TAX POLiCY TOWARD 

REGEARCii AND DEVELCPMENT 

George Carlson 

U.S. Treasury Department 

OTA Paper 45 January, 1981 

OTA papers are circulated so that the preliminary findings 

of tax research conducted by staff members and others 

associated with the Gffice of Tax Analysis may reach a wider 

audience. The views expressed are those of the zuthor, and 

do not reflect Treasury policy. Comments are invited, but 

UTA Papers should not be quoted withcjut permission Lrom the 

authors. Managing editors are liichael Kaufman anu Gary 

Robbins. 

Off ice oE Tax Analysis 

U.S. Treasury Gepartment, Room 1116 

Nashington, D.C. 20220 

Issuea: January, 1981 
TABLE OF CONTENTS 

Page 

ABSTRACT .................................................. 

I. INTRODUCTION............ ............................ 1 

IV. R&D AND '~RADE.....~.,.............,,,~.,,. ..........23 

V. TAXATION OF R&c.....................................~~ 

VI. CONSIDERATION OF ADDITIONAL R&D. ...................47 

TAX INCENTIVES 
ABSTRACT 

This paper assesses the need for research and 

development (R&D) tax incentives in light of the post-1960's 

decline in the U.S economic growth rate. Although tot.al 

U.S. R&D spending relative to gross national product (GNP) 

has fallen since the mid-1960'~~it still compares favorably 

with 'other industrial countries. Like the United States, 

other industrialized countries hhve also suffered from a 

growth slowdown. In the United States, perhaps 15 percent 

of the slowdown is related to reduced R&D spending. Many 

countries, including the united States, provide preferential 

taxation of R&D activity. A number of issues should be 

addressed in considering any additional R&D tax incentives 

for the United States. 
TAX POLICY TOWARD RESEARCH AND DEVELOPMENT* 

I, INTRODUCTION 

Government policy makers are understandably concerned 

over the decline in the u.S. economic growth rate. Suppressed growth aggravates inflationary pressures, retards 

increases in the standard of living, and makes the united 

States less competitive in world markets. While real product per unit of labor increased at an average annual rate 

of 3.5 percent between 1948 and 1966, it increased by only 

2.1 percent annually between 1966 and 1973, and fell further 

to 1.1 percent per year between 1973 and 1978, an overall 

drop of nearly 2.5 percentage points. -1/ Concurrently, 

research and development (R&D) spending peaked at nearly, 3.0 

percent of gross national product (GNP) in 1964 and then 

declined gradually until the late 1970's. Quite naturally, 

questions have arisen regarding the role which reduced 

levels of R&D spending has played in this growth slowdown 

-1/ John W. Kendrick "Productivity and Economic Growth," -The

AEI Economist, November 1980, p. 3. 

* I wish to to thank Emil Sunley and Harvey Galper for 

helpful coinnients and Carole Garland, Barbara Hall, and 

Elsa Vargas for their assistance in the preparation of 

the manuscript. 
-2-

and a variety of tax incentives hav.e been suggested to 

encourage technological innovation in general and R&D in 

particular. -1/ This paper assesses the need for such 

incentives. 

Section I1 reviews recent trends in R&D spending, both 

in the United States and in other industrialized nations. 

Although U.S. RbiD spending relative to GNP has fallen since 

the mid 1960's, it still compares favorably with other 

countries. More significantly, industry-supported R&D has 

actually risen since the mid-1960 s. 

Section I11 discusses the recent growth slowdown, both 

in the United States and other countries. It also reviews 

the available evidence on the impact of R&D on the U.S. 

economic growth rate. Although the U.S. growth rate fell 

sharply after 1966, reduced R&D spending is responsible for 

only about 15 percent of the overall decline. Weak capital 

formation is a more important source of the productivity 

.-

-

1/ For example, see Aerospace Industries Association of

America,-Research and Development, A Foundation for 

Innovation and Economic Growth, 19C0, Comnittee for 

Economic Development, Stimulating Technological

Progress, 1980, arid John I.1. Kendrick, "Productivity 

Trends and the Recent Slowdown: Historical Perspective,

Causal Factors, and Policy Options," Contemporary

Economic Problems, American Enterprise Institute, 1979, 

pp. 17-69. 
-3-

decline. The United States is not alone in the productivity 

slowdown; it is a problem widely shared by other countries. 

In fact, some countries have experienced larger declines in 

their growth rates than has the united States. 

Section IV discusses the impact of R&D on international 

competitiveness. R&D spending appears to be positively 

related to export performance in the United States. Since 

1960, the United States, for example, has had a trade 

surplus in RCD-intensive manufactured products and a trade 

deficit in non-R&D-intensive products. The surplus, 

however, increased sharply between 1964 and 1975, the period 

in which R&C spending relative to GNP declined. Although 

Some of the R&D-intensive industries also export their 

technology, this does not appear to have adversely affected 

the competitive position of those industries. 

Many countries provide preferential taxation of R&D 

expenditures. Section V describes the R&D incentive 

provisions in the United States and four foreign countries, 

Belgium, Canada, France, and West Germany. Section VI 

concludes the paper with a discussion of the issues that 

should be addressed in considering any additional R&D tax 

incentives for the United States. 
-4-

11. TRENDS IN R&D SPENDING 

Total U.S. R&D spending, from both public and private 

sources, will reach $60 billion in 1980. 1/ As shown by -

Table 1, private R&D spending has increased relative to 

Federal government expenditures in the last fifteen years, 

with each now providing about one-half of total R&D funds. 

Although universities, colleges, and other nonprofit 

organizations perform significant amounts of R&D activity, 

they are only minimal sources of R&D funding. 2/

-

C)n a historical basis, total U.S. R&D expenditures have 

increased steadily over the past 25 years, but much of this 

reflects the impact of inflation. Table 1 also shows that 

real or price-adjusted R&D expenditures remained roughly 

constant from the mid-1960's to the mid-l970's, but have 

recently resumed their climb and will reach a new high of 

about $35 billion in 1980 (in 1972 dollars). 

-1/ National Science Foundation, "Highlights," May 23, 1980, 

p. 2. 

-2/ According to the National Science Foundation, universities and other nonprofits performed 17 percent of total 

R&D activity in 1980, but provided only 4 percent of 

total funding. 
.. .. .. 

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-6-

The United States spends more on RbiD than any other 

country in the world, and more than France, West Germany, 

Japan, and the United Kingdom combined. -

1/ This is not 

surprising because the United States also has the world's 

largest output of goods and services. -2/ To adjust for the 

absolute size of a country's economy, Tables 2 and 3 relate 

h&D expenditures to GhP for the United States and some of 

its major trading partners. This JnethOd of Comparison is 

popular, although E. F. Denisorl questions its rationale. 

