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TAX REFORM OPTIONS: 

INCENTIVES FOR INNOVATION 

HEARING 

BEFORE THE

COMMITTEE ON FINANCE 

UNITED STATES SENATE 

ONE HUNDRED TWELFTH CONGRESS 

FIRST SESSION 

SEPTEMBER 20, 2011 

( 

Printed for the use of the Committee on Finance 

COMMITTEE ON FINANCE 

MAX BAUCUS, Montana, Chairman 

JOHN D. ROCKEFELLER IV, West Virginia 

KENT CONRAD, North Dakota 

JEFF BINGAMAN, New Mexico 

JOHN F. KERRY, Massachusetts 

RON WYDEN, Oregon 

CHARLES E. SCHUMER, New York 

DEBBIE STABENOW, Michigan 

MARIA CANTWELL, Washington 

BILL NELSON, Florida 

ROBERT MENENDEZ, New Jersey 

THOMAS R. CARPER, Delaware 

BENJAMIN L. CARDIN, Maryland 

ORRIN G. HATCH, Utah 

CHUCK GRASSLEY, Iowa 

OLYMPIA J. SNOWE, Maine 

JON KYL, Arizona 

MIKE CRAPO, Idaho 

PAT ROBERTS, Kansas 

MICHAEL B. ENZI, Wyoming 

JOHN CORNYN, Texas 

TOM COBURN, Oklahoma 

JOHN THUNE, South Dakota 

RICHARD BURR, North Carolina 

RUSSELL SULLIVAN, Staff Director 

CHRIS CAMPBELL, Republican Staff Director 

(II) 

C O N T E N T S 

OPENING STATEMENTS 

Page 

Baucus, Hon. Max, a U.S. Senator from Montana, chairman, Committee 

on Finance ............................................................................................................ 1 

Hatch, Hon. Orrin G., a U.S. Senator from Utah ................................................. 3 

WITNESSES 

Wallsten, Dr. Scott, vice president for research and senior fellow, Technology 

Policy Institute, and senior policy fellow, Georgetown Center for Business 

and Public Policy, Washington, DC .................................................................... 5 

Rashkin, Michael D., author, ‘‘Practical Guide to Research and Development 

Tax Incentives: Federal, State and Foreign,’’ Saratoga, CA ............................. 7 

Nellen, Annette, professor, Department of Accounting and Finance, College 

of Business, San Jose State University, San Jose, CA ..................................... 10 

Pilat, Dr. Dirk, head, Structural Policy Division, Organization for Economic 

Cooperation and Development Directorate for Science, Technology, and Industry, Paris, France ........................................................................................... 12 

ALPHABETICAL LISTING AND APPENDIX MATERIAL 

Baucus, Hon. Max: 

Opening statement ........................................................................................... 1 

Prepared statement .......................................................................................... 29 

Hatch, Hon. Orrin G.: 

Opening statement ........................................................................................... 3 

Prepared statement .......................................................................................... 31 

Nellen, Annette: 

Testimony .......................................................................................................... 10 

Prepared statement .......................................................................................... 33 

Responses to questions from committee members ......................................... 54 

Pilat, Dr. Dirk: 

Testimony .......................................................................................................... 12 

Prepared statement .......................................................................................... 57 

Responses to questions from committee members ......................................... 79 

Rashkin, Michael D.: 

Testimony .......................................................................................................... 7 

Prepared statement with attachment ............................................................. 82 

Responses to questions from committee members ......................................... 103 

Wallsten, Dr. Scott: 

Testimony .......................................................................................................... 5 

Prepared statement .......................................................................................... 113 

COMMUNICATIONS

alliantgroup .............................................................................................................. 117 

Center for Fiscal Equity .......................................................................................... 123 

R&D Credit Coalition .............................................................................................. 125 

(III) 

(1) 

TAX REFORM OPTIONS: 

INCENTIVES FOR INNOVATION 

TUESDAY, SEPTEMBER 20, 2011 

U.S. SENATE, COMMITTEE ON FINANCE, Washington, DC. 

The hearing was convened, pursuant to notice, at 10:06 a.m., in 

room SD–215, Dirksen Senate Office Building, Hon. Max Baucus 

(chairman of the committee) presiding. 

Present: Senators Bingaman, Kerry, Wyden, Schumer, Cantwell, 

Nelson, Carper, Cardin, Hatch, Grassley, Snowe, Kyl, and Crapo. 

Also present: Democratic Staff: Russ Sullivan, Staff Director; 

Diedra Henry-Spires, Professional Staff; Amber Roberts, Tax Exempt Organization Policy Staff Member; Lily Batchelder, Chief Tax 

Counsel; and Holly Porter, Tax Counsel. Republican Staff: Chris 

Campbell, Staff Director; and Nick Wyatt, Tax and Nomination 

Professional Staff Member. 

OPENING STATEMENT OF HON. MAX BAUCUS, A U.S. SENATOR 

FROM MONTANA, CHAIRMAN, COMMITTEE ON FINANCE 

The CHAIRMAN. The committee will come to order. 

Apple cofounder Steve Jobs once said, and I quote him: ‘‘Innovation distinguishes between a leader and a follower.’’ 

Thirty years ago, on the heels of the 1982 recession, a divided 

Congress passed the first Federal research and development tax 

credit to help stimulate economic growth. The United States became the world’s leader in funding research. 

This ushered in years of innovation and investment in groundbreaking research. Since then, United States companies have 

changed the world with revolutionary inventions. These include 

microprocessors, mobile phones, solar panels, office software, personal computers, and social networking. 

The United States still leads the world in international patent 

filings. We risk losing that title. While our international patent applications fell slightly from 2006 to 2010, China’s tripled. We are 

not doing enough to support our research and development, and 

this puts our country’s competitiveness at risk. 

Today, out of the 21 OECD nations, the United States ranks 

17th in tax incentives for research and development. And American 

companies have little certainty that the main tax incentive for research and development, the R&D credit, will continue. 

Since 1981, we have relied on 14 short-term extensions to renew 

the credit. This undermines the potential of the tax credit to provide the certainty businesses need to generate meaningful growth. 

2 

* For more information, see also, ‘‘Tax Incentives for Research, Experimentation, and Innovation,’’ Joint Committee on Taxation staff report, September 16, 2011 (JCX–45–11), https:// 

www.jct.gov/publications.html?func=startdown&id=4358. 

Today, again, in the wake of a recession, Congress must do its 

part to support American ingenuity. Development and innovation 

here at home will boost our economy, and they will help create jobs 

so desperately needed. 

Economists, such as Gregory Tassey of the National Institute of 

Standards and Technology, argue that technology is the singlemost important determinant of long-term growth. Technology creates new market opportunities. This increases productivity and 

quality, and helps businesses create good-paying jobs and profits. 

Today we discuss how we can most effectively encourage R&D to 

help create jobs here at home. Clearly, the world is a much different place than it was 30 years ago when we first created the 

R&D tax credit. We are not the only country thinking along these 

lines. Competition is now fierce as other nations try to lure scientists and investors to their shores. Now, more than ever, it is 

crucial that we remain the leader in R&D. 

To understand this issue and help businesses create jobs, we at 

the Finance Committee must think like inventors. In doing so, we 

must also structure any tax incentives to get the most bang for our 

buck given our enormous fiscal challenges. 

Clearly, tax credits are not the entire solution. But we can look 

to improve the incentives to innovation through tax reform. 

Yesterday we took a major step forward. Senator Hatch and I introduced a permanent R&D tax credit, the Growth Research Opportunities With Tax Help Act, otherwise known as the GROWTH 

Act. This bill would make the research and development tax credit 

a permanent part of the tax code. Making this tax credit permanent will provide certainty. 

It is really nuts, frankly. The R&D tax credit has been like a yoyo. It has been up and down and up and down. Businesses cannot 

depend on it. Sometimes it is extended, sometimes it is not. Sometimes they have gone a period of time when it has not been extended. 

We tell businesses, ‘‘Oh well, Congress will extend it.’’ Yes, we 

will do that. But nevertheless, if we are always extending it, why 

don’t we just make it permanent? I think it would be a lot better. 

Making this tax credit permanent will provide that certainty. It 

will help spur economic growth for generations to come. 

The bill also simplifies and enhances the tax credit, making 

America more competitive in the global race for jobs and investment. I suspect we will hear from some of our witnesses today on 

other ways to improve the credit. I want to hear those ideas. 

So let us be innovative. Let us think like inventors. Let us be 

creative. Let us understand what drives businesses to innovate. Let 

us support that innovation. And most importantly, let us lead, not 

follow.* 

[The prepared statement of Chairman Baucus appears in the appendix.] 

The CHAIRMAN. Senator Hatch? 

