Developing new products, technologies, and even industries requires significant investment. Fortunately, many businesses qualify for tax credits.
R&D tax incentives allow governments to support innovation without interfering with private firms’ knowledge of market opportunities. Research suggests this approach generates valuable results, even if the firm receiving the credit would have invested in its R&D anyway (Appelt et al. 2016).
How Tax Credits Incentivize R&D?
Many companies invest in R&D to develop new products, services, and processes that drive economic progress. R&D is risky and expensive, though. It’s something that only some businesses can afford, and the government offers tax credits to encourage research and development activities they might otherwise be unable to pursue.
These credits allow companies to claim a percentage of their qualified R&D expenses, which helps them offset the Federal Insurance Contributions Act (FICA) portion of payroll taxes. A company may qualify for the research & development tax credits if it conducts research that meets four criteria. This incentive is for any business, including startups and large corporations. It doesn’t matter whether the company has profits or losses as long as it meets the research requirements.
The R&D tax credit was extended through 2025 by the PATH Act and will remain available to qualifying firms after that date. The credit is valuable for any business but benefits startups and small businesses that still need to generate profits. It is because the credit can be used to offset both regular and alternative minimum taxes (AMT).
Some critics of R&D tax credits argue that direct subsidies have a greater impact on research activity than tax credits. Each dollar of direct subsidy can theoretically result in an additional $1 of research through indirect benefits such as crowding out private capital or windfall gains to researchers.
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Another common criticism of R&D tax credits concerns the effect on state economies. Critics point out that, given the openness of the national and international economies, a large proportion of spillover effects from R&D tax credits will accrue outside of a given state. As a result, critics suggest that the state-level implementation of R&D tax incentives is counterproductive.
Despite these concerns, R&D tax credits have been vital for encouraging innovation. The credit has helped many cutting-edge businesses, from technology providers to energy firms, pursue research and development projects that would otherwise be stranded. However, although billions of dollars are awarded to R&D investors yearly, even more companies need to realize the benefits they can get from this tax incentive. Often, these businesses need to be made aware of their eligibility for the credit or need clarification about how to apply for it.
What is R&D?
Research and development is the first phase in a process that involves designing, testing, manufacturing, and launching products for sale. Companies rely on R&D to increase their productivity and profit margins by improving or developing new products. R&D is also crucial to economic growth. Governments often feature some R&D tax credits in their plans to grow their economies.
R&D can be a high-risk endeavor. If a project fails, the company may lose valuable intellectual property and incur significant costs. As a result, some organizations choose to outsource R&D work instead of doing it internally. It is especially beneficial to small businesses needing more in-house expertise to conduct certain R&D projects.
Nevertheless, many organizations still need help to maximize their innovation investments. An articulated R&D strategy is essential to delivering on the potential of research. For example, an R&D team must ensure its work taps the true source of competitive advantage. It is important because capabilities that provide differentiation can quickly become commoditized, undermining a firm’s strategic value proposition.
A company must meet four criteria to qualify for the R&D tax credit. These include spending on qualified research expenses and ensuring that the results of its work are proprietary. R&D activities must also be aimed at specific commercial objectives and cannot be based on existing science.
Expenses related to developing a software program, migrating legacy systems to the cloud, or automating an aspect of a manufacturing process are all qualified research expenses. The IRS lists many exclusions, including market research, systematic data collection, and other activities that do not contribute to the advancement of scientific knowledge.
R&D can be a complex process, and the benefits of these initiatives take time to quantify. In addition, research and development expenditures can often be lumped together in financial statements without a clear line between what is R&D and what is not. It makes it difficult for corporate leaders to understand the full value of their R and D efforts.
Tax Credits for R&D
Companies can invest in R&D with the help of tax credits for research and development. They can reduce a company’s tax bill or be claimed as payable cash credits as a percentage of R&D expenditures. They are an important component of any state’s economic development strategy. Several states have enacted R&D credits, and California is one of the most comprehensive in the nation. It is modeled after the federal credit and was originally enacted in 1987.
Generally, R&D tax credits are claimed on a company’s CT or PIT return. Companies can use the credits to offset payroll taxes for five years, providing a maximum of $2,500,000 in cash savings. To claim the credit, a company must meet certain requirements. These include the following:
Regardless of whether a company’s research and development efforts are successful, they can claim the R&D tax credit. The credit can vary from $20,000 to $90,000, depending on the size of the company and the amount of R&D spending. To be eligible, a company must have taxable revenue of at least $25 million in the previous year, and at least $60,000 of qualifying R&D spending must be made. Generally, R&D tax credits are calculated based on qualified research expenses (QREs) or, more specifically, the difference between total QREs and adjusted gross receipts.
Many studies have been conducted on the impact of R&D tax credits. The studies indicate that $1 of tax credits induces about $1 of additional R&D spending. However, some economists argue that direct subsidies are more effective than R&D tax credits and may lead to greater increases in research spending.
Another argument against R&D tax credits is that they do not produce good economic benefits for their costs. It is because, due to the nature of the economy, spillover effects from R&D cannot be confined to a single jurisdiction. Instead, a portion, or even the majority of the benefits, would accrue to other states and, potentially, other countries.
As a result, the overall level of research and development spending in society may be well below what would be optimal from a social perspective without some form of government financial support to increase R&D investment. However, the economic evidence supporting R&D tax credits is mixed, and, in any event, numerous other state and local programs compete with R&D subsidy spending for limited taxpayer dollars.
Tax Credits for Innovation
The research and development tax credit is an important tool for promoting innovation in the United States. It helps businesses of all sizes and industries to offset some of the high costs associated with researching and developing new products and services. For smaller companies, it can also provide a significant boost in operating capital. The Protecting Americans from Tax Hikes Act of 2015 materially altered the use and credit claims. The new law requires that R&D expenses be amortized rather than expensed immediately. This change in the treatment of R&D expenses has significantly limited the credit’s impact, especially for small and medium-sized businesses.
This change is likely to result in higher investment rates than would otherwise have been the case and has led some economists to argue that the federal R&D credit should be repealed or reduced. Others argue that there may be better ways to encourage R&D than requiring amortization and that direct subsidies may be more effective.
Although studies on the R&D tax credit are inconclusive, many researchers have found that $1 of credits generates slightly less than one dollar of additional investment. This inefficiency largely results from diminishing marginal returns to R&D investments, meaning that the benefits of a given increase in R&D spending tend to decline as spending increases (see the graph below).
The R&D tax credit is available for all types of R&D activities. While wages are the primary source of the credit, other costs that qualify for the credit include contractor payments, supply purchases, and even some software licenses. Moreover, the credit can be offset against payroll taxes rather than just the employer portion of FICA, making it a much more versatile tax incentive for innovative companies.
R&D tax incentives are prevalent in most OECD countries. However, there are many important differences between the extent to which OECD governments support R&D by large incumbent firms and their support for research in different sectors. This difference is partly explained by the difficulty in obtaining administrative data on individual firm-level support for R&D.