Just because the size of the economy is, say, 

twice as big, does it take twice as much R&D to 

obtain the same annual productivity gain? Doubtless it would take twice as much R&D if an economy 

Goubled its size by producing twice as many products, each with a unique technology, and nu more 

of any one product. But why should more R&D bc. 

needed if growth occurs by expanding the average 

output of products rather than their number? An 

invention that cuts one percent from the production 

cost of 5 million automobiles should do as much for 

10 million. 3 /

-

-1/ National Science Foundation, Science Indicators 1478, 

p. 6. 

-2/ U.S. Department of Commerce, Bureau of the Census, 

Statistical Abstract of the United. States 1979, 

hashington, p. 895. 

-3/ Edwaru F. Genison, "Explanations of Declining

Productivity Growth ,I1 Survey of Current Business , August 

1979, p. 6. 
-7-

Accoririny to Table 2, R&D spending in the United States 

reached a peak of nearly 3.0 percent of GNP in 1964, 

declined steadily until the lhte 1970's when it reached a 

low of 2.26 percent, and has recently recovered. Table 2 

also shows that the post-1964 decline in R&D spending is 

attributable solely to reduced Federal spending for defense 

and space related for R&D. During this period, industry R&D 

fundi'ng increased relative to GNP ana Federal nondefense R&D 

spending remained constant. 

Although U.S. spending for R&D relative to GNP has 

declined since the mid-1960'~~it still compares favorably 

with other industrialized countries. As shown by Table 3, 

total R&D expenditures relative to GNP are &bout equal in 

the United States and West Germany. ~xpendituresare lower 

in the United Kingdom, Jhpan, France, and Canada. Between 

the mid-1960's and mid-1970'~~R&D expenditures increased in 

West Germany and Japhn arid decreased in France and the 

United Kingdom, 8s well as the United States. But since the 

mid-1970's R&D expenditures in each of these countries has 

been a relatively constant fraction of GNP. The increases 

in West Germany and Japan have leveled off and the declines 

in Frmce, the United Kingdom, and the United States have 

abated. 
-8-

Table 2 

United States Research ad Developnent Expenditures by 

Source of Funds hs a Percent of GNP, 1953-1980 

Year : Total : Total 

1953 1.40 0.75 

1954 1.54 0.86 

1955 1.55 0.88 

1956 1.99 1.15 

1557 2.20 1.38 

1958 2.39 1.51 

1959 2.54 1.65 

1960 2.67 1.73 

1961 2.74 1.77 

1962 2.73 1.76 

1963 2.87 1.88 

1964 2.97 1.97 

1965 2.91 1.89 

1966 2.90 1.86 

1967 2.91 1.81 

1968 2.83 1.72 

1969 2.74 1.59 

1970 2.64 1.49 

1.971 2.50 1.40 

1972 2.43 1.35 

1973 2.34 1.25 

1974 2.32 1.15 

1975 2.30 1.19 

1976 2.28 1.15 

1977 2.26 1.15 

1978 2.27 1.13 

15179 2.29 1.13 

1980 2.34 1.14 

Percent of GNP 

Feder &l 

:Defense 1/: Nondefense 

0.68 0.07 

0.77 0.09 

0.76 0.12 

0.99 0.16 

1.20 0.18 

1.29 0.22 

1.45 0.20 

1.46 0.27 

1.52 0.25 

1.51 0.25 

1.57 0.31 

1.67 0.30 

1.57 0.32 

1.48 0.38 

1.43 0.38 

1.33 0.39 

1.23 0.36 

1.12 0.37 

1.02 0.38 

0.99 0.36 

0.90 0.35 

0.82 0.37 

0.80 0.39 

0.77 0.38 

0.76 0.39 

0.75 0.31 

0.75 0.38 

n.a. n.a. 

: Industry 

0.61 

0.64 

0.63 

0.79 

0.78 

0.83 

0.84 

0.89 

0.91 

0.91 

0.92 

0.93 

0.95 

0.97 

1.02 

1.04 

1.07 

1.06 

1.02 

1.00 

1.02 

1.05 

1.03 

1.05 

1.04 

1.05 

1.08 

1.11 

: Universities 

: and other 

: nonprofits 

0.04 

0.04 

0.03 

0.05 

0.04 

0.05 

0.05 

0.05 

0.06 

O.O� 

0.07 

C.07 

0.07 

0.07 

0.07 

0.07 

0.08 

0.09 

0.08 

0.08 

0.07 

0.00 

0.08 

0.08 

0.07 

0.09 

0.08 

0.09 

Office of the Secretxy of the Treasury 

Office of Ta Analysis 

January 6, 1981 

-1/ Includes spending fcr defense ad space purposes. 

Source: National Science Foundation, National Patterns of R&D 

Resources, 1953-1977 and 1953-1978-79, Science Indicators 

1978, and "Science Highlights ," Flay 23 , 1980. 

-10-

The relative position of the United States with respect 

to civilian R&C expenditures, defined as total R&D expenditures less government funds for defense and space R&D, is 

less favorable. According to Table 3, civilian R&D expenditures in the united States relative tu GNP are equal to 

those in the United Kingdom, higher than in France, but 

lower than those in west Germany anu Japan. 

One explanation is that hest Germany and Japan have 

modest defense budgets; most of the R&D expenditures in 

these countries are for civilian purposes. A recent 

National Science Foundation publication observes that "the 

concentration of R&D in civilian areas may have assisted the 

Japanese and the West Germans to increase productivity rates 

and be more competitive in worid trade," -1/ Still, defense 

arid space related R&D may have spinoff effects that improve 

productivity and the quality of output in the civilian 

economy. Moreover, recent international developments stress 

the need for the United States to make more, rather than 

less, defense related R&D. 

-1/ National Science Foundation, Science Indicators 1978, 

p. 9. 
-11-

111, IMPACT OF R&D ON ECONOMIC GROWTH 

Since the mid-l960's, the United States has suffered 

from a depressed growth rate. The average annual increase 

in real product per unit of labor, for example, declined 

from 3.5 percent in the 1948-1966 period, to 2.1 percent 

between 1966 and 1973, and 1.1 percent between 1973 and 

1978. -l/ Since R&D spending as a proportion of GNP reached 

its peak in 1964, attention has understandably focused on 

the possible role of reduced R&D spending in the growth 

slowdown. R&D, of course, is only one of many ingredients 

of economic growth. 

Output may be increased by using more resources, such as 

capital or labor, or by increasing the efficiency or productivity of existing resources. Growth or productivity 

analysis frequently concentrates on labor productivity or 

output per unit of labor. But these msasures do not necessarily reflect changes in the efficiency of labor. Labor 

productivity may increase for a variety of reasons: an 

increase in the amount of capital per worker, an improvement 

in the quality or education of labor, or a more efficient 

-1/ Kendrick, "Productivity and Economic Growth," ­op. G., 

p. 3. 
-1.2-

combination of labor with capital and other resources. 