3 

OPENING STATEMENT OF HON. ORRIN G. HATCH, 

A U.S. SENATOR FROM UTAH 

Senator HATCH. Thank you, Mr. Chairman. I appreciate your 

comments. And thank you for holding this hearing. It could not 

come at a better time. 

The economic growth that will ultimately drive lasting job creation lags behind that of previous recoveries, and economists increasingly fear that we are at risk for a double-dip recession. 

In response to the increasingly dire economic picture, the President recently urged Congress to take up and pass legislation that 

would promote job growth. 

For reasons I will not get into here, individuals from both parties 

have objected strongly to the President’s jobs proposal. However, 

there are steps that this Congress could take today to start turning 

the economy around and create American jobs, and those steps 

begin with the promotion of innovation. 

The importance of innovation to job creation is not just a belief 

of mine. It was a central teaching of the early 20th-century economist Joseph Schumpeter. Schumpeter argued that innovation is essential to economic change and growth. Of course, research is essential in discovering innovations. 

So then the question becomes, how can we be assured that research and development is occurring at a pace that ensures innovation and economic growth? 

Generally speaking, the answer is by promoting a vibrant free 

market. A private sector fortified by economic liberty and the rule 

of law is our strongest engine of economic growth—not the Federal 

Government, by the way. With a robust private sector, capital flows 

to innovations and technologies that will profit not only those who 

invest in them, but society as well. However, there can be cases 

where those performing R&D create significant positive externalities. 

Those investing in and performing R&D may create great benefits for society at large. Yet, they are not always able to capture 

much benefit for themselves through increased profits. Though an 

innovation might be quite valuable for our society, researchers and 

developers are not always able to capitalize on those innovations. 

To correct this problem of positive externalities, the government 

does act to promote research and development in certain limited 

contexts. One way the government steps in is by awarding inventors patents, to give them an exclusive right to sell their invention 

for a certain set number of years. 

Sometimes the government directly funds R&D. This has proven 

particularly useful with respect to national security. In addition, 

for decades, the government has also provided tax incentives to 

promote and reward R&D. Since 1954, there has been a deduction 

for R&D expenditures. This is a permanent feature of the tax code. 

The deduction for R&D expenditures is an incentive to perform 

R&D. It has also proven to be a significant simplification, saving 

taxpayers and the IRS from having to debate the useful life of intellectual property resulting from R&D. 

Since 1981, there has also been a credit for R&D expenditures. 

The United States’ R&D credit has always been incremental in nature. One cannot claim a credit based on all R&D expenditures, but 

4 

only to the extent one’s R&D expenditures exceed a certain base 

amount. 

The rationale for this has been that there is no need for the government to give a credit for R&D that would have been done even 

in the absence of a credit. Instead, the R&D credit has always been 

focused on the margin, on the increment above and beyond R&D 

that would have been performed anyway. 

This is not the way that all countries structure their R&D tax 

incentives. Some grant an R&D benefit for any and all R&D expenditures. 

One of the keys to successful tax policy is permanence. The tax 

policy goal of economic growth is undercut by temporary provisions. 

Unfortunately, the R&D credit has always been temporary. It has 

sunset numerous times over the course of the last 30 years, and it 

is currently scheduled to sunset yet again in a mere 3 months, at 

the end of 2011. 

The temporary nature of the credit significantly undermines its 

incentive effect. So I am pleased, Chairman Baucus, that you and 

I introduced a bill just yesterday to extend permanently the R&D 

credit. I am glad to be joined in this effort not only by you, but also 

by a number of our colleagues on the Finance Committee. 

As Congress contemplates actions to stimulate job growth, it 

would do well to start with this hearing today. Reauthorizing the 

R&D credit and making it permanent would be a real lift for our 

economy. 

I personally want to thank you for your leadership on this issue. 

It has been a pleasure to work with you over these many years. 

You are absolutely right. We have to make it permanent so that 

businesses can rely on it, plan on it, and continue to move ahead 

from a research and development standpoint, and I think you deserve a lot of credit for that. 

Thank you, Mr. Chairman. 

[The prepared statement of Senator Hatch appears in the appendix.] 

The CHAIRMAN. Thank you, Senator. 

The committee will now move into Executive Session. 

[Whereupon, at 10:18 a.m., the hearing was recessed, reconvening at 10:34 a.m.] 

The CHAIRMAN. I would like to call the witnesses to the table. 

Again, I thank all Senators. Senators who wish to stay for the 

hearing are certainly invited to do so. We all might learn something. 

Our first witness is Dr. Scott Wallsten. Dr. Wallsten is the vice 

president for research at the Technology Policy Center and a senior 

policy fellow at the Georgetown Center for Business and Public Policy. 

Second is Michael Rashkin. Mr. Rashkin is the author of ‘‘A 

Practical Guide to Research and Development Tax Incentives: Federal, State and Foreign.’’ 

The next witness is Annette Nellen. Ms. Nellen is a professor of 

accounting and finance at San Jose State University’s College of 

Business. 

Finally, Dr. Dirk Pilat. Is that correct? Yes? Good. Thank you. 

Dr. Pilat is head of the Structural Policy Division for the OrganizaVerDate Nov 24 2008 17:53 Dec 05, 2012 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 R:\DOCS\76378.000 TIMD
5 

tion for Economic Cooperation and Development Directorate for 

Science, Technology, and Industry. 

Thank you all very much for coming. This is an extremely important subject. And I encourage you to summarize your statements 

for about 5 or 6 minutes. Statements will automatically be included 

in the record. 

Dr. Wallsten, you are first. 

STATEMENT OF DR. SCOTT WALLSTEN, VICE PRESIDENT FOR 

RESEARCH AND SENIOR FELLOW, TECHNOLOGY POLICY INSTITUTE, AND SENIOR POLICY FELLOW, GEORGETOWN CENTER FOR BUSINESS AND PUBLIC POLICY, WASHINGTON, DC 

Dr. WALLSTEN. Thank you, Mr. Chairman, Senator Hatch, and 

members of the committee, for inviting me to testify here today. My 

name is Scott Wallsten, and I am vice president for research and 

senior fellow at the Technology Policy Institute, as well as a senior 

policy fellow at the Georgetown Center for Business and Public Policy. 

Research and development plays a crucial role in our economy 

and our future welfare. Two factors, however, suggest that there 

could be a gap between the optimal and actual levels of R&D activity in the economy. 

First, R&D exhibits classic positive externalities. In other words, 

its benefits extend beyond the innovator as others build on it. But 

because firms base their R&D spending on their own expected returns, not the social expected returns, they invest less than they 

would if they could appropriate all their returns. That is, by themselves, businesses are likely to invest fewer resources than is efficient from society’s overall perspective. 

The private returns to R&D are difficult to measure, but studies 

suggest that, in industrialized countries, they are probably about 

20 to 30 percent, significantly higher than returns to other investments. Measuring the so-called research spillovers and, thus, the 

total returns to R&D is even more difficult, but a wealth of studies 

suggest that they are substantially higher than private returns. 

If the marginal private returns are so high, why don’t firms invest more? The answer is the second reason there may be a gap 

between optimal and actual levels of R&D activity. 

Primarily because of its riskiness and the inability of the researcher to provide full information to financiers, the cost of capital 

for research may be higher than for other goods. Both factors suggest that government can play an important role in supporting 

R&D, ranging from conducting R&D itself, to directly financing 

others to do it, to creating incentives for others to invest their own 

money in it. And, indeed, the government does all those things. 

In 2010, Federal agency budgets included about $149 billion for 

R&D spending. That represented a general upward trend over the 

previous decade in real dollars, though R&D budget obligations decreased by about 3.5 percent in fiscal year 2011. 

To be effective, however, government R&D activities must generate R&D that would not happen otherwise. If government merely 

subsidized R&D that firms or others would have undertaken anyway, then the government support would have zero effect, and 

would simply crowd out other sources of finance. 

6 

Identifying the areas government should fund is not always easy. 

Industry spends far more than the government on R&D. According 

to the National Science Foundation’s most recent data, in 2008, industry funded about $268 billion in R&D. The trick for government 

is to figure out how to generate R&D that would not happen without subsidies. 

Achieving this goal is probably easiest in the case of basic research, where private returns may be small, especially in the short 

run, but the total returns may be large, especially when they diffuse among lots of researchers. And government does spend more 

on basic research than industry does. While only about 4 to 5 percent of industry R&D spending is on basic research, nearly half of 

all Federal non-defense R&D is on basic research. 

But stimulating additional research is more difficult for government policy in the case of applied R&D or projects closer to commercialization, where the private sector has stronger incentives to 

provide funding. 

In theory, research projects do exist, even ones very close to 

yielding commercializeable products, that industry does not expect 

to be profitable, but whose total benefits would exceed costs and, 

thus, justify government support. Unfortunately, we generally have 

no good way to identify those projects. 

