Economists have gained notoriety for their differences of opinion on a variety of policy issues. Notable examples include the long-term economic effects of large, permanent tax cuts; the impact of illegal immigration on domestic wages; and the best ways to lessen income inequality. But on two issues there is little, if any, disagreement: (1) the impact of technological innovation on economic growth in the long run and (2) the proper role of government in the development and commercial uses of new technologies. Among economists, it is widely believed that technological innovation has accounted for a major share of long-term growth in real per-capita income in the United States and certain other developed countries. Economists who study the forces driving economic growth see innovation as a convoluted and uncertain process that encompasses the acquisition of new scientific and technical knowledge and its application to the development of new goods and services or methods of production through a process of research and experimentation. Learning-by-doing and learning-by-using play critical roles in this process. In market economies, technological innovation is driven by the efforts of competing firms to gain, sustain, or reinforce competitive advantages by being the first to introduce or use new or improved products or services; more efficient production processes; or more effective strategies for management, marketing and promotion, and customer service and support. Most economists also recognize that private R&D investment is likely to be less than the amounts that are warranted by its overall economic benefits. The reason for this shortfall lies in the nature of these benefits. It seems probable that the average company investing in R&D cannot capture all the returns to their R&D investments, even in the presence of patents, trademarks, and other forms of intellectual property protection. There are several channels through which the returns from innovation may elude full capture by innovating firms and spill over to society at large. The most common ones are reverse engineering by other firms, migration of research scientists and engineers from one firm to another, and the availability of new or improved goods and services at prices below what most consumers and companies would be willing to pay. Economists refer to an excess of total (or social) returns to R&D investments over private returns as the spillover effects or external benefits of R&D. Numerous studies have found that the average social returns to private R&D investments greatly exceeded the average private returns. The ratio of the former to the latter from available estimates averages two to one. This finding held true regardless of whether a firm invested in research projects narrowly focused on its existing lines of business, or in research projects aimed at extending the boundaries of knowledge in particular scientific disciplines in ways that had no obvious or immediate commercial applications. When seen through the lens of standard economic theory, the external benefits from technological innovation resemble a market failure. They signal that too few resources are being allocated to the activities leading to the discovery and commercialization of new technical knowledge and know-how. As a remedy for this failure, most economists recommend the adoption of public policies aimed at boosting or supplementing private investment in R&D. The U.S. government supports R&D in a variety of ways. Direct support comes mainly in the form of research performed by federal agencies and federal grants for basic and applied research and development intended to support specific policy goals, such as protecting the natural environment, exploring outer space, advancing the treatment of deadly diseases, and strengthening the national defense. Indirect support is more diffuse. The chief sources are federal funding of higher education in engineering and the natural sciences, legal protection of intellectual property rights, special allowances under antitrust law for joint research ventures, and tax incentives for business R&D investment. Federal tax law offers two such incentives: (1) an expensing allowance for qualified research expenditures (QREs) under Section 174 of the Internal Revenue Code (IRC), and (2) a non-refundable tax credit for QREs above a base amount under IRC Section 41—also known as the research and experimentation (R&E) tax credit, the research tax credit, the R&D tax credit, or the credit for increasing research activities. The expensing allowance has been a permanent IRC provision since it was first enacted in 1954. Its main advantages are that the allowance simplifies tax accounting for R&D expenditures, reduces the likelihood of IRS challenges of the expensing of QREs, and encourages business R&D investment by taxing the returns to such investment at a marginal effective rate of zero and increasing cash flow among companies claiming the allowance. A similar policy objective lies behind the research tax credit, which was a temporary provision of the IRC from July 1981 until 2015, when the Protecting Americans from American Tax Hikes (PATH) Act of 2015 ( P.L. 114-113 ) permanently extended the credit. The credit is intended to stimulate more business R&D investment than otherwise would take place by lowering the after-tax cost of engaging in qualified research. But unlike the deduction, it complicates tax compliance for firms investing in qualified R&D. In FY2016, the combined revenue cost of the expensing option and the credit could total an estimated $13.5 billion. This report examines the current status of the R&E tax credit, describes its legislative history, and discusses some of the key policy issues raised by the current credit. Many think of the research tax credit as a single unified credit. But it actually has four discrete components: a regular research credit, an alternative simplified credit (ASC), a basic research credit, and a credit for energy research. Each is non-refundable. In any tax year, taxpayers may claim no more than the basic and energy research credits, plus either the regular credit or the ASC. To prevent taxpayers from benefiting twice from the same expenditures, any research tax credit claimed must be subtracted from deductible research expenses. The four components of the research tax credit were extended permanently in December 2015 by the Ultimately, claims for the regular credit and the ASC hinge on the definition of qualified research expenditures (QREs). There are two aspects to this definition: (1) the nature of qualified research and (2) the expenses that qualify for the credit. Each is examined below. One aspect of what constitutes a QRE concerns the nature of qualified research. Under Section 41(d) of the federal tax code, research must satisfy the following four criteria in order to qualify for the regular credit or the ASC: The research must involve activities that qualify for the deduction under Section 174, which means that the activities must be "experimental" in the laboratory sense and aimed at the development of a new or improved product or process. The research must seek to discover information that is "technological in nature." The research should be intended to gain new technical knowledge that is useful in the development of a new or improved "business component," which is defined as a product, process, computer software technique, formula, or invention to be sold, leased, licensed, or used by the firm performing the research. The research must entail a process of experimentation aimed at the development of a product or process with "a new or improved function, performance or reliability or quality." Businesses, the courts, and the IRS have clashed repeatedly over the interpretation of the four criteria. Although the IRS issued final regulations clarifying the definition of qualified research in December 2003 (T.D. 9104), numerous businesses and the IRS have continued to disagree over what activities qualify for the credit. Section 41(d) (4) identifies the activities for which the credit may not be claimed. Specifically, the credit does not apply to research conducted after the start of commercial production of a "business component"; research done to adapt an existing business component to a specific customer's needs or requirements; research intended to modify a business component according to "style, taste, (and) cosmetic or seasonal design factors"; research related to the duplication of an existing business component; surveys and studies related to data collection, market research, production efficiency, quality control, and managerial techniques; research to develop computer software for a firm's internal use (except as allowed in any regulations issued by the IRS); research conducted outside the United States, Puerto Rico, or any other U.S. possession; research in the social sciences, arts, or humanities; or research funded by another entity. The second aspect of the definition of QREs is the expenses to which the credit applies. Under Section 41(b) (1), qualified expenses relate to both in-house research and contract research. In the case of in-house research, the regular credit and ASC apply to the wages and salaries of employees and supervisors engaged in qualified research, as well as the cost of materials, supplies, and leased computer time used in this research. In the case of contract research, the credits apply to the full amount paid for qualified research conducted by certain small firms, colleges and universities, and federal laboratories; 75% of payments for qualified research performed by certain research consortia; and 65% of payments for qualified research performed by certain other nonprofit entities dedicated to scientific research. As a result, the credits do not cover all the expenses a company incurs in conducting qualified research. Specifically, outlays for depreciable durable assets used in qualified research (such as buildings and equipment), overhead expenses (e.g., heating, electricity, rents, leasing fees, insurance, and property taxes), and the fringe benefits of research personnel are excluded. The exclusion of these expenses dilutes the incentive effect of the credit (more on this later). According to some estimates, excluded expenses account for 27% to 50% of business R&D spending. The regular research tax credit was extended 16 times before the PATH Act permanently extended it. Congress has also significantly modified the credit six times, including the changes made by that act. Under IRC Section 41(a) (1), the regular credit is equal to 20% of a firm's QREs beyond a base amount.