to all qualified business research, whereas government research grants can be
directed to support particular research efforts, especially those with promising
spillover benefits that the private sector is inclined to ignore. Available evidence on
the effects of both instruments, however, does not shed light on the question of which
instrument is likely to lead to higher levels of economic welfare at the same revenue
cost. The analysis of cost and benefit in government R&D policy is fraught with too
much uncertainty. One approach would be to stick with the status quo: the federal
government currently relies on a variety of policy instruments, including tax incentives
and direct research funding, with the aim of creating an economic environment that
is conducive to the commercial development and widespread diffusion of new
technologies.27
Proposals in the 106th Congress to Extend
Permanently or Modify the R&E Tax Credit
At the end of the first session, the 106th Congress passed legislation (H.R. 1180,
P.L. 106-170) that retroactively extended the R&E tax credit from July 1, 1999 to
June 30, 2004. Nevertheless, a number of bills to extend permanently the credit or
extend its reach are still pending and could be considered in the second session. The
bills are summarized in the following table.
26Cohen, Linda R. and Roger G. Noll. “Research and Development.” Setting Domestic
Priorities: What Can Government Do? Edited by Henry J. Aaron and Charles L. Schultze.
Washington, Brookings Institution, 1992. P. 227-228.
27For a discussion of the full range of policy instruments that might be employed to create
such an environment, see Branscomb, Lewis M. and James H. Keller. “Towards a Research
and Innovation Policy.” Investing in Innovation, edited by Branscomb and Keller.
Cambridge, MA, MIT Press, 1998. P. 462-496.

CRS-23
Table 3. Bills in the 106th Congress to Extend or Improve the
R&E Tax Credit
Bill
Provisions Pertaining to the Credit
Number
H.R. 760,
! Permanently extends the credit, as of July 1, 1999.
H.R. 835,
S. 195,
S. 680,
S. 1770,
and S. 1803
H.R. 1328
! Establishes a flat 20% credit for payments made to
qualified research consortia;
! Defines a qualified research consortium as a non-profit,
tax-exempt, scientific research organization that is not a
private foundation and has a minimum of fifteen
supporting members, no three of whom may account for
over 50 % of the total amount received by the
organization for scientific research in a year, and no one of
whom can account for over 25% of this amount;
! Makes 100% of payments to qualified research consortia
eligible for the credit.

CRS-24
H.R. 1682
! Permanently extends the credit as of July 1, 1999;
and S. 951
! Replaces the alternative incremental credit with one that is
equal to 20% of the amount by which qualified research
expenses exceed the base amount as of January 1, 2000;
! Establishes the following rules for the base amount of the
new alternative incremental credit: (a) the fixed-base
percentage is equal to 80% of the ratio of aggregate
qualified research expenses to aggregate gross receipts in
the base period; (b) qualified research expenses may be
less than 50% of the base amount; (c) the base period is
the eight years preceding the one for which the credit is
being claimed, or the period the firm has been in existence
if it is less than eight years old; and (d) the gross receipts
in any year in the base period for all taxpayers are at least
equal to $1 million;
! Makes the following changes to the credit for basic
research as of January 1, 2000: (a) credit is equal to 20%
of qualified payments; (b) basic research in the social
sciences is eligible for the credit; (c) specifies that basic
research meets the criterion of not having a “specific
commercial objective” if its results are made available to
the general public before they are used for commercial
purposes; and (d) makes payments for basic research
conducted at federal laboratories eligible for the credit;
! Establishes a flat 20% tax credit for 100% of payments to
qualified research consortia as of January 1, 2000;
! Redefines a qualified research consortium as a tax-exempt
organization that conducts “scientific or engineering
research” and that has at least five contributing members
or clients, no one of whom can account for more than
50% of the money received by the consortium for
scientific or engineering research in a calendar year;
! Directs the Secretary of the Treasury to assist small and
startup firms in complying with the requirements for the
R&E tax credit, and to reduce their compliance costs;
! Makes 100% of the amount paid to eligible small firms,
universities, and federal laboratories for contract research
eligible for the credit;
! Creates a flat 20% tax credit for all patent fees paid by
small firms in carrying on a trade or business, as of
January 1, 2000.