Understandably, government typically tries to fund projects most 

likely to succeed, especially if a metric of success is whether the 

subsidy yielded a payoff. But in that case, government risks basing 

funding decisions on the same criteria the private sector would use. 

If that happens, the program as a whole may appear to be successful, but, if government funding simply replaced private funding, 

then the program is not effective at all. 

In part for that reason, direct government funding of commercializeable industrial research has a mixed track record, at best. 

The first step in making those programs more successful would be 

designing them in such a way that they could be rigorously evaluated. Such evaluations would mean, at a minimum, tracking 

projects and firms that did not receive subsidies, as well as those 

that did, and, in the best case, introducing evaluation tools such as 

randomization. 

However, government has shown no interest in rigorous evaluation of corporate subsidies in the past, and no evidence suggests it 

will in the near future either. 

The R&E tax credit, however, is different from direct R&D subsidies. Unlike direct subsidies that, by definition, require difficult 

decisions that yield winners and losers, the tax credit encourages 

R&D more broadly and appears to be a rather successful policy tool 

that most studies find does stimulate additional R&D. 

Although the R&D tax credit should be considered successful, 

two factors have probably blunted its effectiveness. First, its lack 

of permanent status reduces its ability to coax firms to do more 

R&D. Because firms tend to smooth their R&D spending over time, 

their responses to temporary policies are likely to be muted. 

A temporary tax credit will, therefore, have limited effectiveness. 

That is, if firms do not have confidence that the credit will remain 

in effect, they will probably not increase their R&D spending by as 

much as they would if the credit were permanent. 

7 

A permanent R&D tax credit would be more consistent with the 

way companies make decisions regarding R&D spending and is 

more likely to have the intended positive effect on private spending. 

A second reason the tax credit may not have been as successful 

as it could have been is related to how it determines which expenditures are eligible. In order to be effective, the credit must generate 

new R&D, not just subsidize R&D that would have happened anyway. 

For this reason, the credit appropriately requires defining qualified expenditures and setting a baseline amount. Neither of those 

is simple, and a recent GAO report found that the credit was inadvertently subsidizing some R&D spending that would have occurred anyway, in part because the baseline level of spending was 

calculated using data more than 20 years old. 

Updating and simplifying the process for determining eligible expenditures is also likely to increase the effectiveness of the tax 

credit, if that makes it possible to better target the credit to do 

R&D. 

Stimulating new research in the U.S. requires additional policies, 

as well. For example, most R&D expenditure are for scientists and 

engineers, and their supply is relatively fixed in the short run. 

More spending on R&D without increasing the number of scientists 

and engineers may result in higher salaries for people already 

doing R&D, but not more R&D itself. 

The most effective way to increase the supply of scientists and 

engineers in the U.S. is to attract the best from wherever they are, 

which requires looser immigration policies. While immigration is 

beyond the scope of this committee, it nevertheless remains an important complement to tax policy if the goal is to encourage new 

R&D. 

In short, R&D is crucial to our future well-being. The R&E tax 

credit is one of the few government policies that is widely recognized as successfully stimulating additional R&D. 

Its effectiveness would be strengthened, first, by making it permanent and, second, by careful consideration of what is considered 

baseline spending and what is eligible for the credit. 

Thank you. 

[The prepared statement of Dr. Wallsten appears in the appendix.] 

The CHAIRMAN. Thank you, Dr. Wallsten. 

Mr. Rashkin, you are next. 

STATEMENT OF MICHAEL D. RASHKIN, AUTHOR, ‘‘PRACTICAL 

GUIDE TO RESEARCH AND DEVELOPMENT TAX INCENTIVES: 

FEDERAL, STATE AND FOREIGN,’’ SARATOGA, CA 

Mr. RASHKIN. Good morning, Chairman Baucus, Ranking Member Hatch, and distinguished members of the committee. Thank 

you very much for inviting me to testify here today. 

The CHAIRMAN. You might want to pull your microphone closer, 

Mr. Rashkin, so we all can hear you better. 

Mr. RASHKIN. All right. 

The CHAIRMAN. Thanks. Much better. Thank you. 

8 

Mr. RASHKIN. Thank you very much for inviting me here to testify today. It is truly an honor to participate in this legislative process. 

My name is Michael Rashkin. I am the author of ‘‘The Practical 

Guide to Research and Development Tax Incentives.’’ I have been 

a tax lawyer practicing for almost 40 years. During that time, I 

have worked for companies that invented the minicomputer, the 

personal computer, and the plug computer. So I have seen the development of the information age from inside companies that 

helped create the technologies for the information age. 

The testimony I give here today is on my own behalf and not on 

behalf of any company or organization. 

The United States is a very innovative country. We have the 

greatest universities. We have the greatest high technology companies. We spend more money on research and development than 

anywhere else in the world, and we have Silicon Valley, which is 

the center of innovation in the entire world. 

And yet, we see things are going wrong. We see that jobs are 

leaving the United States. Capability, manufacturing capability, is 

leaving the United States, and even design capability is leaving the 

United States. 

So why is this happening? Well, there are a number of factors, 

of course. There are labor rate disparities. There is the high cost 

of medical care. There are deficiencies in our science and technology education system. 

But there is one factor that I believe we have not been giving 

enough attention to, and that is our tax system. Our tax system 

is part of a process which is working to cause the export of jobs 

and technology from this country. And, if we wanted to design a 

system to do that, we could not have done a better job. 

So let me explain to you how this process works. You can see on 

this chart—— 

The CHAIRMAN. I cannot see it. It is too small. Is it in your statement? 

Mr. RASHKIN. I can describe it, Senator. 

The CHAIRMAN. All right. 

Mr. RASHKIN. The first step in the process is that the government provides subsidies for basic research through the NSF and 

other government agencies, and we do a great job of that. 

We also provide subsidies for private companies to do product development research, and sometimes that product development research is based on the basic research that has already been subsidized by the government. 

Companies then take this technology that they have developed, 

and they park it in tax havens. This gives them the ability to earn 

profits on a tax-free basis outside the United States. 

They then receive foreign incentives from countries that would 

like to attract them. The result is, we have a manufacturing or an 

R&D facility in a foreign country, we have foreign jobs, foreign 

R&D, no U.S. jobs, no U.S. revenue. 

Is it any wonder that we have an employment and deficit problem? And this process creates a very long-term problem because, as 

it continues, it becomes irreversible. And it has become irreversible 

for many industries. 

9 

But this process has been caused by the tax code, and we could 

reverse this process by making changes to the tax code. And I am 

recommending three steps that we could take. 

The first one is to eliminate tax deferral for tax haven profits. 

By allowing companies to put their technology in a tax haven and 

operate tax-free outside the United States, we are basically giving 

U.S. companies an engraved invitation to set up foreign manufacturing and technology operations. Why should our tax system provide an artificial advantage for foreign operations as opposed to 

U.S. operations? 

Step two, we should increase the R&D credit to 30 percent, but 

make the credit applicable only to innovative research and breakthrough products. Currently, the R&D credit applies to ordinary research and development. Why should the U.S. Government be financing the ordinary day-to-day activities of U.S. corporations? We 

should increase the rate to 30 percent, make it applicable to innovative research, and make the U.S. a magnet for breakthrough 

technologies. 

Step three, we should provide, for companies that develop products in the United States and manufacture in the United States, 

a zero or low tax rate. If we do that, then, instead of companies 

looking for which country to put their products in, to manufacture 

their products in, they will be looking at which State to put the 

products in, and we would reinvigorate the manufacturing industry 

in the United States. 

So, if we do these steps, as you can see on the chart in my presentation, the result will be U.S. jobs and R&D instead of foreign 

jobs and R&D. 

Now, I would like to switch now to talking about the R&D credit. 

The R&D credit has been the primary tool for incentivizing industrial research. Unfortunately, I believe the R&D credit has not 

been effective. 

There is something called the one-to-one ratio, meaning you get 

$1 of increased R&D for each $1 of tax benefit. I think this is a 

very poor return. Who would have thought that we can set up an 

R&D credit, give a company $1, get $1 back, and assume that that 

is a success? I think that is a failure. 

So we have to do something that will multiply the benefit that 

we give companies. First of all, we should make the R&D credit applicable to small companies. The R&D credit at this point only applies to cash-rich large companies. Small companies do not have 

tax liability. They cannot utilize the R&D credit. 

We should make the credit refundable or transferrable. 

Two, the credit is much too complex. We must simplify the credit 

by eliminating incrementality, limiting the credit to wages of technical personnel, eliminating the loss of the section 174 deduction, 

and eliminating the separate basic research credit. 

We should also eliminate stock option compensation in the qualified research expenditure base. There is no reason for us to be subsidizing the exercise of employee stock options. 

The CHAIRMAN. I am going to have to ask you to summarize, Mr. 

Rashkin. 

