R&D Tax Credit Crucial for Regional Economies

Last week the Tax Foundation published its “International Tax Competitiveness Index,” which ranked 34 OECD countries on the competitiveness of each nation’s tax code. According to the report, the United States ranks 32nd. Ooph.

The report rightfully dings the U.S. tax code for its statutory corporate tax rate (currently the highest in the OECD). But, the United States also ranks poorly for its R&D tax credit. With more than two dozen countries having a more generous R&D credit, it seems obvious that the credit is hurting U.S. tax competitiveness because of its miserliness.

Yet, according to the Tax Foundation analysis the opposite is the case: The $7 billion R&D tax credit is bad for U.S. businesses, and should be completely eliminated, because it violates tax “neutrality” by incentivizing firms to invest in R&D beyond what the market alone might dictate.

But that’s exactly the point.

The R&D credit is important because economic logic suggests firms will underinvest in R&D. Much of firm research turns out to be what economists call a “non-rivalrous, non-excludable good.” In other words, much of the benefits of a firm’s investments in research spill over to other firms. This fact is confirmed both in the economic literature and by common sense. Consider the iPad. Apple unveiled the iPad in September 2010. Four months later at the Las Vegas Electronics Show there were over a dozen tablets on display. It’s simply impossible for innovative firms to retain all the value of their intangible investments.

And yet, as we at the Metro Program have contested, these innovation spillovers are a core feature of U.S. regional competitiveness. Gone are the days of Bell Labs, where large companies innovate in closed research parks. Today, innovation is far more horizontal, open and metropolitan. Economic research shows firms cluster in metropolitan technology centers like Silicon Valley, Raleigh-Durham, Boston and Seattle and leverage joint technical competencies to remain globally competitive.

Yet open innovation creates a serious dilemma for firms. On the one hand, R&D spillovers are a force multiplier for metro areas and the firms located within them; on the other hand, firms are constantly under pressure to maintain a high rate of return on their research investments. The R&D tax credit and other “non- neutral” tax policies help firms rationalize these investments. This is why an innumerable number of studies have found the R&D credit offers an extremely high rate of return to taxpayers.

To be sure, not everyone is convinced. There are those like Mariana Mazzucato who argue the credit is only effective if coupled with high-levels of public investments, and others that have criticized state R&D credits (as opposed to the federal credit) as being beggar-thy-neighbor policy. But to assert the credit is bad for business because it induces extra investments in R&D is simply bewildering.

The Tax Foundation and other libertarian leaning organizations oppose policies like the R&D tax credit because they misunderstand the role of regional innovation ecosystems in the modern economy. Fifty years ago it may have made sense for governments to remain neutral to firm investments. But today, U.S. competitiveness is directly related to the speed at which intangible capital like research is spread. The R&D credit is a simple, non-intrusive mechanism to nudge firms to invest in research, which in turn benefits the entire innovation system. Opposing the R&D credit based on old economic ideologies does a disservice to the Tax Foundation’s analysis and the states and countries that seek their council.