In 1981, Congress created the research tax credit to encourage business to do more research. The credit has never been a permanent part of the tax code. Since its enactment on a temporary basis in 1981, the credit has been extended six times and modified four times. The research tax credit has always been incremental in nature. Taxpayers receive a credit only for qualified research spending that exceeds a base amount. Beginning in 1981, taxpayers could reduce their tax liability by 25 percent of qualified research that exceeded a base amount that was equal to the average research expenditure of the 3 previous years or a base amount that was equal to 50 percent of the current year’s expenditures, whichever was greater. The Tax Reform Act of 1986 modified the credit by reducing the rate to 20 percent of qualified spending above the base amount and more narrowly defining qualified expenditures. The credit was changed again in 1988 to require that taxpayers reduce their deductions for research expenditures by an amount equal to 50 percent of the credit they claim. In 1989, this amount was increased to 100 percent of the credit they claim. The Omnibus Budget Reconciliation Act of 1989 changed the method for calculating the base amount. The base calculated as the average expenditure of the 3 previous years was replaced by a base amount equal to the ratio of total qualified research expenses to total gross receipts for 1984 through 1988, multiplied by the average amount of taxpayer’s gross receipts for the preceding 4 years. This base change removed the link between increases in current spending and future base amounts that had reduced the incentive to undertake additional research spending under the prior method for calculating the base. The evaluation of the effectiveness of the credit requires first estimating the additional research spending stimulated by the credit. Ideally, this additional spending should then be evaluated according to the net benefit it produces for society. However, this net social benefit is difficult to determine because it depends on how the research of some companies affects the costs and products of other companies. Some researchers who have studied the credit have instead calculated a “bang-per-buck” ratio, the amount of spending stimulated per dollar of revenue cost. Once a decision has been made to provide some form of credit, this ratio is a relevant criterion for assessing alternative designs. Most early studies of the research tax credit found that, although the credit may have stimulated some additional research spending, the effect on spending was relatively small. For example, Edwin Mansfield in his 1986 study asked a random sample of corporate officials to assess the effect of the credit on research spending and estimated from their responses that the additional spending induced by the credit equaled about one-third of the revenue cost. Robert Eisner, et al., in 1984 compared the growth of research spending that qualified for the credit and spending that did not qualify in 1981 and 1982, and found no positive impact of the credit on the growth of research spending. Other early studies relied on estimates of the responsiveness of research spending to reductions in its price to arrive at similar conclusions. Because the credit is effectively a reduction in the price of research, the greater the responsiveness of research spending to price reductions, the more additional spending the credit is likely to stimulate. Economists measure the responsiveness in terms of the “price elasticity” of spending, which shows the percentage increase in spending that would result from a 1-percent reduction in the after-tax price of research and development (R&D). In 1989, we reported that the best available evidence indicated that research spending is not very responsive to price reductions. Most estimates of the price elasticity of spending fell in the range of –0.2 to –0.5, implying that a 1-percent reduction in the price of research would lead to between a 0.2 percent and 0.5 percent increase in spending. In our 1989 report, we used Internal Revenue Service (IRS) data to estimate that between 1981 and 1985, the credit provided companies with a benefit of 3 to 5 cents per dollar of additional spending. This benefit to companies is equivalent to a reduction in the price of research. Combining these price reductions with the range of elasticity estimates, we estimated that the credit stimulated between $1 billion and $2.5 billion of additional research spending between 1981 and 1985 at a cost of $7 billion in tax revenue. Thus, we estimated that each dollar of taxes forgone stimulated between 15 and 36 cents of research spending. Reports on the research tax credit by KPMG Peat Marwick and by the Office of Technology Assessment (OTA) include reviews of studies of the credit’s effectiveness that were issued since our 1989 report. The KPMG Peat Marwick report concludes that the studies provide evidence that the spending stimulated by the credit equals or exceeds its revenue cost. Specifically, the report concludes that the recent studies show that one dollar of credit stimulates about one dollar of R&D spending in the short run, and as much as two dollars in the long run. According to the KPMG Peat Marwick report, the recent studies KPMG Peat Marwick reviewed provide better estimates of the effectiveness of the credit than earlier studies because they analyze longer data series and because they use what