Mr. RASHKIN. I will be happy to take your questions. 

10 

[The prepared statement of Mr. Rashkin appears in the appendix.] 

The CHAIRMAN. Thank you very, very much. That was very interesting. 

Ms. Nellen? 

STATEMENT OF ANNETTE NELLEN, PROFESSOR, DEPARTMENT OF ACCOUNTING AND FINANCE, COLLEGE OF BUSINESS, SAN JOSE STATE UNIVERSITY, SAN JOSE, CA 

Ms. NELLEN. Good morning, Chairman Baucus, Ranking Member 

Hatch, and members of the committee. My name is Annette Nellen. 

I am a tax professor at San Jose State University. I am both a CPA 

and an attorney. 

My testimony today is based on over 20 years of experience working with the tax law, particularly time devoted to understanding 

the tax treatment of R&D, software, intangibles, and the Internet, 

as well as tax policy and reform. 

Much of my writing, including blogging, is focused on promoting 

tax reforms that follow principles of good tax policy and reflect 

21st-century ways of living and doing business. 

Thank you for the opportunity to testify today. 

The topic of this hearing is a welcome one in that it carries with 

it at least two messages. First, our Federal tax system is in need 

of reform; second, a tax system should be designed to support the 

taxing jurisdictions’ economic, societal, and environmental goals. 

Innovation is a hallmark of our country and a key driver of economic growth, improvement in living standards, and a better environment. Innovation must be considered in tax reform at least to 

be sure the tax law does not hinder innovation, thereby harming 

economic growth. 

Tax reform should also consider whether there are economic reasons for the tax system to help support innovation. I believe such 

reasons exist. The question then becomes how. This is a complicated question involving various aspects of tax law, including depreciation, treatment of investment, AMT, international tax rules, 

and direct financial support in the form of tax credits. 

Innovation should also be considered in administration of the tax 

system. Too often, tax reform focuses only on the base and the 

rates rather than, also, on administering the tax system. 

Tax innovation brings to mind the research credit, but there are 

additional provisions relevant to innovation, such as the deduction 

for R&D under section 174 and the capital gains incentive for inventors under section 1235. 

There are also provisions that potentially hinder innovation. I 

will point out a few of these obstacle provisions and suggest some 

improvements. I will also note a few possible improvements of the 

research credit. My written testimony includes further details. 

First, any incentive offered as a tax credit will not help companies such as startups operating at a loss, or a business that owes 

AMT. Thus, any credit intended as an incentive or to provide financial support should be useable against AMT and refundable. 

Alternatively, for startups, a grant-type program, similar to that 

used for certain energy credits in the American Recovery and Reinvestment Act of 2009, should be considered. 

11 

Next, depreciation. Many Modified Accelerated Cost Recovery 

System lives, such as for computers, are too long. Also, R&D leads 

to new and better computers, cars, and equipment. If there are limitations on claiming depreciation for these items, such as a section 

280F limit on car depreciation, there will be a reluctance for businesses to purchase the innovative products. 

Improvements include a review of MACRS lives and repeal or 

cutback of the section 280F limitations, particularly for cars that 

use new technologies to achieve high mileage rates. 

Also, the section 179 expensing election should be brought into 

the 21st century by also applying it to the purchase of intangible 

assets. 

Next, consider targeted incentives to help provide funds to companies to engage in innovation, particularly small startup ventures. 

Section 1202 provides a benefit to individuals investing in qualified 

C corporations. Why not a similar benefit to encourage equity investment in partnerships and S corporations? 

Innovators with a great idea need funding beyond a maxing out 

of their credit cards. More individuals would be willing to fund 

emerging innovators if any possible bad debt could be treated as 

ordinary loss, such as has been allowed for certain equity investments under section 1244 for over 50 years. 

Tax-based approaches used in some States to incentivize angel 

investors or the innovators themselves should also be considered. 

Finally, I offer a few suggestions for improving the research tax 

credit so it can better reach its goal of supporting more R&D activities in the U.S. The research credit will expire for the 15th time 

at the end of this year. Research activities involve a long-term 

view. Thus, research incentives that focus on the short-term cannot 

be fully beneficial and effective. 

Short-lived incentives compare unfavorably to permanent incentives offered by other countries. Temporary incentives, even if likely to be renewed, cannot factor into the long-term research and financial planning decisions that companies must make. The shortterm perspective of the current credit diminishes the benefits our 

economy could otherwise achieve through a tax credit. The research 

credit should be made permanent. 

Next, the credit was created in the industrial era. It needs to be 

brought into the information age, such as by reconsidering the exception for internal use software, which is a key component of webbased products and services that did not even exist in 1981. 

Finally, as corporate tax reform discussion focuses on reducing 

the corporate tax rate, consideration should be given to the global 

competitive realities that, not only do other OECD countries have 

a lower statutory rate, they also tend to offer tax incentives for 

R&D. 

Thank you. I look forward to your questions. 

[The prepared statement of Ms. Nellen appears in the appendix.] 

The CHAIRMAN. Thank you, Ms. Nellen. 

Dr. Pilat? 

12 

STATEMENT OF DR. DIRK PILAT, HEAD, STRUCTURAL POLICY 

DIVISION, ORGANIZATION FOR ECONOMIC COOPERATION 

AND DEVELOPMENT DIRECTORATE FOR SCIENCE, TECHNOLOGY, AND INDUSTRY, PARIS, FRANCE 

Dr. PILAT. Chairman Baucus, Ranking Member Hatch. 

The CHAIRMAN. Could you bring the microphone a little closer, 

too? 

Dr. PILAT. I will. Thank you very much for inviting the OECD 

to testify here today. My name is Dirk Pilat. I am an economist 

working at the OECD, with over 15 years of experience in innovation policy. 

At the OECD, we collect the best possible data from countries on 

their investments in R&D, and we also analyze the factors and 

policies that drive innovation and growth. My testimony will, first, 

look at the use of R&D tax incentives across the globe and then examine some of the international evidence on their impact. 

R&D tax incentives are now widely used in OECD and nonOECD countries. Today, 26 out of the 34 OECD member countries 

offer such incentives to businesses. Among the non-OECD countries, Brazil, China, India, the Russian Federation, and South Africa also provide tax incentives for R&D. Germany is the only G7 

country that does not offer such incentives at the moment. 

The existing schemes differ significantly across countries in 

terms of their generosity, their design, and how they explicitly target different firms or specific areas. Most countries apply a system 

where an R&D tax credit is provided on the volume of R&D expenditure undertaken, while others, including the United States, 

target R&D incentives to the incremental R&D expenditure. 

Some countries target firms that conduct basic or collaborative 

research, and many provide more generous incentives for small and 

medium-size enterprises. Some countries also provide special incentives for small firms and young firms. Some of these differences are 

illustrated in more detail in our written testimony. 

Tax incentives for business R&D are typically part of a broader 

set of policies to support business investment in R&D, which also 

includes direct support, such as grants, or R&D procurement contracts. 

Estimates of the costs of most of these systems are shown in figure 1 of our written testimony. It illustrates that some OECD countries basically provide all their support for business R&D through 

direct systems, while others, like the United States, rely much 

more on direct support for business R&D. A third group of countries, like Canada and also Japan, relies mainly on R&D tax incentives. 

A general trend among many OECD countries has been to make 

their R&D tax incentives more generous. Another has been to increase the availability and simplicity of the use of these systems, 

with many countries moving towards volume-based credits. 

The evidence on the effectiveness of R&D tax incentives comes 

from a wide range of studies from countries that often are very different. What works in a small European country, obviously, may 

not work in the United States and vice versa. Nevertheless, we believe such studies may illustrate some of the possible impacts. 

13 

The available evidence shows that R&D tax incentives do increase business expenditure on R&D, with the effects typically 

being larger in the long run than in the short run. The evidence 

also suggests that smaller firms seem to be more responsive to the 

R&D tax incentive than larger firms, typically because these firms 

are much more credit-constrained. The evidence also suggests that 

the impact is affected by policy design, with estimates for incremental R&D tax credits typically being higher than those with 

volume-based R&D tax credits. 

The stability of the R&D tax incentive scheme over time also 

plays an important role. Expectations that R&D incentives are permanent strengthen their impact on R&D investment. 

Finally, let me come to the issue of R&D fiscal incentives and the 

location of innovative activities. In recent years, several governments have also started to use innovation policies to attract R&D 

activities of multinational firms. The evidence suggests that the decisions of multinational enterprises (MNEs) to conduct R&D in a 

certain country are certainly influenced by the availability of tax 

incentives. 

However, it also suggests that other factors are typically more 

important. These factors include access to local science and technology, proximity to university research and centers of excellence, 

availability of a skilled workforce, including engineers and scientists, and strong intellectual property rights. And, if the focus is 

on development, not on the research but mainly on development, 

access to a large market is particularly important, as well. 

