U.S. Tax Law’s Retrograde Treatment Of R&D Is A Threat To National Security

In February of 2020, long before he was chosen to be the next National Security Advisor by president-elect Joe Biden, Jake Sullivan co-authored an essay in Foreign Policy about the nexus between economic policy and security policy.

Reflecting on the rise of China and the increasingly rapid pace of change around the world, Sullivan and co-author Jennifer Harris argued that the foreign policy community needed to reach for “a new economic model.” They said “America’s national security depends on it.”

Reasonable people can disagree on what the elements of such an economic model might be, but there is widespread agreement across the political spectrum that the government needs to promote private-sector research and development.

Technological innovation isn’t just a driver of progress and prosperity, it is essential to deterring and/or defeating aggression. One need look no further than the performance of Russian weapons in Ukraine to grasp what happens when a nation falls behind.

However, innovation in the national-security arena means something different today than it did during the cold war. At the time Sullivan coauthored his piece about a new economic model, the top-ten technologies identified by the Pentagon as national-security priorities included microelectronics (#1), 5G communications (#2), biotechnology (#4), artificial intelligence (#5), and other “dual-use” technologies.

The implication is clear: sustaining a robust national-security posture today requires more than just encouraging research and development of defense-unique technologies, it demands broad support of commercial innovation.

One area where Washington has an uneven track record in this regard is tax policy. The United States maintained one of the highest corporate income-tax rates in the world for many years until 2017, when Congress brought the rate into alignment with rates in other countries.

However, in enacting that change, it also made the treatment of private R&D investments less favorable than is typical of other advanced economies. Prior to 2017, the Internal Revenue Code had allowed companies to deduct from their taxable base the full amount of allowable R&D expenses made in the year they occurred, or spread the deductions out over a period of up to five years.

But the same Tax Cuts & Jobs Act that lowered the corporate income-tax rate also required that starting in 2022, companies would only be able amortize R&D spending over a five-year period in order to receive the full benefits of tax deduction (15 years in the case of R&D conducted overseas).

That change, which is supposed to take effect this year, is a significant hit to corporate cash flow and a disincentive to engage in R&D. For instance, applying the maximum corporate income-tax rate using the traditional approach favored by many companies, 21% of R&D expenditures could be shielded from taxation in the year they occurred. Under the new rule, the deduction falls to only 4.2% per year spread over five years.

Eventually the company taking the deductions gets the full 21% of its investment shielded, but that takes five years and thus it has less cash flow with which to work in any given year.

This is very different from the practice in China, where companies can expense 200% of their R&D outlays in the year they occur. In fact, it is different from the practice of every other industrialized country, because using tax policy to support investment in R&D has become the global norm.

Since the proposed change was delayed by five years, it isn’t clear that lawmakers supporting the language in the 2017 legislation understood what the fallout from the change would be. However, a 2019 study by Ernst & Young projected the eventual impact on research and development in the U.S., and it was decidedly negative:

• As currently worded, the new approach would reduce domestic R&D spending by $4.1 billion annually during the first five years the provision is in effect, and then by $10.1 billion in subsequent years.
• The new approach would reduce domestic employment in R&D activities by 23,4000 positions in each of the first five years it is in effect, and by 58,600 in each subsequent year.
• It would also reduce domestic labor-related income by $3.3 billion in each of the first five years it is in effect, and then by $8.2 billion annually in later years.

The heavy impact on employment and income reflects the fact that roughly 70% of all expenses claimed under the R&D Tax Credit are for the compensation of skilled technical personnel like scientists and engineers. Texas alone would eventually lose nearly $400 million annually in R&D-related wages as a result of how the law dictates amortization of expenditures, compared with what would happen under the traditional approach of deducting all allowable expenditures in the year they occur.

The United States, one of the first countries during the postwar period to recognize the importance of R&D in its tax code, would thus become the most retrograde of nations in its approach to the subject, dead last among industrialized countries in rewarding innovation.

The U.S. was already losing ground globally before the new law took effect: in 1999, America accounted for 40% of all global R&D, but by 2019—the last “normal” year before the pandemic—that share had fallen to 30%. Meanwhile, China’s share of global R&D outlays had risen steadily to 24% in the latter year.

It is no surprise that China’s investment in research and development is rising. Beijing has committed to becoming the world’s leading technological powerhouse by 2049, the hundredth anniversary of the founding of the People’s Republic. What is harder to understand is why the U.S. government would start treating R&D more harshly in its tax system at a time when China’s rise is widely deemed the greatest challenge to U.S. security.

There appears to be broad bipartisan support in Congress for preventing the new rule from taking effect, but that requires amending Section 174 of the relevant law and thus far it has not been done. The omnibus spending bill expected to replace the current continuing resolution that keeps the government running looks like the last opportunity this year to fix the problem.