it considered to be better methodologies for analyzing the effect of the credit. The OTA report reviewed the same recent studies as KPMG Peat Marwick and observed that the available literature generally reports that the credit stimulates about one dollar of additional spending per dollar of revenue cost. However, OTA pointed out that the studies contain data and methodological uncertainties. For our review, we evaluated the studies cited in these two reports as well as other studies not included in either report. We also addressed some methodological issues that were not addressed in these reports and provided a more detailed evaluation of each study. Our first objective was to evaluate recent studies of the research tax credit for the adequacy of the data and methods used to determine the amount of research spending stimulated per dollar of revenue cost. In particular, we were to determine if recent studies provided adequate evidence to conclude that each dollar of tax credit stimulates at least one dollar of research spending in the short run and, over the long run, stimulates about two dollars of research spending. Our second objective was to identify the factors other than spending per dollar of revenue cost that determine the credit’s value to society. To meet our first objective, we reviewed the six studies cited by the KPMG Peat Marwick report and two studies that the report did not cite that we identified from our review of the literature on the credit and from our interviews with authors of research tax credit studies. In general, these recent studies were published since our 1989 report, although one study cited by KPMG Peat Marwick was published in 1987. The studies are listed in appendix I. We used standard statistical and economic principles in our review and evaluation of the studies of the research tax credit. We relied upon internal economists to carry out this evaluation. In our evaluation, we considered such factors as the adequacy of the data used to estimate the effect of the credit, the adequacy of the variables used to measure the incentive provided by the credit, and the sensitivity of the estimates to assumptions about taxpayer behavior. We also interviewed the authors of the studies of the research tax credit and requested comments on a draft of our evaluation of their studies. We received comments from the authors of six of the eight studies that we reviewed. All agreed that our report accurately summarized their studies. However, not all agreed with the importance of the data and methodological limitations that we identified in their work. A summary of their comments appears on pages 12 and 13. We also requested comments on a draft of our report from the authors of the KPMG Peat Marwick report. They stated that they appreciated the opportunity to comment on our report but that after reviewing our report, they had no comments to submit. To meet the second objective, we reviewed academic articles and government studies about the determinants of the social benefits of research spending. We also reviewed studies that describe the difficulties encountered when attempting to measure the full social costs and benefits of research. We did our work in Washington, D.C., from December 1995 through January 1996 in accordance with generally accepted government auditing standards. The recent studies that we reviewed provided mixed evidence on the amount of spending stimulated per dollar of revenue cost. Of the eight studies we reviewed, three supported the claim that one dollar of credit stimulated about two dollars of additional research spending. Another study, which did not directly evaluate the research tax credit, reported estimates of the responsiveness of research spending to other tax incentives. These estimates appear to be consistent with the claim that the credit stimulates spending that exceeds its revenue cost. However, two studies reported that the credit stimulated spending that was less than its revenue cost, and another two of the studies reported estimates of additional spending that do not appear to support the claim that spending exceeded revenue cost. One of these latter studies does not compare additional research spending to revenue cost but does report an estimate of additional spending that is likely to be less than the revenue cost. The other study reported that additional spending exceeded revenue cost through 1985 but reported estimates of additional spending that were likely to be less than the revenue cost after 1985. Most of the recent studies used more sophisticated methods than prior studies when analyzing the effectiveness of the credit. For example, the studies improved on prior studies by using methods that attempt to distinguish the credit’s effect from other influences on research spending like the potential size of the market for the product of the research. However, the studies have the following data and methodological limitations. The most appropriate data for assessing the effect of the credit are tax return data. These confidential tax return data were not available to the authors of the studies. Instead, they used publicly available data sources, chiefly the COMPUSTAT data service, which do not accurately reflect the incentive provided by the credit. This incentive depends on a company’s ability to earn credits by having qualified research spending that exceeds the base amount and on a company’s ability to claim its credits by having sufficient taxable income.