New ideas are the basic craft and contribution of entrepreneurs. Whether a new product or service, “building a better mousetrap,” or new methods of producing, distributing, or delivering products and services, new ideas are the essence of innovation, which drives productivity gains and economic growth, and creates jobs, wealth, and opportunity. New ideas can come from the mind and imagination of entrepreneurs or as the result of scientific inquiry and discovery.
The Research and Experimentation Tax Credit – commonly known as the research and development (R&D) tax credit – was created as part of the Economic Recovery and Tax Act of 1981 to incentivize technological progress and innovation by allowing businesses to deduct a portion of the cost of research and product development from their taxable earnings. The United States was one of the first countries to incentivize R&D by way of the tax code and claimed the world’s most generous tax treatment of R&D into the early 1990s.
Since its introduction, the R&D tax credit has been shown to be a powerful driver of innovation and economic growth. A large and growing body of research indicates that R&D investment is associated with future gains in profitability and market value at the firm level, and with increased productivity at the firm, industry, and broader economy levels. R&D also has significant “spill-over” benefits, as research conducted by one firm can lead to progress that increases the productivity, profitability, and market value of other firms in related fields. A recent analysis of the R&D expenditures of 15 OECD countries over the period 1990 to 2013 concludes that a 1 percent increase in R&D spending accelerates economic growth by 0.61 percent. Research also shows that R&D investment has become increasingly mobile, with businesses and corporations locating more of their investment outside their home countries. Investment location decisions are determined by many factors, including the growth of foreign markets, production costs, talent and skills availability – and tax and other incentives offered by governments.
The United States no longer claims the most favorable tax treatment of corporate R&D. Today, 26 of the 34 OECD nations offer R&D tax incentives, and other non-OECD nations like Brazil, India, Russia, Singapore, South Africa, and China do as well. A recent analysis by the Information Technology and Innovation Foundation has shown that the United States now ranks 27th of 42 nations studied in terms of R&D tax treatment. More favorable tax treatment of R&D means that foreign companies are able to invest more heavily in relative terms, with potentially profound implications for innovative advantage over the longer term. Moreover, as global companies – including American companies – look for places to invest in R&D, many other countries are now substantially more attractive than the United States.
Restoring America’s preeminence in incentivizing R&D will not be cheap. But losing the innovation advantage our nation has enjoyed for 70 years would be much more costly. Moreover, academic research regarding the stimulative effect of R&D investment on the rate of economic growth and job creation, as well as the significant “spillover” impact of such investment, strongly suggests that any short-term loss in tax revenue will be substantially or even entirely recovered through faster economic growth and job creation over the longer run.
The R&D tax credit would be particularly relevant for startups, which often incur substantial losses in their early years due to development of new products, services, methodologies, and techniques – and for whom preservation of cash flow and operating capital is crucial to survival. And yet, until recently, startups were largely shut out of any benefit associated with the credit because it can only be applied against taxable earnings, which many startups don’t have for years, and sometimes many years.
The Protecting Americans from Tax Hikes (“PATH”) Act of 2015 made a number of improvements to the application of the R&D tax credit, perhaps most notably finally making the credit permanent after numerous extensions and expirations since its creation in 1981. Now certain of the credit’s availability, businesses can make investment decisions more effectively and efficiently. In addition, the PATH Act addressed the disconnect between the policy intention of the R&D credit and startups by allowing new businesses to apply the credit against payroll taxes, rather than income taxes, up to $250,000 annually. To qualify, companies must have had gross receipts for five years or less and gross receipts of less than $5 million for the tax year the credit is applied.
CAE recommends enhancing the PATH Act’s tax provisions for startups by: 1) aligning the criterion for eligibility with that of Section 1202 of the tax code; 2) raising the eligibility threshold; and, 3) increasing the deduction limit.
First, CAE recommends that the eligibility criterion be changed from gross receipts to gross assess. This change would make the PATH Act provisions consistent with the tax code’s definition of “Qualified Small Business,” (QSBs) which are currently defined as businesses with “less than $50 million in gross assets.” This consistency would simplify and harmonize related provisions of the tax code, facilitating compliance and reporting by investors and, thereby, promoting capital formation.
Second, CAE recommends that the eligibility threshold for the PATH Act’s payroll tax provisions be raised from the current definition of QSBs of “less than $50 million in gross assets” to “less than $100 million in gross assets.” The current gross asset limit is too restrictive, as the high costs of innovative research, coupled with valuable intellectual property and successive rounds of financing, often push new innovative companies over the $50 million limit (see recommendation regarding Section 1202 on page 20 below).
Finally, CAE recommends that the payroll tax credit deduction limit be raised from the current $250,000 to $1 million. Doing so would align U.S. policy with similar policy in Canada, a major innovation competitor to the United States.