Multinational firms typically first draw up a short list of preferred locations on the basis of such economic fundamentals and 

consider government support in the short list of locations only at 

a later stage when they have already looked at whether the economic fundamentals are correct. 

It is clear, of course, that when having two or more relatively 

similar locations, especially when such competition happens in a 

small region, government support and R&D tax incentives can tilt 

the investment decision of a firm in one way or the other. 

This concludes my testimony. Thank you, and I look forward to 

your questions. 

[The prepared statement of Dr. Pilat appears in the appendix.] 

The CHAIRMAN. Thank you, everybody, very much. Very interesting. 

A basic question that is arising here in the Congress is, what if 

we were to very significantly broaden the base and lower the rate, 

get rid of a lot of these so-called tax expenditures, including the 

R&D tax credit, and, in return, we had a very low rate? 

Your response? I know there are different industries. Some industries use the credit more than others. That may be worse than 

rough justice. 

But your thoughts about, generally, not increasing the tax credit, 

the R&D tax credit, not greater incentives, but going the other direction, eliminating many of the credits, deductions, exclusions that 

we have in the code. One might be the R&D tax credit. Let us assume, for the sake of discussion, that that is on the list. 

Let us just go the whole way. We have $1 trillion worth of tax 

expenditures in this country a year. I am not saying get at the 

14 

whole $1 trillion. We raise about $1 trillion in income tax a year. 

But let us say we—here’s the basic question: would companies tend 

to innovate, spend what they want to spend on research and innovation if the rate were a lot lower than it is today? That might also 

get to the haven question, because, obviously, a disparity of rates 

makes it more attractive for a U.S. company to look at another 

country, a haven country, and to locate some of its facilities there. 

I will just throw it open. If anybody has a strong view on that 

subject, raise your hand. Let us get at it. 

Mr. RASHKIN. Yes. First of all, I would say that I do not think 

the R&D credit is very effective. I do not think it actually increases 

any R&D or any innovation. Companies do R&D for strategic purposes. They have to make products to compete with other companies. And all the economic studies, the GAO report, for example, 

points out that there is a lot of wasted money that is paid to companies for research they would otherwise do. 

If we reduce the tax rate, it would have no effect on innovation, 

and it would also give us an opportunity to do other things, such 

as eliminate the tax-free nature of tax havens. 

In other words, if we made tax havens taxable, we expanded subpart F, but we had a lower rate, that would be acceptable to—I believe that would be acceptable to American industry, and it would 

cut out all the games we have to play by putting technology offshore, all these cost-sharing agreements and things of that nature, 

and companies would be looking to do business in the United 

States instead of overseas. 

The CHAIRMAN. Does anyone else have a thought on that question or maybe a response to Mr. Rashkin? 

Dr. Wallsten? 

Dr. WALLSTEN. So, first, to your question. My answer is probably 

unsatisfying, but—— 

The CHAIRMAN. I want to hear what you want to say. 

Dr. WALLSTEN. The answer is, it depends. 

The CHAIRMAN. I do not care whether I am satisfied or not. Just 

say what you think. 

Dr. WALLSTEN. The answer is, it depends. By simply lowering the 

taxes overall, it will change the relative returns of lots of different 

types of investments for the firm, and then they will sort of change. 

It will sort of reorder the marginal returns of each type of investment. 

Whether that means more innovation or less probably depends 

on what the net effect of the tax rate on investment in R&D is and, 

also, relative to how it affects their returns on other types of investments. 

So the answer is, I do not know, but it is probably a more complicated answer. 

But also, to respond just to Mr. Rashkin’s point, it is important 

to minimize the amount of infra-marginal subsidies, the extent to 

which we subsidize research that would have occurred anyway. 

But most studies do find that the tax credit is effective on the 

margin. And getting an extra $1 of R&D is actually quite a good 

outcome. I do not know how you would expect to get more than $1 

from $1. 

The CHAIRMAN. Ms. Nellen? 

15 

Ms. NELLEN. Yes. I think lowering the corporate tax rate would 

help R&D, because money that is not—— 

The CHAIRMAN. In return, we are going to also lower the credit. 

Ms. NELLEN. Yes. Because lowering the rate, less money going to 

tax—if you look at tech companies, they do not tend to pay much 

in dividends, so it is going to go back into R&D. So I think there 

is certainly a benefit there. 

The CHAIRMAN. Dr. Pilat, what do you think about it? I do not 

want to cut you off. I just do not have a lot of time here. 

Dr. PILAT. Perhaps two points. One is, I think that the U.S. is 

now the largest spender on business R&D because of the R&D tax 

credit, and I think that is something we need to recognize. That is 

one element in your policy mix. 

The second point is, I think that we always think that R&D is 

perhaps a little bit special, in a sense, that there are spillover effects to the rest of the economy, which is the reason why you might 

want to perhaps give a credit. 

The CHAIRMAN. I was stunned—perhaps ‘‘stunned’’ is too strong 

a word—when you said that Germany does not have a credit. Germany is doing pretty well. 

Dr. PILAT. And in fact, actually, a number of countries do not 

have them. Finland is another country which does not have a tax 

credit, Switzerland is another one, and Sweden. 

The CHAIRMAN. I assume those other countries give other benefits to their private sector. 

Dr. PILAT. Most of them—— 

The CHAIRMAN. Do or do not? 

Dr. PILAT. Most of them basically provide support to business 

R&D through direct support: grants, loans, procurement sometimes, and, of course, also, they support universities, research institutes, and so on. 

The CHAIRMAN. Senator Grassley, you are next. 

Senator GRASSLEY. I would like to ask you and also Senator 

Hatch—but Senator Hatch is not here—to pay attention to my first 

question, and to ask you if I could work with you on your bill to 

ensure that small businesses are not disadvantaged from some unnecessary restrictions that are in the tax code. 

The CHAIRMAN. I will speak for Senator Hatch and say he will 

work with you. 

Senator GRASSLEY. Well, thank you very much. And you too. 

The CHAIRMAN. Yes. 

Senator GRASSLEY. Thank you. 

And I say to the panel, before I ask the question, and I will start 

out with Ms. Nellen, but if anybody else—I do not have to have all 

your opinions. But if there is any light you can shed on this, I 

would appreciate it. 

Oftentimes, small businesses may not take advantage of the existing R&D credit just because they or their practitioners were not 

aware that they were eligible. 

When they do realize that, they often do not have resources to 

reconstruct the records needed to claim the original R&D credit. 

This leaves them with only being able to claim the alternative simplified credit. 

16 

However, the Treasury Department has taken the position that 

taxpayers cannot claim the alternative credit if they did not elect 

to do so on their original return. That means that they cannot 

amend it. 

So those businesses that do not have the resources to hire an 

army of tax lawyers and accountants essentially get no credit for 

their research activities. 

GAO, in a 2009 report, found these taxpayers are ‘‘materially disadvantaged by the election limitations and there appears to be no 

reason for this prohibition.’’ 

You may remember, Mr. Chairman, that this is something that, 

when Dean Zerbe was a staff person, he would keep bringing up 

to us. 

So I would like the panel’s thoughts, starting with Dr. Nellen, on 

whether or not the prohibition on claiming the alternative simplified credit on amended returns is appropriate and what public 

policy is served by the restriction, and do any other countries have 

such limitations? 

Ms. NELLEN. Thank you. I cannot talk about other countries, but 

that is an administrative burden that could be changed by saying, 

on the amended return, you could elect either one, because clearly, 

if you do not have the records going back to 1984 to 1988, you are 

going to be disadvantaged. 

Another thing that might help is, if there are companies that just 

are overlooking the credit for some reason, maybe on the return 

itself, there should just be a statement, ‘‘Do you engage in this type 

of activity?’’; bring it to their attention so they also have the opportunity to do that. 

But so far as the change, so far as what they would claim on an 

amended return, there seems to be no policy reason why it should 

be restricted to one or the other. 

Senator GRASSLEY. Do any of the others have a contribution to 

that? Go ahead. 

Dr. PILAT. Just two small points. First is, I think quite a number 

of countries have tried to simplify access to the tax credits. Canada, 

for instance, has recently undertaken a number of steps to make 

it easier for smaller companies to get access to the tax credit. 

Secondly, there are a couple of countries, including France, which 

have special credits for small firms and even for young firms, for 

startup firms, to make it easier for them to get access, because, as 

I mentioned earlier on, a lot of the small firms are more creditconstrained. So they often have more problems in sort of spending 

on R&D. 

Senator GRASSLEY. Anybody else? 

Mr. RASHKIN. I would say this is an incentive, and the public policy for it should be to allow companies to take the maximum incentive that they can obtain. And there does not seem to be any public 

policy to try to limit them by administrative means. 