CRS-25
Likely Effects on Business R&D Investment of
Selected Proposals in the 106th Congress to Extend
or Improve the R&E Tax Credit
While it is difficult to estimate the impact of the bills listed in table 3 on business
R&D investment, it is reasonable to expect that each could boost business R&D
spending to the extent it enhances the credit’s incentive effect. This prospect raises
the questions of which bills are likely to do this, and to what extent. The key to
answering these important questions lies in the intended purposes of the bills
themselves. The purposes indicate how the bills would affect the credit’s incentive
effect.
On the whole, the bills would achieve one or more of the following aims:
! permanent extension of the credit (H.R. 760, H.R. 835, H.R. 1682, S. 195, S.
680, S. 951, S. 1770, and S. 1803);
! more favorable tax treatment of payments to research consortia (H.R. 1328,
H.R. 1682, and S. 951);
! replacement of the current alternative incremental credit with one that offers
firms a higher effective credit rate (H.R. 1682 and S. 951);
! more favorable tax treatment of payments for basic research (H.R. 1682 and
S. 951); and
! special assistance for smaller firms (H.R. 1682 and S. 951).
Permanent Extension of the Credit
A total of eight bills in the 106th Congress address the credit’s temporary status.
The longest period that the credit has been in effect without interruption was the five
and one-half years from July 1, 1981 to December 31, 1986. Moreover, the credit
was extended for one year on four separate occasions; it was extended for thirteen
months once, for eleven months once, and for six months once; and the credit has
never been available for the period between July 1, 1995 to June 30, 1996. Since the
early 1990s, a chief obstacle to making the credit permanent has been the budget rule
requiring the federal government to offset the cost of new permanent tax preferences
over five consecutive fiscal years.
More Favorable Tax Treatment of Research Consortia
Three bills in the current Congress would liberalize the tax treatment of
payments for research performed by joint R&D ventures such as Sematech, the
Partnership for a New Generation of Vehicles, and the Advanced Battery Consortium.
Under current law, the R&E tax credit applies to 75% of payments to qualified
research consortia for qualified research done on behalf of two or more firms;
qualified research consortia are defined as tax-exempt organizations (excluding

CRS-26
private foundations) whose primary purpose is to conduct “scientific research” (IRC
section 41(b)(3)(c)). By contrast, the three bills would create a flat 20% credit for the
entire amount of payments to qualified research consortia for qualified research done
on behalf of the firm making the payments. Moreover, H.R. 1328 would alter the
definition of a qualified research consortium to specify that it must have a minimum
of fifteen supporting members, no one of which can account for over 25% of the
consortium’s annual research budget; and H.R. 1682 and S. 951 would redefine a
qualified research consortium as a tax-exempt organization whose primary purpose
is to conduct “scientific or engineering research” and that has at least five supporting
members, no one of which can account for over 50% of the annual research budget
of the consortium.
The three bills would likely give firms a stronger financial incentive to increase
their payments to research consortia. Under current law, the maximum effective rate
of the credit for these payments varies from 5% to 10%; but under the three bills, the
rate would rise to a flat 20%. Furthermore, because H.R. 1328 would add this
incentive while retaining the terms of the regular R&E tax credit, it would give firms
a stronger financial incentive to conduct research through research consortia than
through their own R&D facilities. Yet it is unclear to what extent firms participating
in such consortia would raise their payments to them in response to this enhanced
subsidy. The R&E tax credit is one of many factors influencing business R&D
investment decisions.
Recent Growth in U.S. Research Consortia.
Data on the amount invested in domestic research consortia are scanty, and what
is available sheds little light on the share of U.S. business R&D spending that goes to
joint research ventures. Nonetheless, it is clear that since the early 1980s, the number
of firms participating in U.S. research consortia and the dollars they have spent on
basic and applied research have soared. One indicator of this trend is the number of
joint research ventures registered with the U.S. Department of Justice (DOJ) under
the National Cooperative Research Act of 1984 and the National Cooperative
Production Amendments Act of 1993; by registering, firms joining these ventures gain
added protection from antitrust lawsuits. Between 1985 and 1996, a total of 665 joint
research ventures were registered, with 212 of the registrations occurring in 1995 and
1996.28 And as of late 1998, U.S.-based firms had entered into more than 5,000
cooperative R&D agreements (or CRADAs) with federal laboratories under the
Federal Technology Transfer Act of 1986.29
This growth in cooperative R&D ventures is the product of a number of factors.
Worldwide, large and small firms face growing pressure to collaborate with rivals,
28National Science Board. Science & Engineering Indicators - 1998. Arlington, VA, national
Science foundation, 1998. P. 4-30.
29See Library of Congress. Congressional Research Service. Cooperative Research and
Development Agreements (CRADAs). Report No. 95-150 SPR, by Wendy H. Schacht.
Washington, updated November 17, 1998. P. 1; and Congressional Research Service. R&D
Partnerships: Government-Industry Collaboration. Report 95-499 SPR, by Wendy H.
Schacht. Washington, November 17, 1998. 6 p.