Thus, "increases in output per hour may best be viewed as 

reflecting the saving of labor per unit of output as the 

result of the joint effect of all inputs and the way they 

are combined." I./ -

E. F. Denison's lkndmark studies on the sources of 

productivity growth illuminate the reasons for the productivity decline and the possible role of R&D. Denison finds 

that the growth rate in national income per person employed 

in the nonresidential business sector declined from 2.7 

percent per year in the 1948 to 1969 period, to 2.1 percent 

annually between 1969 and 1973, and to -0.6 percent per year 

between 1973 and 1976. -2/ Thus, between the 1948-1969 and 

1973-1976 periods, productivity growth actually fell by 3.3 

percent per year. Denison has divided this productivity 

decline into two periods, 1969-1973 and 1.973-1976. 

-1/ Steven P. Zell, "Productivity in the U.S. Economy: 

Trends and Implications ,I1 Economic Review, Federal 

Reserve Bank of Kzlnsas City, November 1979, p. 13. 

-2/ Ibid., F. 19. 
-1.3-

In the earlier period, the sources of the productivity 

decline are about evenly divided between factors affecting 

input quantity or quality, such as hours worked, education, 

and capital per worker and factors affecting output per Unit 

. of input, such as improved allocation of resources, 

economies of scale, and a residual described as "advances in 

knowledge and not elsewhere classified." In contrast, in 

the 1.973-1976 period, all of the productivity decline of 2.7 

Percent per year is attributable to 

per unit of input. The "advances in 

elsewhere classified" factor ucourits 

points of the 2.7 percent decline in 

Denison's "Edvances in knowledge 

factors affecting output 

knowledge and not 

for 2.3 percentage 

measure output. -1/ 

and not elsewhere 

classified" category has two components. 

The contribution of advances in knowledge is, conceptually, a comprehensive measure of the gains in 

measured output that result from the incorporation 

into production of new knowledge of any typemanagerial and organizational as well as technological-regardless of the source of that knowledge,

the way it is transmitted to those who can make use 

of it, or the way it is incorporated into 

production. -2/ 

-2/ Denison, 9.cit., pp. 3-4. 
-1.4-

The "not elsewhere classified" component refers to a number 

of miscellaneous determinants which are not separately 

specified, but whose effects are "believed small." -1/ 

Although the contribution of advances in knowledge to 

the growth in output declined dramatically between the 1.9�9-

1973 iind 1973-1976 periods, Denison doubts that reduced F3D 

spending was much of a fzctor. Chsed on an earlier 

estimate, he concludes that only one-sixth of the total 

contribution of advances in knowledge is related to RhD 

spending. -2/ If correct, this estimate would assign less 

than 0.40 percentage points of the 2.7 percent per year 

decline in output growth to R&D, i.e., about 15 percent of 

the total decline. Denison also refers to Z. Griliches' 

estimate that the maximum contribution of R&D to the growth 

rate as of 1966 was 0.3 percentage points. Noting the 

approxim&tely one-fourth drop in total R&D expenditures as a 

percent of GNP between 1964 and 1976, Denison observes that 

"if the 0.3 percentage ~ointcontribution of R&D to the 

growth rste of output were reduced 

-1/ Ibid., p. 4. 

-2/ Edward F. Denison, The Sources of Economic Growth in the 

United States, Committee for Economic Development, 1962, 

p. 245. 
-- 

-15-

proportionately, it would decline by less than 0.1 percentage points." -1/ But, he cautions, since industry-supported 

R&D did not decline at all, "there is no assurance that R&D 

spending contributed anything to the decline in productivity 

growth." 2/ 

In contrast to Denison and Griliches, J. W. Kendrick, 

using' a modified version of Denison's growth accounting 

framework, estimates a much higher contribution of R&D to 

productivity growth. But because the decline in the R&Drelated source of growth is less drastic than in Denison's 

analysis, his estimate of the role of R&D in the productivity slowdown is similar to Denison's. According to 

Kendrick, R&D contributed 0.9 percentage points annually to 

the growth rate between 1948 and 1966, 0.7 percentage points 

between 1966 and 1973, and 0.6 percentage points between 

1973 and 1978. -3/ Thus, R&D was responsible for 0.3 

percentage points of the 2.4 percent annual decline in the 

growth rate of real product per unit of labor estimated by 

-1/ Denison, "Explanation of Declining Productivity Growth,''

9.G.,p. 6.

-2/ Ibid. 

-3/ Kendrick, "Productivity Trends and the Recent Slowdown,"

op* tit., p. 33. 
-1 6 -

Kendrick between 1948-1966 and 1973-1 978. This is 12.5 

percent of the total decline and similar to Denison's 

estimste of 15 percent. 

Other investigstors hiive stressed the importance of 

reduced investment spending in explaining the growth slowdown since the mid-1960's. Citing the decline in the growth 

rate .of the capital stock and the increase in the growth 

rate in labor hours, M. D. McCarthy concludes thzt "the 

slowdown in productivity growth, in the 1970's in 

Farticular, cm be traced to a very slow growth in the 

capital/labor ratio in the years 1970-1975." -1/ Along with 

reduced R&D spending, S. P. Zell believes that the decline 

in the capital/labor ratio is an important cause of the 

"Epparent slowdown" in the rate of technological progress in 

the United States. -2/ Likewise, J. A. Tatom concludes that 

"the relatively slow pace of capital formation, including 

resedrch and development capital, has quietly played an 

important. role in productivity's decline. -3/ 

-1/ Michael D. McCarthy, "The U.S. Productivity Growth 

Recession: History and Prospects for the Future," -The 

Journal of Finance, June 1978, p. 977. 

2/ Zell, -op. G.,p . 20. -

-3/ John A. Tatom, "Tk1e Productivity Problem," Review, 

Federal Reserve Bank of St. Louis, September, 

p. 15. 
-1 7-

Like others, J. R. Norsworthy, M. J. Harper, and K. 

Kunze have divided the productivity slowdown into two 

periods: 1965-1973 and 1973-1578, with 1948-1965 as the base 

period. Their method of analysis measures the effect of 

changes in capital, lzibor, and a residual described as 

"other fhctors." They find that the "other factors" 

category is important in exFlaining the earlier slowdown, 

but that reduced capital formstion explains most of the more 

recent slowdown, 

One conclusion is immediate--two slowdowns occurred 

with two different patterns of contributing causes: 

the 1965-1973 slowdown is largely unexplained by 

factors quantified in this analysis, the 1973-1978 

slowdown is largely accounted for by the relative 

weakness in capital formation. -1/ 

One of the reasons advanced for the weakness of capital , 

formation in the 1973-1978 period is that, compared to the 

ekrlier period, the price of capits1 services increased by 

nearly four times whereas the price of labor increased by 

only one-third. -2/ 

-I/ J. R. Norsworthy, Michael J. Harper, and Kent Kunze, 

"The Slowdown in Productivity Growth: Analysis of Some 

Contributing Factors," Erookings Papers on Ecoriomic 

Activity, 2: 1979, p. 415. 

