Keep tax credits for research

Treasury Secretary Henry Paulson is launching a new initiative to reform the U.S. corporate tax code. Based on a new Treasury report it appears that his goal is a simple one: eliminate a whole slew of deductions and credits and use the savings to lower the corporate rate. But in his zeal for the holy grail of tax codes — a low rate with no deductions — he risks throwing out the baby with the bathwater. In particular, by suggesting that the research and experimentation (R&E) tax credit be eliminated to fund rate reduction, he risks eliminating one of the most effective components of the corporate tax code and a provision that drives growth, innovation and U.S. competitiveness.

Economists have long argued that, left to the market alone, business will under-invest in research. This is because the benefits of research spill over to other firms and society as a whole, so that the firms investing don’t capture all the benefits. Economists have found that the private sector invests about half in research and development (R&D) than is optimal for society.

Even thought the Treasury report acknowledges that spillovers “may” exist, it questions the effectiveness of the research credit. Yet, there is near unanimity among economists that the credit is a cost-effective tool that spurs at minimum one dollar of private sector research investment for every tax dollar forgone.

In framing its proposals the report rightly focuses on the international competition America faces, advising, “Maintaining our competitiveness in today’s global environment requires us to think comprehensively and act prudently.” But paying for a lower corporate tax rate by jettisoning the R&E tax credit will only hurt our competitiveness. As economists Nick Bloom and Rachel Griffith found, R&D in one country responds to a change in its price in another “competitor” country. Eliminating the credit would mean that R&D would migrate to other nations with more generous tax treatment. In contrast, eliminating the credit would raise taxes for R&D-intensive companies competing intensely in global markets while reducing taxes on other industries, many that face little or no international competition (such as retail, consumer banking and healthcare).

Paulsen argues that we need to match other nations’ actions. But he overlooks the fact that while some other nations were lowering their corporate tax rates, they were also increasing their R&D tax incentives.

Why does the secretary want to kill such an effective and needed tax policy tool?  The answer lies in the fact that the lion’s share of economists at Treasury, and in much of Washington’s economic-policymaking circles, are “neo-classical” economists who focus on one major goal: maximizing “allocation efficiency.” Allocation efficiency refers to a state whereby all economic decisions are made on the basis of the marginal costs and benefits to those involved. Taxes, by their very nature, distort allocation efficiency, and taxes that favor or burden particular activities distort it even more. This is why neo-classical economists — conservative or liberal — worship at the altar of a tax code with low rates and few distortions.

But where the neo-classicalists go wrong is by giving short shrift to two other key factors: productive efficiency and dynamic efficiency. Productive efficiency is the ability of organizations to produce in ways that lead to the most amount of output with the fewest inputs. Adaptive efficiency is the ability of organizations to change over time, in part by developing and adopting technological innovations.

So, Paulson is right: Tax incentives like the R&E credit “distort” the market.  But he is wrong in saying that this distortion would outweigh the benefits. In fact, the innovation and productivity spurred by the additional R&D that the credit produces vastly exceed any minor losses from “misallocation” of economic resources.

Atkinson is president of the Information Technology and Innovation Foundation.