Although the recent debt ceiling agreement curbs discretionary spending, it does not include significant amendments to the tax code. One remaining tax issue is the write-off of research and development (R&D), which has a negative impact on investment across the economy and a disproportionate effect on technology, manufacturing, and small businesses.
To reduce the revenue impact of the Tax Cuts and Jobs Act (TCJA), lawmakers introduced research and development expense write-off, which will take effect at the end of 2021. Under R&D write-off, Firms must spread their deductions for R&D expenses over five years for domestic R&D and 15 years for foreign R&D, rather than deducting them immediately. Due to tax code accounting conventions, domestic businesses ultimately have to deduct 10 percent of costs in year one, 20 percent of costs each year in years two through five, and the remaining 10 percent of costs in year six.
Making taxpayers spread out deductions for research and development means companies can’t deduct the full cost of the investment thanks to inflation and opportunity cost. Businesses value present deductions more than future deductions because a deduction now means tax savings can be reinvested. Under the half-year convention, assuming a discount rate of 3 percent and inflation of 2 percent, firms could only deduct 88.3 percent of domestic R&D investment. Higher inflation means an even bigger tax penalty: With inflation below 5 percent, a business could deduct just 82.8 percent of its costs.
To justify an investment, companies must earn a high enough expected return. R&D amortization means that companies cannot deduct their total costs, which increases the cost of capital and the rate of return required for a company to make an investment. As a result, R&D amortization leads to lower R&D investment at margin, as fewer investments can meet the higher expected return required.
Less investment has a negative impact on the economy as a whole. It also has a disproportionate impact on sectors and industries it depends on investment in R&D, that is, information technology and manufacturing. In 2019, manufacturing and information technology invested a combined $357 billion in research and development, representing 83 percent of the $429 billion in private domestic investment in research and development that year. Research and development is also concentrated in specific sub-industries; Chemical manufacturing, computer and electronics manufacturing, software publishing, and transportation equipment manufacturing combined for more than half of domestic research and development conducted and paid for by companies in 2019.
Policymakers have focused on supporting many of the same industries in the past year, with the Science and CHIPS Act providing a new semiconductor investment tax credit and the Cut Inflation Act subsidizing manufacturers of green energy technology. Writing off research and development undermines that support.
The R&D write-off also creates liquidity problems for small companies. By forcing companies to spread deductions over several years, R&D write-off taxes revenue that doesn’t exist.
| Fiscal responsibility in expenses | Tax Liability for Amortization of R&D | |
|---|---|---|
| Revenue | $275,000.00 | $275,000.00 |
| Deduction for operating expenses | $225,000.00 | $225,000.00 |
| Deduction for Investment in R&D | $50,000.00 | $5,000.00 |
| taxable income | $ | $45,000.00 |
| Fiscal responsibility (assume a 21% tax rate) | $ | $9,450.00 |
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Source: Author’s calculations. |
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Suppose a company has $5,000 in cash on hand at the beginning of the year, and over the course of the year, it earns $275,000 in revenue, has $225,000 in operating expenses, and invests $50,000 in research and development. The business breaks even, which means it has no profit to tax. Plus, you end the year still with $5,000 in cash on hand.
On the other hand, under R&D amortization, the company could only deduct $5,000 this year under the half-year convention, which means it will report $45,000 in taxable income and owe $9,450 in taxes. But that taxable income doesn’t exist, and the business only has $5,000 in cash at the beginning of the year, so it would need to borrow money to pay the tax liability. Now, a large company with a strong credit rating might find this a relatively minor inconvenience. But for small businesses or start-ups with limited access to capital, the situation is a much bigger hurdle.
Reporter Richard Rubin of The Wall Street Journal highlighted the struggles of various small businesses to manage the change. Some taxpayers are using the R&D tax credit to help mitigate the large tax bills they owe due to write-off, but the credit itself is difficult for small businesses to access. In 2013, the Small Business Administration analyzed how much of certain tax breaks went to small businesses and found that small businesses benefited much more from spending on research and development than from using credit. Credit is complex and difficult to navigate relative to the simple R&D cost deduction.
The current tax treatment of R&D expenses is irrational, complicated and counterproductive. Policymakers should allow companies to write off R&D expenses entirely immediately. Fortunately, fixing this problem is a bipartisan matter, as Senators Maggie Hassan (D-NH) and Todd Young (R-IN) recently reintroduced a bill to restore spending on research and development, among other changes in the tax treatment of R&D.