-

2/ Ibid., p. 420.
-1 8-

Since the effect of R&D is one of the elements in the 

"other factors" category, the authors concede it may have 

been partially responsible for the productivity slowZown in 

the earlier period. "Although R&D expenditures slowed 

during this period and may well have contributed to the 

productivity slowdown , we devised no satisfactory means to 

take this factor into account." 1/

-

Even Kendrick, who reports relatively high estimates of 

the impact of R&D or1 productivity growth, also stresses the 

importance of chpital formation. 

Policies to promote tagible investment ... woul6 

obviously accelerate the growth of real product per

unit of 1;bor input .... In addition, the ucceleration in tangible capital formation would have a 

positive effect on R&D spending and other tangible 

investments that are part and parcel of the 

inventive-innovative process. 2/

-

The productivity slowdown is riot confined to the United 

States. klthcuyh the United States has ij relatively high 

level of productivity, it has a relatively low level of 

productivity change, but compares favorably with other 

-

1/ Ibid., p. 421.

-2/ Kendrick, "Productivity Trends snd the Recent Slowdown ," -op. &., p. 51. 
-19-

. 

industrialized countries in the degree to which productivity 

has decelerated, Tables 4 and 5 highlight the elements of 

the inter nat i onal product ivi t y compar i son. 

Table 4 compares the productivity level, or real gross 

domestic product per employed civilian, for the United 

States and five other major industrialized nations. As of 

1977, the United States has the highest productivity level 

for the countries under comparison, although each of the 

five countries improved its position relcitive to the United 

States since 1960. Japan, for example, has a very high 

productivity growth rate, but its productivity level is less 

thzn two-thirds that of the United States. 

The Zeterior&tion in the relative position of the United 

States is shown by Table 5 which compares annual growth 

rates in real gross domestic product Fer employed civilian 

for the same countries, plus Italy. For the period 1960-

1973 the United States has the smallest growth rate and for 

the 1973-1977 period only Italy has a smaller growth rate. 

But the United Stetes compares reasonebly well with respect 

to how much productivity has fallen between the two periods. 

According to column 3 of Table 5, only West Germany 

experienced a significantly smaller productivity slowdown. 

c 
-20-

Table 4 

Real Gross Dcenestic Product Per mployed Civilian, for 

Selected Countries Compxed with the United States: 1960-77 -1/ 

[Index, United States = 1003 

: United : : West : : United 

Year : States : Canada : France : Germany : Japan : Kingdom 

1960 100 86.6 55.4 52.4 24.7 51.1 

1961 100 85.8 57.0 53.1 25.2 49.8 

1962 100 85.6 58.0 53.1 27.6 47.9 

1963 100 86.2 59.0 53.2 29.6 48.5 

1964 100 86.0 60.0 55.2 32.1 49.1 

1965 100 85.6 60.8 56.2 32.2 48.2 

1966 100 83.5 61.2 58.1 33.4 47.4 

1967 100 83.4 63.4 57.3 36.8 49.0 

1968 ' 100 84.6 64.2 59.5 40.0 49.7 

1969 100 86.2 67.6 63.2 43.9 50.4 

1970 100 88.6 71.4 67.0 48.7 52.6 

1371 100 90.6 72.9 67.5 50.8 53.9 

1972 100 90.7 74.8 68.5 53.5 53.6 

1573 100 90.8 76.4 70.2 56.5 54.8 

1974 100 93.0 80.0 74.3 58.0 56.0 

1975 100 91.9 81 .2 74.7 59.5 55.4 

1976 100 92.2 83.1 77.7 60.8 55.6 

1977 (prel.) 100 91.6 84.7 75.1 62.2 55.1 

Office of the Secretary of the Treasury January 6, mi 

Office of Tax Anblksis 

-1/ Output bhsed on internhtionA price weights to enable comparable 

cross-country comparisons. 

Source: National Science Foundation, Science Indicators 1978, p. 1.57. 
-21-

Annual Growth Rates in Real Gross Domestic Product Per Employed 

Civilian, for Selected Countries, 1960-1973 arid 1973-1977 

Growth Rates 

(1) (2) Country : 1960-73 : 1973-77 

United States 

Canada 

France 

West Germany 

Italy 

Japan 

United Kingdom 

2.1 0.3 

2.4 0.5 

4.6 2.9 

4.4 3.3 

5.6 -0.2 

8.6 2.7 

2.6 0.4 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

(Percent) 

(3) 

: Change (2-1) 

-1.8 

-1.9 

-1.7 

-1.1 

-6.0 

-6.1 

-2.2 

January 6, 1981 

Source: Edward F. Denison, "Explanations of Declining Productivity 

Growth," Survey of Current Business, August 1979, 

Part 2, p. 20. 
-22-

Thus, although other countries continue to gain on the 

United States in the productivity race, they are gaining 

somewhat less quickly. 
-23-

IV. F&D AND TRADE 

Considerable evidence exists that U.S. R&D spending 

improves the country's competitive position in world 

markets. For the United States, D. B. Keesing, for example, 

compared the percent of an industry's work force involved in 

H&D activity with that industry's exports as a shsre of 

world, exports. Keesing finds a linear correlation coefficient of .88 for the 18 manufclcturing industries studied; 

that is, 88 percent of the variation in export shares is 

"explained by" variations in R&D activity. -11 Keesing also 

allows for the influence of other fzictors on U.S. trade 

performance, but concludes that 

there turns out to be a powerful correlzition 

between the intensity of R&D activity in American 

industries and their export performance. The 

association is probably heightened by a tendency 

for industries that conduct intensive R&D activity 

to exhibit at the same time economies of scale 2nd 

high requirements for skills in production.

Capital rtquiremonts, however, &re inversely 

associated with R&D. -2/ 

-1/ Donald b. Keesing, "The Impact of ReseLrch 2nd 

Development on United States Trade ,I1 Journel of 

Political Economy, February 1967, F. 39. 

-2/ Ibid., p. 45. 
-24-

Similarly, W. Gruber, D. Mehta, and R. Vernon's crossindustry study of research effort and export performance 

finds "L strong export position for research-oriented 

industries and a weak export position for industries without 

large research inputs." -1/ 

A review of the trade balance performance of R&Dintensive and non-R&D-intensive product groups also indicates the importance of R&D to international competitiveness. Although the U.S. merchandise trade balance his a 

large deficit ($30 billion in 1979), R&D-intensive 

mcnufactured goods have s substantial trade surplus. 