Senator GRASSLEY. Over the past several months, on another 

issue, we have heard from various academics and executives on the 

need for tax reform. They have testified that certainty regarding 

tax rates and a switch to a territorial system of taxation are important for America’s businesses. 

17 

If such changes are made on a revenue-neutral basis, it would 

seem likely that you would have to broaden the tax base in exchange for the reforms. 

The written testimony from the OECD highlights the fact that 

research tax incentives are now widely used in OECD countries, 

and non-OECD countries. So it seems that we should retain some 

sort of research tax credit. However, it is fair to question the effectiveness and efficiency of existing credits. 

It is important to understand whether the credit is mainly being 

used by those who would be conducting research and developmental activities regardless of the credit. 

We heard, in November 2009, quoting GAO, ‘‘Large corporations 

have dominated the use of the research tax credit.’’ I will not go 

on with that quote. 

Data from the Joint Committee on Taxation supports the finding. 

So it seems that the credit is not being utilized much by small 

businesses that are the engines of our economy. Testimony from 

the OECD indicates that some countries are implementing targeted 

research tax incentives. 

So my question to Dr. Pilat and Professor Nellen is, what are the 

advantages and disadvantages to providing targeted research tax 

incentives, such as enhanced research credits for startups and 

small businesses, and can targeted incentives be structured without significant compliance or administrative costs? 

Dr. PILAT. I am not a tax expert, and I am definitely not an expert on the U.S. system. So in that sense, I can only talk from 

international experience. 

I would say that the advantage is clearly that small firms are 

important undertakers of R&D, particularly new firms. Startup 

firms play an important role. So to give incentives to these firms 

in one way or the other—and this can also be through other means, 

like the Small Business Innovation Research system, which the 

U.S. has—is probably important. 

The disadvantage, of course, is that it increases the complexity 

of the system. These small firms are more difficult to reach, to target, than larger firms. 

The international experience is typically that large firms are the 

main beneficiaries of R&D tax credits. 

Senator GRASSLEY. Professor Nellen? 

Ms. NELLEN. Thank you, Senator. For a startup company, if they 

are going to have losses, they are not going to have any tax liability. And then, even going into the future, when they first start generating some income, they will have net operating losses to carry 

back. So they are not necessarily in need of the credit, but they are 

in need of funds. 

So perhaps another approach that would get them this necessary 

funding—because I think you see companies of all sizes, just some 

individual with some great idea that they would like to pursue but 

is limited on where they are going to get funding. 

Some States do provide things through credits. Maybe the Federal Government could work with the States in providing even an 

additional amount. Perhaps even a thought about a grant for 

startups, because then they get the money sooner when they actuVerDate Nov 24 2008 17:53 Dec 05, 2012 Jkt 000000 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 R:\DOCS\76378.000 TIMD
18 

ally need it for their startup as opposed to waiting until they file 

a return and request a refundable credit. 

Senator GRASSLEY. Thank you, Mr. Chairman. 

The CHAIRMAN. Thank you, Senator. 

Senator Bingaman? 

Senator BINGAMAN. Thank you, Mr. Chairman. Thank you all for 

being here. 

One of the issues, sort of the broad issue, is whether it makes 

more sense for us to put tax dollars into direct support of this technology development or try to do it through this research and development credit. 

I have a statement here that someone wrote out for me that I 

think I would be interested in getting your reaction to. 

It says, ‘‘Economic analysis has shown that the Federal Govern- ment is able to stimulate about $1 of additional R&D expenditures 

for every $1 it spends on R&D through direct funding.’’ On the 

other hand, analysis shows that the R&D tax credit stimulates 

anywhere from $.20 to $.50 in additional private spending for every 

$1 of foregone revenue. 

Do you generally agree with that, that it is not nearly as effective for us to be trying to do this through the tax code? 

Dr. Wallsten? 

Dr. WALLSTEN. Actually, I disagree with that. I think direct government spending on R&D has big, important benefits, especially, 

as I said, with more basic research. And then, whenever government is funding something that would not have happened anyway—it will not stall defense R&D, for example—that is likely to 

have big spillovers too. 

The problem is, when government tries to directly fund research 

projects, especially those that are more applied or closer to being 

commercialized, the people who are making the funding decisions, 

they try to pick the projects that are most likely to be successful. 

And those projects that are most likely to be successful may also 

be the ones that the private sector is likely to fund, because that 

is exactly the criterion that the private sector uses. 

So, if government wants to look for these projects that would not 

be privately profitable, but would be socially beneficial, even if they 

are close to commercialization—but it is hard to develop a mechanism to do that. 

The grant managers who are making these awards, they do not 

want to fund lots of projects that fail, even though, if you are trying 

to fund particular projects, many of them will fail. 

What is the right number of failures? I have no idea. But, if 

every one of them is successful, it probably was not a successful 

government policy, because R&D is risky. 

But nobody wants to be the one to fund lots of projects that fail. 

Senator BINGAMAN. I think there was some mention of the SBIR 

program, Small Business Innovation Research program. Those are 

direct government grants to folks who want to do research, as I understand it, in small businesses, primarily, and my State has a lot 

of entrepreneurs who apply for and receive SBIR grants to pursue 

those. 

I guess the question is, is that a good way for us to be funding 

them—that is, direct funding, that is the way Germany is doing 

19 

it—or are we better off telling them—setting up some kind of refundable tax credit for anybody who wants to do anything? 

Dr. WALLSTEN. Well, if I might. Actually, I did a lot of work on 

the SBIR program, studying it. It was part of my dissertation, and 

then I published papers on it later on. 

What I found—and this is a long time ago now—was that SBIR 

funding tended to crowd out private funding dollar for dollar. It 

funded lots of projects that yielded commercializeable products, but 

that by itself does not mean that the government subsidy was necessary. 

You find lots of companies that seem to exist now solely for the 

purpose of getting SBIR grants. They get hundreds of them every 

year. They are called ‘‘SBIR mills.’’ And so, is this successful? I do 

not know. For those, it is probably not. 

On the other hand, it is a problem—for small businesses, it is a 

problem. As Dr. Pilat said, they tend to be more credit-constrained 

and, as Ms. Nellen and Mr. Rashkin both pointed out, if they do 

not have taxable earnings, they cannot benefit from the credit. 

So it is a tough problem because, on the one hand, you do not 

want to just fund things that would have happened otherwise. On 

the other hand, they do not seem to benefit much from the credit 

as it is constructed. 

Senator BINGAMAN. Mr. Rashkin, let me ask you one other question. Then you can answer either the question I asked or the previous one. 

You have some ideas for how we could make the R&D tax credit 

less complex, and I fear that most of your ideas are not incorporated in the new bill that Senator Baucus and Senator Hatch 

have proposed. 

You are suggesting we ought to eliminate incrementality. We 

ought to limit the credit to wages of technical personnel. We ought 

to eliminate the loss of the section 174 deduction. And we should 

make provision, I guess, by limiting the credit to the wages of technical personnel, to also automatically ensure that stock option compensation would not qualify, or maybe not. I guess that is a separate thing, because you could have technical personnel who are 

being compensated through stock options. 

But in your view, it makes sense for us to make those changes 

in anything we wind up enacting. 

Mr. RASHKIN. Yes, because, when the credit is complex, people 

really do not know what benefit they are going to get from the 

credit. And, if they do not know what benefit they are going to get 

from the credit, they just do not even consider it as an incentive. 

And I feel that is what has been happening for the past 31 years. 

For the past 31 years, we do not, at this point, have any idea of 

any products that have been developed because a company has received some kind of R&D incentive. 

Now, we know with direct grants—and that gets back to your 

other question—we know with direct grants, the money that has 

been given by the Defense Advanced Research Projects Agency, the 

National Science Foundation, we have many examples of breakthrough technologies that have created new industries. 

But with regard to the R&D credit, the fact of the matter is, companies are going to do R&D. They are going to do the R&D that 

20 

gives them the biggest return. If you give them an incentive, the 

R&D that is done is at the bottom of the barrel. You are not going 

to get the high quality R&D as a result of the R&D credit. You are 

going to get the least quality R&D as a result of the R&D credit. 

So I feel direct grants are more applicable. And I think, with regard to the SBIR grants, there is a study of the top 100 R&D innovations every year by R&D Magazine, and the companies that receive the SBIR grants are a very large percentage of those as compared to large companies receiving R&D credits. 

Senator BINGAMAN. Thank you, Mr. Chairman. 

The CHAIRMAN. Thank you, Senator. 

Senator Wyden? 

Senator WYDEN. Thank you, Mr. Chairman. First of all, Mr. 

Chairman, we have had a long series of hearings on tax reform, 

and I commend you for holding this one, because I think this is 

particularly important. And my own sense is that the tax code is 

driving money, certainly, the investment dollar to tax shelters rather than innovation. And getting at this issue the way you have is, 

I think, exactly what we have to be doing. 