CRS-27
suppliers, customers, and national and regional governments in the development of
new technologies. This pressure arises from a variety of sources.30 One is the rapid
pace, expanding scope, increasing complexity, and rising cost of technological
innovation in many industries. Another factor is the globalization of a wide range of
markets and the increased international competition it brings. Yet another factor is
the growing demands by consumers and governments in advanced economies that
technology development achieve certain social or economic objectives, such as less
industrial pollution or improved productivity or increased safety or security in the use
of a wide variety of goods and services. In addition, firms can realize significant
concrete benefits from participating in research consortia, such as access to expertise
and knowledge that otherwise would be unavailable, risk pooling, cost sharing.
Tax Subsidies for Research Consortia and Federal R&D Policy.
The legislative proposals to liberalize the tax treatment of payments to research
consortia raise certain policy issues. One concerns the incentive effect of the
proposals. Granting firms a flat 20% credit for payments to research consortia could
encourage firms to substitute joint research for their own research, leading to no net
increase in business R&D investment. Another issue relates to the rationale for
federal support for joint research ventures. These ventures can improve the domestic
climate for technological innovation by reducing the market failure associated with
R&D, cutting the costs of performing generic research with promising commercial
potential, and speeding the diffusion of new technologies.31 Yet the recent
proliferation of research consortia involving U.S.-based firms and federal laboratories
calls into question the need for additional federal subsidies for such ventures like the
tax incentives proposed in H.R. 1682/S. 951. A third policy issue linked to the
proposals deals with the economic rationale for federal support for R&D. The
expansion of research consortia in the past decade arguably weakens a central
economic rationale for federal support for research. If many or all the firms in an
industry collaborate in the conduct of R&D, it is possible that most of the returns to
that R&D will be appropriated, reducing the need for federal R&D subsidies.
Another way to frame this issue is to ask whether industry research consortia partially
or fully correct the market failure associated with R&D: the presence of substantial
external benefits. The greater the degree of correction, the lesser the justification for
federal R&D subsidies. Finally, economic theory indicates that an incremental tax
credit would be more efficient that the flat credit contained in the legislative
proposals.
Creation of a More Beneficial Alternative Incremental Credit
Identical bills in the House and the Senate (H.R. 1682 and S. 951) would create
a new alternative incremental R&E tax credit that is more beneficial at the margin than
30Roos, Daniel, Frank Field, and James Neely. “Industry Consortia.” Investing in
Innovation. Branscomb, Lewis M. and James H. Keller, eds. Cambridge, MA, MIT Press,
1998. P. 401-402.
31Cohen, Linda R. and Roger C. Noll. “Research and Development.” Setting Domestic
Priorities, edited by Henry J. Aaron and Charles L. Schultze. Washington, Brookings
Institution, 1992. P. 244.

