Under-taxation of corporations plays a significant role in the decline of research spending. While potential competitive advantage is one reason to pursue research and development, taxes and the interplay between tax and corporate accounting are another reason (even prior to 1981).

While taxes paid by corporations benefit the general public, from the corporation’s point of view taxes are money out the door with zero possible return. So what does a prudent corporation do with its profits? It recognizes that they are potential capital and seeks to maximize the risk-adjusted return on capital.

It can bank them at the risk-free rate of return, but we should remember taxes will take a healthy chunk out of that return on the front end. It can pay them out to investors as dividends (increasing the return on remaining capital by reducing the denominator). Note that under rational tax schemes the risk adjusted return on capital should be equivalent to investing at the risk free rate of return (modulo management of cash-flow risks). It can buy riskier assets with higher return, such as other companies. And it can make much riskier investments, like research and development. As with most things financial, the best overall risk adjusted return on capital is diverse in both kind and in risk level. It should do all of those things (treating dividends as equivalent to investment at the risk free rate of return), with the proportion going to each tuned to achieve the aggregate optimum(1). Also, can you see how a regulated utility with(like AT&T of old) would find R&D attractive for spicing up its asset mix?

Think of R&D as producing a stream of lottery tickets with the drawing in the distant future. Those lottery tickets (for a tech company) can pay off in two ways. One is that they could produce or enhance a revenue stream. The other is that they could reduce risk in the form of patents (reduce competitive risk and risk of patent suits by threat of countersuit). Both of these payoffs improve risk adjusted return on capital (by generating return or reducing risk). The neat thing about R&D for a company that’s paying real taxes is that much of the cost is (from a tax point of view) is an expense. In other words, that allocation of capital doesn’t have the upfront bite taken out of it that occurs when profits are directed to risk free assets. Looking at this from a risk-adjusted return point of view, having a real tax burden increases the appetite for risk by decreasing the relative attractiveness of the risk-free alternative after taxes. This is doubly true for expenditures that look like expenses to tax collectors but look like capital investment for corporate accounting purposes.

None of this holds true if a company isn’t paying much in the way of taxes on its profits. It doesn’t mean some amount of R&D isn’t still attractive, but the appetite for risk is lower. And let’s be clear, R&D in research labs is the riskiest kind of R&D.

Well, you might say, the 1981 R&D tax credit is sweeter than a deduction. Doesn’t that tilt the scales back? Yes, but subject to the limitations of the tax credit (which are numerous). But, like the deduction, the tax credit is much less valuable for companies that aren’t paying taxes on their profits. And, to be clear, this is a Reagan measure taken with full knowledge of what was expected to happen to corporate tax rates and the impact that might have on R&D investment. It’s a partial mitigant for that, nothing more.

I am fully aware that I have murdered both CAPM and the practice of accounting in compressing this down to a reasonable post with what I hope is a clear narrative. My apologies to practitioners of both.

(1) An important aside: People make equity investments to take more risk in the expectation of higher return. Beyond the cash cushion necessary for minimizing cash-flow risk, massive cash hoards do nothing but dilute the risk (and return) rational investors are actively seeking to take. There is some argument to be made that large tech companies keep huge cash hoards because their core businesses are riskier than they appear (esp black swan events), but it probably has more to do with founders desire for independence.