In its hurried attempt to draft a tax bill that would secure enough votes, the Senate accidentally compromised an essential tool for fostering innovation.
The research and development tax credit enables businesses to deduct a portion of their expenditures on developing new and improved products. This credit has been especially beneficial for pharmaceutical and software companies since its introduction in 1981.
Following its permanent establishment in 2015, the Treasury Department projected its cost at $148 billion from 2017 to 2026, making it one of the most significant tax incentives in the tax code.
The credit remained intact in both the House and Senate tax legislation, which eliminated various tax breaks to facilitate a reduction of the corporate tax rate to 20%. It would have further assisted companies in decreasing their taxes but for the Senate’s last-minute decision to keep the alternative minimum tax (AMT) instead of abolishing it, a move long advocated by conservatives.
The AMT acts as a safeguard preventing companies from applying excessive credits and deductions that would result in zero tax liability. Companies currently calculate their “regular” corporate tax rate, capped at 35%, minus any exemptions, and must pay either that rate or a 20% alternative rate based on an alternative income calculation, whichever is higher. According to the Treasury’s last comprehensive analysis of the corporate AMT from 2002, it applied to approximately 13,000 corporations.
While the House version repealed the AMT, it remained intact when the bill was ultimately approved by the Senate early Saturday morning. Should it stay in place, it could render the R&D credit ineffective, as more corporations might be subjected to a minimum tax under the AMT that couldn’t be reduced by most credits or deductions.
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“With the proposed changes, an increased number of mid-market companies will fall under the AMT, losing their eligibility for R&D credits,” explains Charles Goulding, CEO of a tax consultancy based in Long Island that focuses on research credits.
This situation illustrates the complexity of balancing tax rate reductions with the goal of utilizing the tax code to encourage socially and economically beneficial actions, such as investing in research. When companies are not paying substantial taxes to begin with, it becomes challenging to provide them with incentives.
Certainly, corporations would still enjoy significant tax reductions, providing them with additional funds that could be directed toward research and development. Nevertheless, studies indicate that making research investments less expensive than distributing larger dividends to shareholders, for instance, encourages a greater level of innovation than they might pursue otherwise.
The R&D situation is less problematic for smaller businesses—those generating less than $50 million over the past three years can still apply the R&D tax credit against the AMT. Currently, 73% of businesses claiming the R&D tax credit fall below the $50 million threshold, reports the U.S. Treasury.
However, it remains an issue for larger corporations, such as Google (GOOG) and Intel (INTC), which make up the majority of the value of the credits. Taken by surprise, they banded together over the weekend to advocate for the removal of the AMT from the final legislation.
“Keeping the AMT in the reform is even more detrimental than its current state,” the U.S. Chamber of Commerce expressed in a blog post on Monday morning. “This cannot be the anticipated outcome from a Congress that has dedicated years to achieving a more globally competitive tax system.”
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The AMT dispute is not the only concern regarding how tax reform could adversely impact scientific research. The House and Senate proposals also mandate that research expenses be amortized over multiple years rather than allowing immediate deductions, which postpones the benefits for those claiming the credit.
“Though this is somewhat a timing concern, it poses a significant disadvantage for smaller companies that need financial returns sooner,” shares Steven Miller, national director of tax at the consultancy Alliantgroup.
Furthermore, tax reform could have ramifications for federally funded research as well. Federal science funding has reduced as a proportion of GDP since the 1970s and experienced a notable decline during the recession. President Trump’s proposed “skinny budget” from the spring, which gained no traction, would have significantly cut budgets for research supported by the Department of Energy and the National Institutes of Health.
Adding $1 trillion to the deficit will not improve the outlook for federal science funding, argues Joe Kennedy, a fellow with the Information Technology and Innovation Foundation, a D.C.-based think tank promoting the expansion of the R&D tax credit.
“I believe a much more beneficial bill could have been passed,” stated Kennedy. “Corporate reform is crucial, but is it worth introducing all these other flaws?”
