Tax incentives and R&D spending: A review of the evidence

Abstract

Since 1981, U.S. firms have been allowed to claim a tax credit for R&D spending in excess of some base amount. This paper assesses the evidence gathered to date about the effectiveness of the R&D tax credit in the United States. There is considerable evidence that the R&D tax credit has had some effect on the behavior of American firms in the early 1980s. But it is not as yet clear how much of the initial response of firms to the credit is due to increases in total R&D as opposed to increases in R&D that is qualified for the R&D credit. Moreover, different empirical approaches produce substantially different estimates of the size of the effect of the R&D credit. Analyses based on time series data imply that the credit has had a substantial effect on R&D spending. However, indirect evidence based on estimates of the price elasticity of demand for R&D, as well as studies based on more direct evidence from survey data and corporate tax returns imply that the effect of the credit has been rather modest. There are several ways in which these divergent estimates of the size of firms' responses can be reconciled. However, each suggested reconciliation points toward using the more modest estimates to gauge the effects of a permanently enacted incentive for R&D. These estimates imply that had the incremental 25 percent R&D credit been made permanent, it would have stimulated between $0.35 and $0.93 of additional company-funded R&D spending per each $1 of tax revenue forgone.