FRBSF Economic Letter
2005-26; October 14, 2005
The Rise and Spread of State R&D Tax Credits
Tax credits for spending on research and development (R&D)
were first enacted into federal law in the U.S. in 1981.
In the ensuing quarter century, many states have adopted
such tax credits, often using the federal tax credit as
a model.
This Economic Letter reports on recent research
(Wilson 2005a) that quantifies the development of state
tax credits
for R&D, a challenging task because historical information
is not readily available in a single data source and
because of the variations in each state's law regarding
deductibility
and other specifics. Wilson finds that state tax credits
are almost as important, in terms of the cost of conducting
R&D, as federal tax credits. In addition, he finds
that cross-state differences in the R&D cost are
overwhelmingly due to differences in the effective value
(to firms) of
the state R&D tax credits. The results of these cost
measurements also reveal a striking twin pattern of a
rise in the average generosity of state R&D tax credits
and a rapid spread of their availability across states.
This
article begins with a description of the general structure
of state R&D tax credits, and then explains how
their true value can be measured, and how the average
value
as well as the availability of R&D tax credits
have evolved over time. It concludes with a discussion
of
the implications
of this evolution in terms of tax competition among
states.
How the federal R&D tax credit works
Before discussing
the ins and outs of state R&D tax
credits, with their myriad variations across states,
it is useful first to understand how the federal R&D
tax credit works, especially considering that many states
model
their credits on the federal credit. On their federal
corporate income tax returns, corporations are allowed
to take a
credit against their (precredit) tax liability
equal to 20% of their current year's "qualified
R&D" expenditures
in excess of some base amount. (There also is a
less commonly claimed credit for contract payments to
other
institutions
for performing basic, rather than applied, research.) "Qualified
R&D" consists of the salaries and wages,
intermediate/materials expenses, and the rental
costs of certain property and
equipment incurred in performing research "undertaken
to discover information" that is "technological
in nature" for a new or improved business
purpose (see Internal Revenue Code, Section 41).
The federal
credit is known as an "incremental" credit
because it applies only to the incremental R&D
above some base amount. The incremental design
of the credit is meant to
encourage firms to perform additional R&D,
that is, beyond what they otherwise would be expected
to perform,
while limiting the cost to the government. The
definition
of the base amount has varied over time; currently
it is defined for a given year as a "fixed-base" percentage
of the average sales over the preceding four years.
For most firms, this percentage is defined as the
average ratio
of R&D to sales over the five-year period 1984-1988
(there is a different formula for firms started
up more recently).
How state R&D tax credits
work
State R&D tax credits generally work in
a similar fashion. Companies first figure out the
taxable income they owe
to each of the states. Companies pay corporate
income or franchise taxes to states based on an
apportionment of
their total federal taxable income. The share apportioned
to any particular state is based on the income
generated by sales transactions occurring in the
state (known as
the "transactions test"). A transaction
is said to have occurred in a particular state
if the payment for
the transferred good or service was received in
that state. For example, a mail-order company in
Virginia that ships
goods to a buyer in California but receives or
processes payment (via check, credit card, etc.)
in Virginia must
pay corporate income taxes on that revenue to Virginia.
In
some states, companies may take a credit against
their state income or franchise tax equal to a
percentage of
their qualified R&D expenditures over some
base amount (the credit typically can be carried
forward or backward
for a specified number of years). States generally
use the federal definition of qualified R&D
in their tax codes. The value of these credits
varies from state to
state depending on the credit rate, how the base
amount of R&D is defined, and whether the credit
itself is "recaptured" (i.e.,
taxed at the corporate tax rate).
The most transparent
component of the value of a state's tax credit
is the credit rate. These
credit
rates currently
range from a low of 1% to a high of 20%, equivalent
to the federal rate. A number of states offer different
credit rates for different levels of R&D spending,
typically with the rate lower for higher tiers
of R&D (in order
to provide greater incentive to small businesses
and start-ups to perform R&D).
Though the credit
rate is the easiest feature of a credit for policymakers
to trumpet and for companies
to learn
about, the definition of the base level often is
much
more important in determining the true value of
a credit. There
are basically three different ways in which states
define the base level. The first way is to have
no base at all.
A credit with no base is referred to as a "nonincremental" credit.
The second way is to use a moving-average of the
firm's R&D over the past few years (ranging
from one to four years). The third way is to use
recent sales times the
average of the firm's R&D-to-sales ratio over
some fixed, past period; in fact, the 19 states
with this type
of base all follow the federal tax code in designating
this fixed period as 1984-1988 (while also using
the federal formula for more recent start-ups).