In addition to enhancing the tax treatment of private R&D, CAE urges policymakers to restore U.S. government funding of R&D to the historical high of 2.2 percent of GDP. To do so, funding would need to increase from the current $145 billion annually to about $400 billion.
The U.S. government’s commitment to R&D has waned dramatically in recent decades. After growing at an inflation-adjusted average annual rate of 7 percent between 1950 and 1990, growth in government outlays for R&D fell to an annual average of just 1.4 percent between 1990 and 2012. Meanwhile, other nations have dramatically expanded government support of R&D. Over the period 1992 to 2009, Australia increased government R&D spending at an average annual rate of 9 percent, South Korea by 11 percent, Singapore by 14 percent, and China by nearly 20 percent. China’s performance is especially impressive given that its GDP grew at an annual rate of nearly 10 percent over the period. China is expected to overtake the Unite States in total R&D spending this year, according to the National Science Board.
Perhaps most alarming, the federal government’s share of basic research funding has plunged in recent years – from 70 percent through the 1960s and 1970s, 60 percent as recently as 2004, below 50 percent in 2013 for the first time in the post-World War II era, and to just 44 percent in 2015. Basic or “pure” research is conducted to gather general information and to build on existing knowledge and understanding – it is the basis for applied research, establishing the context of knowledge and understanding within which additional progress can be made regarding specific inquiries. Government funding of basic research has played a critical role in driving many technological breakthroughs that have helped U.S. industry become a global technology leader. Google, Sun Microsystems, Pfizer, Genentech, and Cisco are examples of companies whose origins can be traced directly back to basic research funded by the government.
U.S. government-funded R&D peaked at 2.2 percent of GDP in 1964, then steadily declined to a low of 0.7 percent of GDP in 2000 and has remained at or below 1 percent of GDP ever since.
If America is to retain its status as the world’s innovation leader, the multi-decade decline in the commitment of federal dollars to scientific research must be reversed. Tripling government R&D funding is a significant challenge given current fiscal circumstances, but there is little doubt that America’s economic future depends on such a commitment.
 National Science Board Statement on Global Research and Development (R&D) Investments NSB-2018-9: https://www.nsf.gov/nsb/news/news_summ.jsp?cntn_id=244465
Promising innovations stemming from federally-funded research too often face a slow, cumbersome, and uncertain path to commercial viability. Discoveries with significant social and economic benefit often take years to reach the commercial marketplace, while other innovations never leave the research lab. It is not hyperbole to assert that more streamlined and efficient commercialization of federally-funded innovation may have greater impact on the U.S. economy and quality of life of American citizens than any other research and development strategy. On July 30, 2018, CAE submitted a comment letter to the National Institute of Standards and Technology (NIST) regarding reform of federal technology transfer authorities and processes. That letter can be found here: http://www.startupsusa.org/wp-content/uploads/2018/08/CAE-Response-to-NIST-Tech-Transfer-RFI-Final-1.pdf
The National Science Foundation’s (NSF) Innovation Corps (“I-Corps”) program was created in 2011 to accelerate the translation of scientific and engineering discoveries into technologies, products, processes, and services that enhance the nation’s competitiveness, benefit society, and promote economic growth. Developed by famed Silicon Valley entrepreneur Steve Blank and based on his “Lean Startup” model, I-Corps provides education, training, and mentoring to scientists and engineers to identify and explore the commercial potential of NSF-funded research. The goals of the I-Corps program are to: 1) spur translation of fundamental research to the marketplace; 2) encourage collaboration between academia and industry; 3) train NSF-funded faculty, students, and other researchers in innovation and entrepreneurship; and, 4) maximize the potential of NSF’s investments in basic research through creation of a National Innovation Network (NIN) comprising I-Corps “Nodes” (or central training sites) and sites (universities) that work cooperatively to build, utilize, and sustain the national innovation ecosystem.
The American Innovation and Competitiveness Act (AICA) was signed into law in January of 2017 (P.L. 114-329), and Section 601 of AICA directs NSF to further develop and expand the I-Corps program. Since its launch in 2011, the I-Corps program has been adopted by several other federal research agencies including the National Institutes of Health, the Department of Energy, the Department of Health and Human Services, and the National Security Agency, and has delivered remarkable results – to date, the program has trained over 1,200 teams of scientists and engineers, resulting in 583 startups and $300 million in follow-on funding. The FY 2019 funding request for I-Corps is just $30 million. CAE recommends that I-Corps’ resources be significantly increased and that the program be expanded to include all research agencies, including through widespread integration into other relevant R&D programs such as the Small Business Innovation Research (SBIR) program.