According to Table 6, the United States has had a trade 

surplus in R&D-intensive maufactured products since 3960 

and a trade deficit in non-R&D-intensive products. R&Dintensive industries &re defined as: (1) h&ving at lesst 

2.5 percent of their work force employed ss scientists or 

engineers engaged in R&D and (2) making R&D expenditures 

-1/ William Grubtlr, Dileep Mehta, arid Raymond Vernon, "The 

R&D Factor in International Trade and International 

Investment of United States Industries," Journal of 

Political Economy, February 1967, p. 23. 
4443-4 

mmmmmm 

wwwwww 

04"Vln
-26-

equal to at least 3.5 percent of net sales. -1/ On this 

basis, only 5 groups of manufactured products qualify as 

R&D-intensive: aircraft snd phrts, chemicals, electrical 

machinery, nonelectrical machinery, and professional and 

scientific instruments. 2/ All other menufhctured proc'ucts -

are classified as non-R&D-interisive. 

While U.E. R&D spending relative to GNP peaked in the 

mid-l960's, the U.S trade surplus in R&D-intensive products 

increased sharply between 1964 and 1975, nearly tripling 

between 1972 and 1975. The surplus has fallen slightly 

since lS'75, coinciding hith a substantiF.1 increase iii the 

trade deficit in non-R&D-intensive goods. The total tra2e 

surplus in manufuctured products, both E&D-intensive and 

non-R&D-intensive, fell from a peak of nearly $20 billion in 

1975 to about $3 billion in 1977. 

In recent years, nesrly 90 percent of the trade surplus 

in K&D-intensive prociucts has been generated bq- three product groups: ncnelectrical machinery, (including 

-1/ Nsttional Science Fouildation Science Indicators 1978 

&. 30. 
-27-

computers), chemicals, and aircraft, -1/ There is some 

evidence that these industries also are active in the export 

of technology. U.S. direct investment abrozd, for exiimple, 

will reach nearly $200 billion in 1980. -2/ The largest 

portion of this investment is in manufacturing, with 

machinery (electrical and nonelectrical) and chemicals being 

the most important industries. -

3/ Net receipts (receipts 

minus payments) of U.S. companies of royalties and fees from 

foreign affiliates will epproach $3 billion in 1980, i/ 

Again, manufacturing activity generates the largest portion 

of these receipts, with m6chinery and chemicals being the 

most important individual industries. -5/ Machinery and 

transportation equipment, along with chemicals, also are the 

leading industries in the volume of R&D performed abroad by 

foreign affiliates of U.S. firms. -6/ 

-

1/ Ibid., p. 162.

-2/ Obie G. Whicard, "U.S. Direct Investment Abrohd in 

1979 ,I1 Survey of Current Business, August 1980, 

pp. 16-36 and author's estimate for 1980. 

3/ Ibid., p. 27. -

-4/ Ibid., p. 23 and author's estimhte for 1980. 

-5/ Ibid., p. 23, 33-36. 

-6/ Sumiye Okubo, "The Impact of Technology Transfer on the 

Competitiveness of U.S. Producers," paper presented to 

Trade Policy Staff Committee, July 18, 1980, p. 15. 
-28-

Although the machinery and chemical industries are 

important exporters of technology, S. Okubo doubts that the 

trade competitiveness of these industries has been adversely 

affected. Foreign direct investment, she notes, may have 

encouraged exports. "In general, American exports tend to 

be enhanced by foreign direct investment, but possibly up to 

some threshold level after which exports are no longer 

complementary and the relation between exports and foreign 

investment appears to be haphazard." -1/ 

-1/ Ibid., p. 39. 
-29-

V. TAXATION OF R&D 

Business firms undertake R&D activity in order to 

enhance their future profits. Successful R&D projects 

produce "properties" that frequently generate income over a 

number of years. In this respect, R&D is like other types 

of business investment; the expense is associated with a 

future stream of income, The intangible properties produced 

by R&D may be cost-saving processes, innovative marketing 

techniques, product variations, previously unexploited 

scientific principles, or patents. Aside from the form of 

the income-earning property that is acquired, R&D 

expenditures are conceptu3,lly like other kinds of business 

investment. Net income from the use of either an idea or a 

machine is measured by the annual difference between the 

additional gross income stream that results and the 

depreciation of the property due to deterioration and 

obsolescence. 

An income tax system that favored neither H&D nor 

tangible investment would require the capitalization of all 

expenses. In the case of R&D, this would require that 

wages, materiEls, and depreciation of equipment and 

structures zllocable to R&D would be charged to capital 
-30-

account and depreciated over the earning lifetime of the R.&D 

"property." Whether or not this treatment would be 

administratively practical, it is the proper standard for 

neutrality among R&D and tangible investments under an 

income tax. 

Whether dictated by administrative or incentive 

considerations, many countries provide for preferential 

taxation of R&D. These provisions are outlined below for 

the United States and four other countries. 

A. United States 

1. Section 174(a) of the Internal Revenue Code permits 

business taxpayers to deduct research or experimental. 

expenses in the year they are incurred. Alternatively, a 

4 

taxpayer may elect under section 174(b) to capitalize 

deductible R&D expenses and amortize them over at least 60 

months. This election may be appealing to new or smhll 

firms with insufficient income to absorb a current year R&D 

ded uc t i on. 

Section 174 aoes not apply to expenditures for the 

acquisition or improvement of land or depreciable property 

used for research or experimental activity. Depreciation 
-31-

allowances themselves, however, are covered by the provision 

"to the extent that the property to which the allowances 

relate is used in connection with research or experimentation." L/ R&D expenditures for labor and materials are 

therefore deducted under section 174 and expenditures for 

buildings and equipment are depreciated as if employed in 

current production. A patent acquired from another, rather 

than resulting from one's own R&D activity, and having a 

determinable useful life, is depreciated, not expensed. 2/ 

Congress enacted section 174 into the Code in 1954 "to 

eliminate uncertainty and to encourage taxpayers to carry on 

research and experimentation." -3/ Prior to 1954, no special 

statutory provision existed for the treatment of R&D. fn 

some cases, the capital nature of research expense and the 

difficulty of specifying a useful life combined to deny the 

deductibility of R&D expenses. 

Where they could not be clearly classified as 

current operating expenses, the courts required 

their capitalization for tax pur-poses. Because of 

~~ 

-1/ IRC S1.174-2(b)(l). 

-2/ IKC §1.167(a)-3. 