CRS-28
the current R&E tax credit. Under the bills, the calculation of the proposed alternative
credit would be the same as the calculation of the current credit, with the following
exceptions:
! the base period would be the previous eight tax years, or fewer in the case of
firms that have been in existence fewer than eight years;
! the fixed-base percentage would be equal to 80% of the ratio of aggregate
qualified research spending to aggregate gross receipts in the base period;
! the base amount could be less than 50% of qualified research expenses in the
current tax year; and
! gross receipts for all firms, established and startup, could not fall below $1
million in each year of the base period.
This proposed alternative credit would address several key policy issues raised
by the current credit. One was discussed earlier: the current credit subsidizes
business R&D in a seemingly arbitrary and inequitable manner. Abolishing the 50-
percent rule and permitting firms to select base periods that reflect their current R&D
intensity would likely do much to make the credit’s marginal effective rate more
uniform among firms and industries.
Furthermore, the proposed credit would offer established and startup firms a
stronger financial incentive to keep increasing their R&D spending than the current
regular or alternative credits. Three aspects of the proposed credit would make it
more beneficial at the margin: 1) the absence of the 50-percent rule under current
law; 2) the 20% reduction in a firm’s fixed-base percentage under current law; and 3)
the use of a moving base period. The probable benefits of this enhanced incentive
effect can be seen in the calculations given in the appendix, which estimates the R&E
tax credits that two actual pharmaceutical firms, Merck and Cephalon, could claim in
1998 under current law and under S. 951/H.R. 1682. Under current law, Merck, a
large, established, and perennially hugely profitable pharmaceutical firm, could claim
no regular credit and an alternative credit of $39 million in 1998. By contrast, under
S. 951/H.R. 1682, Merck could claim an alternative credit of $67 million. Cephalon,
a small, startup, biopharmaceutical firm which as of 1998 had never earned a profit,
would also be better off under the proposed alternative credit: under current law, it
could claim a regular credit of $3 million and an alternative credit of $1 million in
1998; but under S. 951/H.R. 1682, it could claim an alternative credit of $6 million.
Another way to illuminate the incentive effect of the proposed alternative credit is to
compare the average credit rates for the three R&E tax credits; the average credit rate
is defined here as the ratio of the R&E tax credit claimed to R&D spending reported
to shareholders. In 1998, the estimated average credit rates for Merck were 0% for
the regular R&E tax credit, 2.1% for the alternative incremental R&E tax credit, and
3.7% for the proposed alternative R&E tax credit; and for Cephalon, the same three
rates were 7.0%, 2.5%, and 13.7%. The main point to be made here is not to
demonstrate that either firm deserves a larger tax credit for the R&D they perform;
that issue could be resolved only by estimating and comparing the after-tax private
and social rates of return to their R&D investments. Rather, it is to compare the
credit’s incentive effect under current law and under the two legislative proposals.

CRS-29
More Favorable Tax Treatment of Basic Research Expenses
The same two bills would also make the tax treatment of basic research expenses
more favorable. As a result, they would give firms a stronger incentive to conduct
basic research. The National Science Foundation estimates that in 1999, firms spent
$10.9 billion on basic research conducted in the United States; this amount is 88%
more than they spent in 1992 and 27% of all basic research done in the United States
in 1999. To encourage firms to spend more on basic research, the bills would replace
the current incremental basic research credit with a flat credit that is equal to 20% of
qualified basic research expenses. In addition, the bills would make basic research in
the social sciences eligible for the credit, loosen the definition of basic research to
cover research whose results are made available to the general public before they are
used for commercial purposes, and make payments for basic research conducted at
federal laboratories eligible for the credit.
The proposed changes in the tax treatment of basic research expenditures raise
several policy issues. One is a perceived need for a more generous tax subsidy for
business spending on basic research. Proponents of such a subsidy cite recent declines
in real business investment in this research to justify their insistence that the federal
government take additional steps to encourage firms to invest more in basic research;
in support of this argument, they note that the social returns to this research tend to
be relatively large. Recent trends in real industry spending on basic research lend
inconclusive support to this view: according to figures published by the National
Science Foundation, U.S. industry spent 14% less in constant 1992 dollars for this
purpose in 1995 ($5.0 billion) than in 1992 ($$5.8 billion), but the trend reversed
itself between 1995 and 1998 when industry spending on basic research rose from
$5.0 billion to a preliminary $8.6 billion, a gain of 72%.
A second policy issue raised by the proposed enhanced tax subsidy for basic
research concerns the impact of a more generous tax subsidy on business investment
for this purpose. In the 1990s, a powerful constraint on this investment was an
increased managerial emphasis on funding R&D projects that are likely to pay off in
three years or less.32 Arguably, this emphasis had its origins in the demise of the Cold
War and the restructuring of major U.S. firms and the rise of formidable foreign
competition that began in the late 1980s and continued through most of the 1990s.
Nowadays, firms rely heavily on the public and nonprofit sectors to fund basic
research, and the basic research they conduct is intended largely to address gaps left
over from publicly funded research and further their own product development.33
Thus, it is doubtful that an enhanced tax incentive like the one proposed in H.R. 1682
and S. 951 would be sufficient to trigger a surge in business spending on basic
research.
32Uchitelle, Louis. “Basic Research Is Losing Out As Companies Stress Results.” New York
Times, October 8, 1996, p. B6.
33Broad, William J. “Study Finds Public Science Is Pillar Of Industry.” New York Times,
May 13, 1997, p. C1 and C10; and Committee for Economic Development. America’s Basic
Research: Prosperity Through Discovery. New York, 1998. P. 16.