The CHAIRMAN. Thank you. 

Senator WYDEN. I commend you for it. 

Let me ask you a question, Mr. Rashkin, if I could, about the 

chart you put together on page 2, because I think this is right at 

the heart of an important issue. 

People know generally that there are tax breaks for doing business overseas. You go to any supermarket, people will tell you, 

‘‘Hey, get rid of those tax breaks, that is outrageous.’’ And they associate them with manufacturing jobs and the like. 

But I think what you are laying out on page 2 is a new dimension that really has not been focused on, because I think what you 

are saying on page 2 is that tax breaks like deferral, where a business shuts down here, goes overseas, does not pay taxes to the 

American government until they bring the money back, that process is also hurtful to the cause of getting more research and development done in the United States. Is that correct? 

Mr. RASHKIN. That is correct. I have been involved as a consultant to companies who had absolutely no reason, no business reason, to set up R&D operations outside the United States, and they 

did it primarily to take advantage of the benefits that I have outlined in this chart. 

And so the U.S. is losing jobs, losing technology simply to allow 

companies to reduce their tax rate. 

Senator WYDEN. Because you have done a lot of work in high 

tech, and it has been an area I have been interested in over the 

years, could you give us a couple of examples just on the point you 

were talking about, where you saw technology that you watched in 

this space over the last couple of years take the R&D offshore? 

Mr. RASHKIN. Well, I could just say that this is a very generic 

tax structure, that, if you were a high-technology company and you 

went to a big 4 accounting firm or an international tax lawyer, 

what they would tell you is, what you should do is set up a tax 

haven company in the Caymans, Bermuda, or somewhere else, set 

up a cost-sharing agreement to put that technology in that country, 

21 

and basically, from then on, you are going to be able to earn taxfree profits on that technology for your foreign operations. 

And then, also, the way the tax law works with regard to transfer pricing, the more activities that you have offshore, the more 

profits you have offshore. So our tax law, the transfer pricing, the 

intangible taxation, the subpart F rules, they are all forcing manufacturers to go offshore to reduce their tax rates. 

Senator WYDEN. As far as I am concerned, Mr. Rashkin, the 

chairman can have you testify about twice a day, because it seems 

to me this transfer pricing is also at the heart of the upcoming debate. 

For example, I came to the conclusion a while back, apropos of 

the chairman’s point, that competitive rates solved a lot of problems. 

One of the problems with transfer pricing, which is not addressed 

in some of the ideas for territorial reform and the like, is you can 

generate the sale one place and you can book the profit somewhere 

else, so that we could actually have more transfer pricing under 

some of these territorial regimes. 

So you advocate—just so I have it correct—you would like to see 

the corporate rate in the vicinity of 25 percent, which kind of puts 

you right about where all the mainstream reform proposals are, the 

Bowles-Simpson proposal, almost all of them. Is that right? 

Mr. RASHKIN. That is correct. 

Senator WYDEN. And do any of you want to add any thoughts 

particularly on that last point with respect to the competitiveness 

of the corporate rate? It seems to me it is one of the encouraging 

things about the tax reform debate, that virtually all the reform 

proposals are coming in now about in the same ballpark. So I know 

several of you had comments on that, and my time is about out. 

Did you want to add anything on the corporate rate? 

Dr. PILAT. Perhaps not on the corporate rate. One comment from 

some of our work is that we do find that a lot of intellectual property is stored in places which you would not expect to be a place 

where a lot of R&D is taking place. So we do find that certain 

small islands are places where there is a lot of intellectual property. 

As I mentioned in my earlier statement, we do not find, unlike 

Mr. Rashkin, that companies go out and invest in R&D in different 

locations mainly because of R&D tax incentives. The main reason 

they go somewhere is because of the market. It is because they can 

find science and research there. They can find scientists and engineers there. These are some of the main factors which seem to 

drive international location of R&D. 

Senator WYDEN. Thank you, Mr. Chairman. 

The CHAIRMAN. Thank you, Senator. 

Senator Carper, you are next. 

Senator CARPER. Thanks, Mr. Chairman. 

To our witnesses, welcome. Good to see you all. Thanks for joining us and for sharing your thoughts. 

When considering any change to the tax code, I look at the issue 

really through a prism of four questions that I like to ask. And the 

first of those four questions is, will a proposal encourage economic 

22 

growth and provide what I describe as a nurturing environment for 

job creation? 

The second question is, will it be fiscally responsible and provide 

the certainty and the predictability that both families and businesses say that they need? 

The third question is really the golden rule kind of question: is 

the proposal fair, is it arguably fair? 

And the fourth is, does the proposal make the tax code more simple or more complicated? 

Those are the four questions I ask. The R&D credit affects or 

touches on just about all of these four questions. I agree that businesses need more certainty when it comes to making their research 

investments, and it makes sense to permanently extend the R&D 

credit. 

I also agree that the current credit is greatly in need of simplification, maybe modification. You all have given us a lot to chew 

on here today. 

I think a number of good proposals have been put forth to address these issues, including some that you all have mentioned. 

However, as this committee undertakes efforts to reform the tax 

code later this year, I also believe that it is critically important to 

enact proposals that strengthen productivity and the underpinnings of long-run economic growth. 

And with that having been said, I want to direct a question, if 

I could, to Mr. Rashkin. 

In your testimony, sir, you suggested that the 20-percent credit 

for R&D is, I think you said, inadequate and should be raised in 

order to increase the after-tax return to R&D investments by companies. 

I would like for you to make the case for a higher percentage. 

And then I would like the other witnesses on the panel to weigh 

in in response. 

Mr. RASHKIN. I believe, in order for an incentive to be effective, 

it really has to present a significant reduction in cost. The 20- 

percent rate also has an incrementality feature, and it also is subject to the 174 loss of deduction. And, when you take into account 

all these other restrictions and limitations, even though it is 20 

percent, probably the effective rate of benefit to the company might 

be somewhere between 5 and 10 percent. And I do not think 5 or 

10 percent is going to make much of a difference in a company 

making a decision to make a new product or not make a new product. 

Now, the 30 percent that I am recommending is 30 percent, a flat 

30 percent. We have no incrementality. We do not have any loss 

of 174 deduction. But we focus it only on innovative, breakthrough 

products. We should not be giving the R&D credit for people making new steering wheels or very ordinary things. 

And so, therefore, the overall fiscal cost would probably be lower, 

even though you are giving 30 percent as a higher rate. 

Senator CARPER. How do we make that judgment as to what 

qualifies? Some people are really big on steering wheels. 

Mr. RASHKIN. I realize that there is a problem with setting the 

line, but I think it is better to have that problem than it is to let 

everything qualify. And so I think, when I take a look, for example, 

23 

at the solar energy credit, where we have a 30-percent rate, and 

in the calculations I have been involved in, I feel that they are very 

compelling. 

When you get 30 percent, you really want to go out there and 

take advantage of that and put that solar panel on your company’s 

roof. 

Senator CARPER. Or your car’s roof. 

Mr. RASHKIN. Yes, even your car. So I think it has to be of that 

magnitude to really catch the attention of corporate decisionmaking. 

Senator CARPER. Thanks for that. Let me just go down the list— 

would you go first, sir, please? 

Dr. PILAT. Just two comments. One is that I think that the issue 

of refundability is definitely one issue which is important particularly for small firms that do not always have the income streams, 

basically. So you do need to think about that, I think, if you want 

to reach small firms. 

The second point I would like to make is, at the moment, compared to other OECD countries, the U.S. system is not very generous. But I think you have to look at this in a broader context. 

The U.S. does provide a lot of support for business R&D through 

direct support, and that has definitely certain advantages. So it is 

a question of balance. 

Senator CARPER. Thank you. Please? 

Ms. NELLEN. I think, in the context of us talking about lowering 

the corporate rate to increase the research credit rate, that might 

cause a problem with revenue neutrality, obviously. 

I think looking at why you want to incentivize the R&D, and 

part of it, to get back to an earlier question, is that it is also compensating for some reluctance to engage in really risky products 

that might really be very beneficial to our society, where there is 

an economic need for that. 

I would encourage looking at the section 280C cutback, because, 

if you are really trying to incentivize this, why then cut it back a 

little bit? I think that was probably done for revenue reasons, but 

I think lowering the corporate tax rate should be looked at. 

Also, I would encourage an incremental credit, because otherwise 

you are awarding research that would be done anyway. It perhaps 

does not make a lot of sense. 

Senator CARPER. Mr. Chairman, can I have one more comment? 

Please? 

Dr. WALLSTEN. Right. So you are asking, assuming the credit is 

good, what is the right level. And I think that is sort of an empirical question, and I do not know of any studies that look at what 

are the different effects of different tax rates, say, across countries. 