-3/ House Report 1337, 83d Cong. 2d Sess., 1954, p. 28. 
-32-

the indefinite nature of their useful life, amortization was generally not allowed. Difficulties 

of proving abandonment of a research project or 

termination of its utility usually precluded a loss 

deduction. The end result was disallowance of any 

deduction for these purposes. -1/ 

Pre-1954 administrative practice, however, was more 

liberal than judicial interpretations and sought to allow 

current expensing of R&D expenditures. A 1924 Trecsury 

Department regulation allowed current expensing, but: this 

oFticn was withdrawn in 1926 in response to 3 Board of Tax 

Appeals decision that it contravened the statute. -2/ Nonetheless, the Bureau of Internal Revenue continued to permit 

the current deduction of R&D expenses "where this practice 

hbd been consistently followed by a thxpzyer." -3/ 

Commissioner Dunlap explained the administrative rationale 

for this policy in a 1552 appe3rance before the Joint 

Committee on Internal Revenue Taxation. 

-1/ William M. Horne, Jr. , "Research and Development

Expenditures," Tax Revision ComFendium, Vol. 2, 

Committee on Ways and Meuns, November IC, 1955, p. 1316. 

-2/ Charles R. Orem, Jr. , "Research and Development Costs," 

Tax Revision Compendium, -op. G.,F. 1131. 

Ibid. , 1112. 
-33-

On account of the difficulty of determining the 

specific costs applicable to various projects and 

processes, as well as determining in advance, or at 

any time prior to patenting or successful opera­ tions, the actual cost of a successful research and 

development project, the Bureau has allowed all 

such costs to be deducted annually, except costs of 

obtaining patents. Many projects take as much as 

10 years or more to develop; many are unsuccessful; 

some unpatentable .... The problem of allocating 

such expenditures to individual projects ...is most 

difficult and would require elaborate accounting techniques. -1/ 

Section 174 thus codified existing practices for taxpayers with a history of deducting R&D expenditures. For 

new or small businesses, with no established p;,ttern of �?&D 

activity, it meant that such expenditures were clearly deductible. The Treasury Department, in endorsing the 1954 

legislation, described its purpose: "Encourage research and 

experimental activity. Help small, pioneering businesses." 

Section 174 contains an addition61 incentive feature in 

thgt expenses need only be paid or incurred "in connection 

with" a trade or business. 3/ In Snow v. Commissioner, the -

-

1/ Ibid.

-2/ Hearings on H.R. 8300, Senate Finance Committee, 83d 

Cong., 2d Sess., April 1954, p. 105. 

-3/ IRC Sec. 174(a)(l). 
-34-

Supreme Court opined that the "in connection with" language 

of section 174 is intended "to dilute some of the conception 

of 'ordinary and necessary' business expenses under 

~162(a) .'I -1/ Observing that section 174 was legislated "to 

encourage expenditure for research and experimentation ,I' -

2/ 

the Court reversed a Court of Appeals decision denying a 

limited partner his share of a partnership's research ad 

experimental expenses for 1966, even though the partnership 

made no sales before 1967. 

2. To encourage scientific pursuits, individuals and 

corporations may deduct contributions to educational and 

scientific organizations operated in the public interest. -

-?/ 

Individual deductions are limited to 50 percent of adjusted 

gross income, corporate deductions to 5 percent of taxable 

income. -4/ 

-1/ Snow v. Commissioner, 416 U.S. 502. 

2/ 416 U.S. 504. -
-35-

3. The income of scientific anu educational organizations operated in the public interest is cxempt from Fcdcral 

income tax. L/ An organization conducting scientific 

research will qualify for the exemption if, the research "is 

directed toward benefiting the public." 2/ This condition 

is fulfilled if the research "is publishe6 in a treatise, 

thesis, trade publication, or in any other form that is 

available to the interested public." -3/ To meet this test, 

the Service has ruled that pbblication must be "timely." -

4/ 

Provided it meets these tests, &rid even if performed under 

"a contract or agreement under which the sponsor or sponsors 

of the research have the right to obtain ownership or 

control of any patents, copyrights, processes, or formulae 

resulting from such research," -

5/ research may still be 

regarded as performed in the public interest. 

-1/ IRC Ssc. 501(a) and 501(c)(3). 

-2/ IRC §1.501(~)(3)-i(d)(5)(iii)(c). 

-3/ IRC S1,501(~)(3)-l(d)(5)(iii)(c)(2). 

-

4/ Rev. Rul. 76-296; 1956-2 C.TI. 141.

-5/ IRC Sl.501(~)(3)-l(d)(5)(iii)(c)(4). 

1) 
-36-

Tax exempt organizations, however, are taxable on income 

derived from "unrelated" business activities. 1/ This is -

income from a business enterprise which is "not substantially related" to the organization's exempt purpose. 2/ A 

business activity is not "substantially related" to an 

organization's exempt function if it does not "contribute 

importantly" to the accomplishment of the organization's 

exempt purpose. -

3/ 

Thus, the Service has held that commercially sponsored 

research which is published in timely fashion is scientific 

research carricd on in the public interest and related to 

the organization's exempt purpose. Accordingly, income from 

that research will not be tainted as unrelated business 

income. -4/ But research, the publication of which is 

withheld or delayed significantly beyond the time reasonably 

necessary to establish ownership rights, is not in the 

public interest and constitutes the conduct of an unrelated 

trade or business under the statute. -

5/ 
-37-

There are other exceptions to the tax on unrelated 

business income. The following types of research related 

income xe specifically excluded from the scope of unrelated 

business income: 

(1) research income of a college, university, or 

hospital, -1/ and 

(2) income from any reseiirch performed for the 

United States, a state, or ~01il:ic;lI subdivision. -2/ 

Finally, dividends, interest, and royzlties are not 

unrelated business income, unless received from debt-finance 

property. -

?/ This exclusion provides scientific and educational organizations an opportunity to earn passive income 

without running afoul of the unrelated business income 

provisions of the Code. 

4. Individual inventors who trans[ tr "'.1? substantiil 

rights" to their patents are permitted to treat such revenue 

as capital gains. -4/ ~n determining whether "~,ll 

-1/ IRC Sec. 512(b)(8). 

-2/ IRC Sec. 512(b)(7). 

-3/ IRC Sec. 512(b)(1,2). 

4/ IKC Sec. 1235. -
-38-

substantial rights" h&ve been transferred, the law distinguishes between the sale of patent rights or the granting 

of an exclusive license and the nonexclusive licensing of 2 

patent. If a patent is sold, or exclusively licensed, the 

income is characterized as ii capital giiin, even though the 

payment is partly conditioned on future production or Frofits. If, however, the patent is licensed on a. nonexclusive 

basis, the income is characterized and taxed as ordinary 

income. The capital y&ins treatment is an incentive provision since one might consider the sale of patents as 

ordinary income of an inventor, and it would be so treated 

without the special exemption provided in the law. Corporations thht sell patents or license inventions do not automztically quhlify for capital gains treatment, but such 

trinssctions msy qualify for capital gains treatment as a 

sale of a capital asset. L/ 

B. Belsiuni 

1. Current rese;rch costs are deductible in the year 

incurred, provided they are related to the business activity 

of the taxpayer. -2/ 

-1/ IRC Sec. 1231. 