CRS-30
Yet another policy issue is that the proposed liberalized credit for basic research
expenses would be flat instead of incremental. An argument against a flat credit is
that it is more likely than an incremental one to subsidize research that firms would
do in any event. Thus, in the view of many analysts, the more efficient option for
giving firms a stronger financial incentive to increase their basic research expenditures
is to offer a more generous incremental R&E credit.
Special Assistance for Smaller Firms
Lastly, H.R. 1682 and S. 951 would target special assistance to small firms
engaged in research. Specifically, they would require the IRS to find ways to reduce
the cost to small firms of complying with the requirements of the R&E tax credit, and
they would create a flat 20% tax credit for patent fees paid by small firms. In
addition, the bills would give larger firms a tax incentive to enter into research
contracts with smaller firms by making the entire amount paid to smaller firms for
contract research eligible for the R&E tax credit.
These proposals have unearthed several policy concerns, some of which have
long been associated with the issue of tax subsidies for small firms. On the one hand,
they raise the question of whether such assistance to smaller firms is justified on
economic grounds. Supporters of the two bills contend that the costs associated with
applying for patents and complying with the requirements of the R&E tax credit are
especially burdensome for smaller firms, and as a result they spend much less on R&D
than they otherwise would. This is a serious policy issue, in their minds, because
small startup firms are the sources of many valuable technological innovations.
Available evidence bearing on this claim appears to be inconclusive.
On the other hand, the proposals give rise to a couple of concerns. One is that
they would reward some larger firms for doing what they already do: perform joint
research with smaller startup firms. Unless it can be shown that these ventures are
likely to yield extraordinarily large spillover benefits, it is difficult to make a cogent
economic argument for a more generous tax subsidy for joint research between small
and large firms. Another concern is that the proposals fail to address an important
financial issue for managers at many small startup firms: they are unable to claim the
R&E tax credit during periods when it could substantially boost their cash flow
because they are unprofitable and the credit is nonrefundable.
Conclusions
Government support for business R&D can be justified on economic grounds.
According to standard economic theory, when firms invest in R&D, the total (or
social) returns are likely to far exceed the returns captured by the firms. Because of
this discrepancy, firms are likely to invest less in R&D than would be warranted by
its economic benefits. Thus, in theory, economic performance is better when firms
receive a subsidy that boosts their returns on R&D investments to the level of social
returns. Unfortunately, in this case economic theory is a poor guide for policy
because of the formidable problems involved in measuring the social returns to R&D.

CRS-31
The federal government supports domestic R&D in a variety of ways, direct and
indirect. One indirect subsidy is a tax credit for research and experimentation (R&E).
Under IRC section 41, a firm may claim a tax credit equal to 20% of its spending on
qualified research above a base amount. The credit has an incremental design largely
to give firms a robust financial incentive to spend more on R&D in a given year than
they otherwise would, thereby shrinking the gap between actual and socially desirable
levels of business R&D investment. For a firm, R&D is essentially an investment
decision. This means that a firm is likely to invest in a particular R&D project if its
expected real after-tax rate of return exceeds its real cost of capital. The R&E tax
credit seeks to stimulate increased business R&D investment by lowering the user cost
of capital.
It appears that the R&E tax credit can be a cost-effective instrument for spurring
increases in business R&D investment. Several studies have estimated that by the end
of the 1980s one dollar of the credit leads firms to raise their spending on R&D by
approximately one dollar, maybe more. These results suggest that, dollar for dollar,
the credit is as effective as federal research spending programs in boosting business
R&D investment.
Nonetheless, although the R&E tax credit apparently has a positive effect on
business R&D investment, there is reason to believe that the effect is too modest to
generate the level of this investment warranted by its likely economic benefits. In a
1995 CRS report, Bill Cox estimated that the combined effect of the two current
R&D tax subsidies, the expensing allowance for research expenditures and the R&E
tax credit, on the after-tax returns a variety of hypothetical R&D projects fell short
of the level of subsidy needed to achieve an optimal amount of business R&D
investment. Nevertheless, his findings provide little guidance for policymakers about
how much larger the rate should be. Because the social returns to a particular
business R&D project are difficult to estimate and certainly cannot be known in
advance, the credit’s incentive effect cannot be tailored to specific projects. Even if
it were possible to do this, there is no guarantee in advance that a firm can use the
R&E tax credits it earns because the credit is not refundable.
The credit exhibits two other problems that limit its effectiveness as a R&D
subsidy: a lack of permanence and a variable impact among business R&D projects
and firms performing research. The lack of permanence dampens the credit’s
potential for spurring continuing rises in business R&D investment by increasing the
already substantial uncertainty surrounding the expected returns to prospective R&D
projects. The varied benefit of the credit among firms conducting research and among
business research projects appears to lack justification on economic grounds and
creates the impression that, in its current design, the credit subsidizes business R&D
in an inequitable and arbitrary manner.
Legislation extending the R&D tax credit through June 30, 2004 (H.R. 1180,
P.L. 106-170) was enacted in the first session of the 106th Congress. In addition, a
total of eight bills pending in the current Congress would permanently extend the
credit. Two of these bills (S. 951 and H.R. 1682) would also liberalize the tax
treatment of payments to research consortia and basic research expenditures and
create an alternative R&E tax credit that is more beneficial at the margin than the
current R&E tax credit. These proposals would remove what many analysts see as