I think that would be a useful study and would help us know. I 

do not know that we are getting the biggest bang for the buck possible, even setting aside the question of incrementality, which is an 

important one as well. 

But I think it is an important question, and I do not think we 

have an answer to it yet. 

Senator CARPER. This is a good panel, Mr. Chairman. Thank you 

all very much for your observations. Thanks. 

24 

The CHAIRMAN. I just want to focus a little more on jobs. Do any 

of the four of you think the current credit helps to create jobs? And 

would it make a difference if it is increased a little bit? 

We have such high unemployment. If you add under-employed, 

it gets up there, 20 percent maybe. 

Ms. NELLEN. I think it does have certainly a big tie to jobs, because the bulk of what you are giving the credit for is actually for 

the wages being paid to those doing the research. And I think there 

is a harm to the economy of not having the permanent credit, because, when companies are thinking where they are going to engage in their R&D, they cannot factor our credit into long-term 

planning. Yet, in other countries that have a permanent incentive, 

that can be done. 

I think, also, the type of work that is being incentivized by the 

R&D credit, they are high-wage jobs, high-skill jobs, and I think 

that would be a big plus to have a permanent credit to help get 

the tech companies and others saying, ‘‘Yes, we are going to go 

back and engage in more R&D.’’ 

Mr. RASHKIN. I disagree on that. I disagree with the concept that 

the R&D credit creates jobs. You mentioned Dr. Tassey, and a 

quote from Dr. Tassey is, ‘‘As currently structured, the U.S. R&D 

credit probably has, at most, a minor and transitory effect on industry R&D spending.’’ And as I said, we do not have any evidence 

in 31 years of any products that have resulted from the R&D credit. 

Even the GAO report says, ‘‘In reality, it is impossible for policymakers to know how much research spending taxpayers would 

have done without the credit.’’ 

The CHAIRMAN. Let me ask a different question. We want to generally simplify the tax code. There are many who think that dramatic simplification—broadening the base, lowering the rates—will 

in and of itself result in greater economic efficiency and encourage 

companies, CEOs, to focus more on products, less on the tax code. 

Do you agree? And if so, generally, what simplification do you 

suggest? How far should we go, and to what degree should it include incentives like R&D? 

Dr. WALLSTEN. I do not think it is right to think of the R&D tax 

credit as part of jobs, at least in the short run. In the long run, 

I think it can be important, but, as Ms. Nellen said—I believe it 

was Ms. Nellen—most R&D expenditures are on wages, basically, 

compensation. 

And unemployment among people with doctorates and science 

and engineering degrees is really low. Unfortunately, the latest 

data is 2008. So I am sure it is higher than it was then, but it was 

1.7 percent, according to the National Science Foundation. 

And so, if you do not do something to increase the supply of those 

people, then increasing spending on R&D just leads to higher 

wages, which is great for them, and may even attract more people 

in the longer run. But it is not a short-term jobs program, although 

it is hugely important for economic growth. 

Other tax issues probably have much bigger effects on short-run 

employment. 

The CHAIRMAN. Dr. Pilat? 

25 

Dr. PILAT. Just one comment. I think the evidence in the United 

States shows that most of the jobs are being created in young firms 

and new firms and startups, and, of course, the R&D tax credit system does not reach these firms directly. I do agree with Dr. 

Wallsten that a lot of these impacts of the R&D system basically 

come in the long run, basically because it increases growth, and 

some of these job effects will flow through to the economy. 

The CHAIRMAN. That is an interesting point. I cannot forget the 

testimony of a CEO of a high-tech company in—it might have been 

Silicon Valley, I am not sure—but he made a passionate plea to increase the R&D tax credit, saying other countries give such big 

breaks, greater than does the United States. 

One of the countries was already mentioned by one of you, Canada. He mentioned Canada as one major competitor. Then he said, 

of course, in China, it is even worse, that is, the incentives the Chinese give to R&D are much greater. 

It just struck me that—it was a smaller company; it was not a 

big one. But if he is right, and he certainly thinks he is right, why 

do you not agree with him? 

Mr. RASHKIN. If you take a look at some of these countries that 

have very high R&D incentives, part of the reason is they have 

structural problems in doing R&D in those countries. For example, 

Canada does not generate a lot of Ph.Ds. It is hard for them to get 

companies—— 

The CHAIRMAN. Why is that? 

Mr. RASHKIN. Their educational system. There was a study of 

that done by their chamber of commerce or something that ranked 

them very low in the world in Ph.Ds. And you need those people 

to do advanced research. And you will find that the countries with 

the highest research incentives are the ones that have the most— 

the structural problem makes it difficult to do research there. 

And you were questioning, well, which countries do not have it. 

Sweden, for example, does not have an R&D incentive, and yet 

they are spending almost 6 percent of their GDP on R&D. 

A lot of the countries that—— 

The CHAIRMAN. What explains that? 

Mr. RASHKIN. Why is that? I think it is because they have a very 

good educational system, and they have good overall planning for 

R&D. I wish I knew all the answers to that one. 

But the point is, as you mentioned, Germany does not have it either, Switzerland does not have it. It is the countries that—I feel— 

the countries that feel that they have to overcome other problems, 

they are the ones that are creating high R&D incentives, and it is 

not necessarily the model that we have to follow: because they have 

it, we have to have it. 

And, if you look in Dr. Pilat’s presentation, you will see that, 

when you take a look at combined R&D incentives plus R&D 

grants, out of the 38 countries there, the United States is fifth. So 

we do a very good job of financing R&D between direct grants and 

R&D incentives. 

The CHAIRMAN. Senator Grassley? 

Senator GRASSLEY. I have just one question, Mr. Chairman, and 

this would be to Mr. Rashkin and Ms. Nellen. 

26 

You both suggested that the R&D credit should be refundable. 

Refundable credits, from our work on the Finance Committee, since 

they become grants administered by the Internal Revenue Service, 

seem to have a long history of fraud and abuse, is what we found 

out. 

So, could you speak to what other countries do and how we can 

prevent fraud and abuse if we decide to go to the refundable credit 

route? 

Ms. NELLEN. A few things I would suggest just looking at, perhaps for younger companies, for that to be the option of getting a 

refundable credit, since they do not have tax liability. For an older 

company, if they do have a bad year, they would perhaps have 

NOL they can carry back and get some funds there. So I think 

there would be some simplification of maybe only limiting the refundable part to startup companies, like in the first 5 years. 

And also, your point about the fact that the IRS ends up being 

the one to determine whether proper research was done, that really 

speaks to, I think, trying to keep the credit as simple as possible 

and not adding additional requirements, and I think that is a problem, for example, if you add that it has to be some breakthrough 

innovation. It would be very difficult for the IRS to audit that. 

The current definitions that are actually in the credit are fairly 

strict on that it has to be done in process of experimentation, and 

that already exists. So I think you do want to be careful that we 

are not putting too much burden on the IRS to make it unrealistic 

to engage in that. 

But the refundability should apply, I think, for just the startup 

companies. 

Senator GRASSLEY. Mr. Rashkin? 

Mr. RASHKIN. I would say if we were able to simplify the credit, 

for example, if we were able to limit the credit to technical wages, 

wages of engineers and other technical people, then we would 

eliminate a lot of the discussion of what qualifies and does not 

qualify, and also if we eliminate things like the incrementality. 

So we should be able to come up with a particular dollar amount 

that the small company is entitled to, and they should be able to 

apply for it and get a check. 

There are some States—we do have a number of States that do 

have this type of program, and I think what they do is, you have 

to submit a form prior to receiving the money from the government, and they have to approve it before you actually get the right 

to receive the money. 

So maybe there has to be a process like that, where the claim 

is validated before the check is sent out to the company. 

Senator GRASSLEY. Maybe I should not count out you other two. 

Do you have anything you want to add? 

Dr. PILAT. Just perhaps to stress the point just made by Mr. 

Rashkin. Actually, Norway does exactly the same thing, that you 

have to sort of have the credit preapproved before it is actually provided to a company. 

Senator GRASSLEY. Thank you, Mr. Chairman. 

The CHAIRMAN. Does anybody know in Sweden, Norway, Switzerland, the percentage of doctorates awarded, Ph.Ds in science or 

math, compared to the United States? 

27 

Dr. PILAT. I have the numbers here, but it would take me a second to look for it, if you would like. 

The CHAIRMAN. That is all right. We will look it up. We can look 

it up. Anything else that anybody wants to add? 

Ms. NELLEN. A comment on the Ph.Ds. Not all of the research 

is done by Ph.Ds. It is done by college graduates in engineering 

and other degrees, as well. 

The CHAIRMAN. That is true. Thanks very much. I appreciate you 

all. 

The hearing is adjourned. 

[Whereupon, at 11:46 a.m., the hearing was concluded.] 

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