-2/ C. Sibille, "Relyiuni: Tax Measures and Direct 

Incentives Applicable to Research and Development,"

EUrOFean Taxation, 1977, F. 256. 
-39-

2. Capital expenditures, including buildings, by a 

BcIlj i nn enterprise are generally aepreciated under either 

the straight-line or declining-balance method. Scientific 

research equipment, however, is eligible for accelerated, 

three-year depreciation. 1/ -

3. Belgian lhw provides incentives for investments for 

specified purposes in economically distressed areas of the 

country. R&D is one of the purposes entitled to preferential treatment. Accordingly, investment in a aeveloplnerit 

area for a new research 1aborGtory is entitled to exemption 

from the immovable prepayment tax. The exemption applies to 

the building, as well as the land and equipment related to 

it. -2/ 

4. The sale of patent rights is taxed as ordinary 

income, provided the patent is used in the normal operation 

of the t&xpayer's business or is the result of a continuous, 

rather than incidental, inventing program. Alternatively, 

incidential inventions of a private inventor iire taxed &t a 

reduced rate. -3/ 

-1/ Ibid., p. 258. 

-2/ Ibid., p. 259. 

I3/ Ibid., p. 262. 
-40-

5. Contributions to non-commercial, non-profit 

organizations operated for the promotion of scientific 

research are tax deductible. 1/-

C. Canada 

1. TaxpLyers are allowed. to deduct both current and 

capital expenditures (including buildings, but not land) for 

scientific research in the year incurred, provided that the 

research is related to the taxpayer's business. To be 

deductible, current scientific expenditures may be incurred 

either inside or outside Canada, but capital expenditures 

must be incurred in Cznada. No deduction is 6llowed for 

expenditures made to acquire another's patents or other 

rights arising out of scientific research. The allowzble 

R&D deduction is reduced by any amounts received by the 

taxpayer pursuhnt to hn Appropriations Act and used. for 

scientific research aimed at improving the technological 

capability of Canadian manufacturing industry. Repayments 

of such grants are treated as deductible expenses. The 
-41-

deduction of eligible current scientific expenditure also 

can be deferred at the taxpayer's option and claimed in 

future years. -1/ 

2. Payments to En approved Canadian educational or 

research institute are deductible, provided they are used 

for scientific research related to the taxpayer's line of 

business activity. Payments to a Canadian non-profit 

organization to be used for Bcientific research also are 

deductible, -2/ 

3. Canadian law provides z general investment tax 

credit for qualifying capital expenditures. The credit is 

equal to 7 percent of eligible expenditures 2nd is limited 

to the first $15,000 of Federal tax liability plus 50 

percent of any tax liability in excess of $15,000. Unused 

credits can be carried forward 5 years. -3/ This credit may 

l/ Commerce Clearing House, Canadian Master Tax Guide, 

1980, par. 2810. 

-2/ Ibid. 

3/ Ibid., p2.r. 907'7. -
-42-

also be applied to current and capital scientific research 

expenditures. The deduction for expenditures for scientific 

research 

current 

to make 

4. 

is reduced by the amount of the credit claimed for 

scientific expenditures. -1/ The effect of this is 

the credit taxable. 

Eusiness enterprises are allowed bn zdditional 

deduction equal to 50 percent of qualifying scientific 

expenditures in excess of a three-year base period amount. 

The expenditures must be incurred in Canada for scientific 

activities related to the taxpayer's line of business. Both 

current 

special 

claimed 

D. 

1. 

they are 

amortize 

and capital expenditures are eligible for the 

allowance and the investment tax credit may also be 

with respect to such expenditures. -2/ 

France 

Current research costs 

incurred. No option 

these expenses. 3 / -

must be deducted in the year 

exists to capitalize and 

Treatment of Research and 

of Research ," European 

1/ Ibid., par. 2810. -

-2/ Ibid., par. 2852. 

-3/ C. Sibille, "France: Tax 

Development and the Result 

Taxation, 1978, p. 78. 
-43-

2. Capital equipment and buildings used for scientific 

purposes must be depreciated. While straight-line depreciation is usually mandatory in France for dEpreciable assets, 

declining-balance depreciation may be taken on certain types 

of assets, including scientific and technical research 

equipment, provided the assets are new when purchased and 

have a useful life of at least three years. -

1/ 

3. Buildings generally may not be depreciated on the 

declining-bLlance basis. la special first-year allov,mce 

permits companies to write off 50 percent of the cost of 

acquiring or constructing buildings dedicated to scientific 

research. The remaining 50 percent of the cost is 

depreciated on a straight-line basis over the life of the 

structure. -2/ 

4. Enterprises may deduct 50 percent of their 

investment in the shares of npyroved research compmies. 

When sold, such shares are thxed LS i; cnpitsl gain. -3/ 

2/ Ibid., pp. 78-79. 

-3/ Ibid., p. 80. 
-44-

5. Contributions to organizations operating in the 

public interest and carrying on scientific research are 

deductible. Corporate contributions are limited to 0.3 

percent of gross sales, individual contributions to 1.5 

percent of net income. 1/-

6. Profits resulting from the sale or licensing of 

patent rights are taxed at the long-term capital gains rate. 

Transactions involving a sale, exclusive license, or nonexclusive license of patent rights are all eligible for the 

capital gains rate. To quclifk for this preferential 

taxation, the patent must have been held by the transferor 

for at least two years, unless it w&s stlf-developed. -

2/ 

E. West Germany 

1.. Current RLD expenditures 6rE deductible in the year 

incurred. Capital expenditures, such as for laborhtories, 

buildings, snd equipment are depreciated ss if employed in 

current production. -3/ 

Ibid., p. 82. 

2/ Ibid., ~p.84-85. 

-3/ E. Jehle, "German Federal F.epublic: The Tax Treatment 

of Research and Development ,I1 European Taxation, 1978, 

p. 34;. 
-45-

2, The costs of acquiring another p8rty's research 

results, such a patent, must be depreciated over the useful 

life of the asset acquired. -1/ 

3. Taxphyers may claim an investment tax credit equal 

to 7.5 percent of the acquisition or construction costs of 

capital assets used for R&D purposes. The assets must be 

used for a least three years in the taxpayer's trade or 

business. To qualify for the credit, movable fixed assets 

must be used exclusively for R&L) and at least tko-thittis (11 

a building must be devoted to R&D. The credit does not 

reduce the depreciable basis of the assets on which it is 

clsimed. -2/ 

4. Inventors, both independent and employed, are 

eligible for preferential tax treatment. An independent 

inventor is taxed at one-half the normal rate on income 

earned on the development of & patentable invention, 

1/ Ibid., p. 348. 