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a significant flaw in the current credit – its lack of permanence. In addition, S. 951
and H.R. 1682 would attempt to increase the current credit’s incentive effect and to
reduce the unevenness of its marginal benefit to firms conducting research and to
specific R&D projects.
Some see no need for the changes in the credit that these proposals would make.
In fact, many of these same critics see no need for an R&E tax credit on the ground
that it rewards firms for doing what they must do in any event to remain competitive
in domestic and foreign markets and for undertaking research that has little or no
external benefits. To them, it constitutes a form of corporate welfare that should be
repealed.
Nonetheless, on economic grounds, a case can be made for going beyond the
measures contained in eight R&E tax credit bills pending in the current Congress. At
its core is the contention that the price reduction in R&D engineered by the current
credit is insufficient to expand business R&D investment to the socially optimal level.
The analysis presented here suggests that at least six policy measures might
significantly boost the credit’s incentive effect, and thus make it a more efficient R&D
tax subsidy. In evaluating their desirability, it is important to compare their projected
revenue costs with the potential gains in economic output that could arise from the
added business R&D investment spurred by the measures. The suggested measures
are as follows:
! raising the statutory rate of the credit to 25% or maybe higher;
! getting rid of or relaxing the 50-percent rule;
! getting rid of or easing the basis adjustment;
! expanding the range of expenses that is eligible for the credit;
! clarifying the definition of qualified research in a manner that reduces the
prospect of prolonged legal disputes between the IRS and firms claiming the
credit; and
! making the credit refundable, especially for smaller, newer firms suffering from
cash flow troubles.