For
a given credit rate, nonincremental credits are
obviously the most valuable type of credit
from a
firm's perspective,
because every dollar of qualified R&D, not
just the amount over some base, is eligible for
the credit. Hawaii
and West Virginia have nonincremental credits (Massachusetts
and Connecticut have a combination of an incremental
and nonincremental credit; Maryland offers a choice
between
a low-rate nonincremental credit and a high-rate
incremental credit). Least valuable from a firm's
perspective are credits
with a moving-average type of base. This type of
base can dramatically reduce the true value of
a tax credit, since
whatever R&D a firm chooses to do this year
reduces the amount of creditable R&D in subsequent
years. Ten states (including Connecticut and Maryland)
have an R&D
tax credit with this moving-average type of base.
Evolution
of state R&D tax credits
Over the past two decades,
R&D tax credits offered
by U.S. states have become widespread and increasingly
valuable to firms, as shown in Figure 1. The process
began when Minnesota became the first state to
enact an R&D
tax credit in 1982, one year after the introduction
of the federal R&D tax credit. The number of
states offering such a credit has risen steadily
since then. Currently,
31 states provide a tax credit on general, company-funded
R&D. (A number of other states offer narrowly
targeted tax credits for R&D spending in specific
fields, in particular geographic zones, or only
by small or start-up
companies.)
Not only have more states introduced
R&D tax credits
over time, but the average generosity of these
credits also has grown. The generosity or value
of a tax credit
to firms can be measured by calculating the effective credit rate for firms in a given state (see Wilson
2005a). The
effective credit rate is determined by the statutory
credit rate (i.e., the rate specified in the tax
code), the base
definition, and whether the credit itself is taxable
(recaptured). The effective credit rate measures
the present discounted
value of the credit for the marginal dollar of
R&D
spent by a representative firm in the state. Wilson
(2005a) assumes the representative firm's current
R&D spending
is above any base amount. For nonincremental credits
and credits with a fixed-period base, the effective
credit
rate simply equals the statutory credit rate. For
credits with a moving-average base, the effective
rate is well
below the statutory rate and depends on the number
of years in the moving-average and the interest
rate during those
particular years.
The line in Figure 1 shows the
average effective credit rate across states for
each year from 1981-2004;
each
year's average is computed only over the states
that had an R&D
tax credit in that year. It is clear that not only
have R&D tax credits been offered by an increasing
number of states over the last 25 years, but also
the average
generosity of the credits that these states offer
has grown greatly. Specifically, the average effective
credit rate
has grown approximately four-fold over this period.
A large part of the increase in value has been
due to states increasingly
switching from the moving-average base definition
to the fixed-period base.
Implications for optimal
public policy
The growing prevalence and generosity
of state R&D
tax credits raises the question: Are these trends
socially beneficial or do they instead represent wasteful "tax
competition"? Whenever different jurisdictions
separately choose tax policies that may benefit
their own jurisdiction
at the expense of others, there is the potential
for tax competition. Looking at data on private
R&D by state
from 1981-2002, Wilson (2005a) does, in fact,
find evidence that a reduction in the after-tax
cost
of R&D for a
given state has a detrimental impact on the average
R&D
spending in other states. Since companies appear
to be willing to move R&D activities from
one state to another (though at some cost), states
do have an incentive to compete
via R&D tax credits for that footloose R&D.
Of course, this may be socially beneficial if
the overall,
national level of R&D subsidization is too
low, as the competition provides an incentive
for states to help
make up the shortfall.
On the other hand, if
there are substantial deadweight losses caused
by companies moving R&D from state to
state, by companies calculating the tax implications
of R&D in each of 50 states, or by state
tax agencies administering R&D tax credits,
then the tax competition may be socially wasteful.
In addition, even if tax competition
via R&D tax credits is a second-best solution
to a suboptimally low level of federal subsidization
of R&D,
it is not clear that such competition is constitutionally
valid. Other types of corporate income tax credits
at the state level have recently been successfully
challenged
on the grounds that, because the credits effectively
impose a tax penalty on companies engaging in
economic activity
in other states, they run afoul of the Commerce
Clause of the U.S. Constitution. See Wilson (2005b)
for a discussion
of the issue of the constitutionality of state
R&D
tax credits in light of recent court decisions.
Nonetheless,
the steady rise and spread of state R&D
tax credits over the past 25 years shows no signs
of abating in the near future. At what point
states will collectively
decide (or be forced) to end this trend remains
to be seen.
Dan Wilson
Economist
References
[URLs accessed October 2005.]
Wilson, Daniel. 2005a. "Beggar
Thy Neighbor? The In-state vs. Out-of-state Impact of
State R&D Tax Credits." FRBSF
Working Paper 2005-08. http://www.frbsf.org/publications/economics/papers/2005/wp05-08bk.pdf
Wilson,
Daniel. 2005b. "Are State R&D Tax Credits
Constitutional? An Economic Perspective." FRBSF
Economic Letter 2005-11 (June 3). http://www.frbsf.org/publications/economics/letter/2005/el2005-11.html
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