-2/ Ibid., p. 349. 
-46-

provided it is not exploited in the taxpayer's own trade or 

business. Similarly, a 50 percent reduction in the wage tax 

imposed on payments made by an employer to an employee is 

avhilable for qualifying inventions. -1/ 

5. Organization's engaged in R&D activity for the 

public or common good are entitled to exemption from the 

inc0m.e and net wealth taxes. Within limits, contributions 

to these institutions are tax deductible. -2/ 

-1/ Ibid., p. 351. 

-2/ Ibid., p. 355. 
-47-

VI, CONDISlDERATION OF ADDITIONAL R&D TAX INCENTIVES 

In considering any additional K&D tax incentives for the 

United States, the following issues should be addressed. 

1. Are additional incentives necessary? Although total 

R&D spending relative to GNP has fallen along with the 

growth rate since the mid-l960's, industry-supported R&D has 

increased steadily. The continued strong pcrformz,ncc ~i 

private R&L is significant bccdust. this is the sector Lti<rl 

would be most affected by additional tclx incentives. 

Industry spokesmen have noted that the capacity of business 

to properly absorb the results of successful R&D is limited. 

Greater funding for R&D is not responsive to the 

problem.... The balance bctwecn creating new 

technology and applying it seems out of whack. The 

coming decade is a time when we as a nation nust 

see that our R&D results and our accumulated 

knowledge and technique arc applied to tangible 

engineering projects aimed at specific goals. -

1/ 

Twenty years earlier, when private R&D spending was much 

lower, another executive echoed similar sentiments. 

c 

-1/ E. E. David, Jr., President, Exxon Research and 

Engineering Company, "Engineering and Its ImEact on the 

1980's." Speech before the Conference of the American 

Association of Engineering Societies, Houston, Texas, 

October 16, 1980. 
-48-

There is...the question of the rate at which a 

company or industry can effectively absorb and 

commercialize the good results coming from its 

research and development program, Generally the 

scaling up of new processes costs a great deal more 

in money and manpower than laboratory research and 

development and leads to even larger requirements

for new production and distribution facilities. &/ 

2. Are additional R&D tax incentives the best way to 

improve productivity or the trade balance? Available 

studies indicate tnat reduced R&D spending may have been . 

associated with about 15 percent of the post-1960's productivity decline. The United States already has a large trade 

surplus in R&D-intensive goods. Although not dismissing the 

importance of R&U incentives, recent studies stress capital 

formation incentives as the preferred way of improving 

eccnomic performance. The Committee for Economic 

Development con.cluded that ''a more rapid capital recovery 

allowance is the first-priority action among all the alternative tax measures." -2/ Similiarly, the Advisory 

bubcommittee on Economic ana 'Trade Policy, 5 group of 

business community representatives, stated that "the removal 

-1/ Robert 11. Cairns, "Inconie Tax Provisions Regarding 

Research and Gevelopment Expenditures," Tax Revision 

Compendium, w. u.,F. 1106. 

-2/ Committee for Economic Development, 9.-cit., p. 31. 
-49-

of disincentives to savings arid investment should be the 

primary purpose of tax policy designed to encourage 

innovation." L/ 

3. Do international comparisons suggest a need for more 

R&D incentives? The United States spends more on R&D than 

France, Germany, Japan, and the United Kingdom combined. 

Relative to GNP, its total R&D expenditures coinpare 

favorably with other countries, but its civilian R&G 

expenditures lag somewhat, Nost industrial nations, riot 

lust the bnited States, have experienced a post-1960 growth 

slowdown. Other countries tend to have more generous R&D 

tax incentives than the United States, but this mGy simply 

reflect a different form of support for R&D. Although the 

percentage has declined in recent years, over 50 percent of 

total U.S. R&D funding is from government sources. Industry 

provides a larger share of the R&D budget in 'vrcst Germany 

and Japan. -

2/ Whether the United States should tilt its 

-I/ Advisory Subcommittee on Economic and Trade Pol icy, 

"Final Report on Economic and Trade Policy," Advisory

Committee on Industrial Innovation, February 1579, 

p. 13. 

-2/ National Science Foundation, Science Indicators 1976, 

p. 7. 
-50-

support of R&D away from direct expenditure and toward tax 

incentives is a separate question. 

4. Are additional tax incentives preferable to direct 

zxpenditures? Additional R&D tax incentives would require 

new definitions and guidelines to identify the eligible 

expenditures. It may be difficult, for example, to 

determilie how much of the salaries paid to workers in "white 

coats" is for product research or development compared to 

quality control or market analysis. This generally is not 

necessary under current law since R&D may be expensed 

whether it generates current or future income. Accordingly, 

R&D is not even reported separately on the tax return, but 

is included as part of wages and salaries and other expense 

items. The Financial Accounting Standards Board set forth 

broad guidelines identifying R&D activities in its statement 

requiring the expensing of R&D, but decided against more 

precise definitions. 

Differences among enterprises and among industries 

are so great that a detailed prescription of the 

activities and related costs includable in research 

and development, either for all companies or on an 

industry-by-industry basis, is not a realistic 

undertaking for the FASB. -1/ 

-1/ Financial Accounting Standards Eoard, "Accounting for 

Research and Development Costs," October 1974, par. 24. 
-51-

It may not be a "realistic undertaking" either for the 

Internal Revenue Service, but a "detaileci prescription of... 

activities and.. .costs" would be necessary if significant 

new tax benefits depended on the definition. 

In addition ta the definitional problem, tax incentives 

raise other issues. Like expenditures, they absorb government funds, But unlike expenditures, they are a form'of 

Federal financing outside the scrutiny and rigor of the 

normal budget appropriation process. A tax incentive aimed 

at a particular segment of the H&D community, such as 

"technology-ba'sed" firms or uriiversities, mzy redistribute 

rather than increase total R6 activity. 140 matter how 

precisely the intended eneficiary of the incentive is 

defined, it is difficult to avaid rewarding expenditures 

that would have been made without: the incentive. Making an 

incentive incremental compounds the administrative problems. 

5. If a new R&D tax incentive is necessary, the most 

sensible would be a R&D tax credit for privately-funded R&D 

expenditures on wages and equipment. The creiit shouli be 

taxable and non-refundable. Such a credit would be 

relatively neutral among R&D projects. It would rzduce the 

cost of all R&D spending, except for structures, by the same 
-52-

proportion regardless of the economic life of the projects, 

the mix of current and capital expenditures, or the tax 

circumstances of most taxpayers. Unlike an incentive aimed 

at particular R&D expenditures, there would be no incentive 

for a taxpayer to redistribute, but not increase, its R&D 

expenditures to qualify for the credit. The credit would 

work within the market mechanism as firms would be free to 

Fursue the most profitable innovations and technologies. 

Government officials would not have to make difficult 

subjective judgments concerning the relative merits Of 

various innovations and technologies. Still, the problem of 

determining the particular outlays eligible for the credit, 

as discussed in point 4 above, would remain.