CRS-33
Appendix: Estimation of R&E Tax Credits Earned
by a Startup Firm and An Established Firm Under
Current Law and H.R. 1682/S. 951
One approach to evaluating the likely impact of a legislative proposal to enhance
the R&E tax credit’s effectiveness is to estimate the R&E tax credits that actual firms
could claim in a recent year under current law and under the proposal. In the 106th
Congress, identical bills with that aim have been introduced in the House (H.R. 1682)
and the Senate (S. 951). To assess the implications of those proposals for the credit’s
effectiveness, this section presents estimates of the credits that two pharmaceutical
firms, Merck & Co. and Cephalon Inc., could claim in 1998 under current law and
under H.R. 1682/S. 951. Basically, the two firms were chosen for three reasons: 1)
they both are based in the United States; 2) they both invest heavily in R&D relative
to sales; and 3) for the purpose of claiming the R&E tax credit, Merck is an
established firm, and Cephalon a startup firm. From the standpoint of market power,
however, the two firms could not be more different. Merck is one of the leading
discoverers, developers, manufacturers, and sellers of prescription drugs in the world,
and for years it has also been one of the most profitable pharmaceutical firms
worldwide. Cephalon, by contrast, is a smaller and younger firm that is dedicated to
the discovery, development, and selling of drugs to treat neurological disorders and
certain cancers and had never earned a profit as of 1998.
Table 5 summarizes the results of the comparative analysis. In interpreting them,
it is important to keep in mind the assumptions that undergird them. Specifically, it
was assumed that each firm’s gross receipts were equal to their operating revenues
as reported to shareholders and that each firm’s qualified research expenses were
equal to 70% of their R&D expenditures as reported to shareholders. These
assumptions seem reasonable in view of the fact that the IRS defines gross receipts
as the “gross operating receipts (of firms) reduced by the cost of returned goods and
allowances,” and that anywhere from 50% to 73% of a firm’s R&D expenditures as
defined under current financial accounting standards qualify for the R&E tax credit.
In addition, the calculation of the alternative credits Merck and Cephalon could claim
under current law reflects the terms of the credit as modified by the Ticket to Work
and Work Incentives Improvement Act of 1999 (P.L. 106-170), not the terms that
were actually in effect in 1998. Therefore, the estimated tax credits for Merck and
Cephalon shown in the following table should be viewed as approximations of the
actual credits the two claimed (if any) in that year; it is unclear what the margin of
error is in the estimates.
The results point to several conclusions. First and foremost, H.R. 1682/S. 951
would be likely to bolster significantly the credit’s marginal benefit to both established
and startup firms performing qualified research. For example, if the legislative
proposals had been in effect in 1998, Merck could have claimed an R&E tax credit
that was 71% larger and Cephalon’s credit would have been 100% larger. Second,
under current law, Merck would earn no regular R&E tax credit in 1998, whereas
Cepahlon could claim a regular credit of $3.1 million on a R&D budget that was
about 98% smaller than Merck’s. Given the economic rationale for the credit, such
an outcome can be deemed undesirable, as there is no apparent reason why the future
economic effects of Cephalon’s R&D in 1998 should prove more valuable than the

CRS-34
future economic effects of Merck’s R&D in the same year. And third, while Cephalon
earned credits under current law and under the legislative proposals in 1998, it was
not able to take advantage of them because it lost money in that year; the best it could
have done was to carry the credits forward for up to fifteen years.
Table 4. Selected Financial Data for Merck & Co. and Cephalon
Inc. From 1988 to 1998
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
Operating Revenue (millions of dollars)
Merck
5939
6550
7671
8603
9662
10498
14970
16681
19829
23637
26898
Cepha-
NA
.06
.09
5
9
17
22
47
21
23
16
lon
Pre-Tax Income (millions of dollars)
Merck
1871
2283
2699
3167
3564
3103
4415
4797
5541
6462
8133
Cepha-
NA
-2
-3
-5
-10
-21
-39
-43
-69
-65
-59
lon
R&D Expenditures (millions of dollars)
Merck
669
750
854
988
1112
1173
1231
1331
1487
1684
1821
Cepha-
NA
2
3
8
16
33
52
74
62
52
44
lon
Qualified Research Expendituresa (millions of dollars)
Merck
468
525
598
692
778
821
862
932
1041
1179
1275
Cepha-
NA
1.4
2.1
5.6
11.2
23.1
36.4
51.8
43.4
36.4
30.8
lon
a For both firms, qualified research expenses are equal to 70% of the R&D expenditures reported to shareholders.
Source: Compiled by the Congressional Research Service From Company
Annual Reports.

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Table 5. Estimated R&E Tax Credits in 1998 for Merck & Co. and
Cephalon Inc. Under Current Law and Under H.R. 1682/S. 951
Current Law
H.R. 1682/S. 951
Fixed Base Percentage (%)
Merck: 8.0
Merck: 5.0
Cephalon: 3.0
Cephalon: 2.4
Base Amount (millions of dollars)
Merck: 1,502
Merck: 939
Cephalon: 0.85
Cephalon: 0.7
Estimated R&E Tax Credit (millions of dollars)
Merck: 0 (regular)
Merck: 67.2
Cephalon: 3.1 (regular)
Cephalon: 6.0
Merck: 39.2 (alternative)
NA
Cephalon: 1.1 (alternative)
NA
Average Credit Ratea (%)
Merck: 0 (regular)
Merck: 3.7
Cephalon: 7.0 (regular)
Cephalon: 13.6
Merck: 2.1 (alternative)
NA
Cephalon: 2.5 (alternative)
NA
a The amount of the credit as a percent of R&D expenditures reported to
shareholders.
Source: Congressional Research Service.