Are U.S. tax incentives for corporate R&D likely to motivate American firms to perform research abroad?

• Author: Billings, B. Anthony
• Position: Research and development

Current U.S. tax policy toward research and development (R&D) is based on the notion that the United States is the dominant competitor in the world for technology-intensive products. (1) While there is some truth to this notion, U.S. technological dominance is eroding at a rapid pace. Table 1 demonstrates that the U.S. share of global sales of technology-intensive products has declined steadily as compared with the major trading partners. Table 2 shows that since the early 1980s the U.S. has spent a constant share of gross domestic product (GDP) on R&D, whereas Japan has increased the proportion of GDP spent on R&D.

At the same time, U.S. firms have increased investments in overseas non-defense R&D at a much faster pace than investments in domestic R&D. Overseas R&D performed by U.S. firms now accounts for well more than 10 percent of total R&D performed by U.S. firms. (2) In addition, data from the Bureau of Economic Analysis (BEA) relating to operations of foreign affiliates of U.S. companies reveal that foreign affiliates of U.S. multinational firms are accounting for an increasing proportion of R&D performed by U.S. firms globally. (3)

More recently, Japan revised its tax-based incentives for R&D investments, and countries such as the United Kingdom, India, and Canada have enacted generous tax and non-tax incentives to attract additional R&D investments. To be sure, R&D investments are expected to follow growth in foreign production, but rapidly increasing R&D costs, declining product life cycles, and inter-country differences in the cost of performing R&D may also influence where firms perform R&D. A key question for U.S. tax policymakers is whether the level of tax incentives for the performance of R&D in the United States is competitive with incentives offered by foreign counterparts.

This article investigates whether the level of tax-based incentives influences where U.S. firms perform R&D investments. It compares annual percentage increases in R&D performed by foreign affiliates of U.S. multinationals in 12 countries for 7 industrial groups over the 1990-2000 period. The data are based on private-sector financed R&D investments (non-governmental sources) by U.S. affiliates as reported by the BEA. The reported results indicate that when compared with the companion industry in the United States, the growth rate in R&D performed by U.S. foreign affiliates was higher in countries with tax-based R&D incentives than in countries without tax-based incentives. Moreover, non-financial foreign affiliates of U.S. firms in Japan, Mexico, and Ireland had annual increases in R&D at rates higher than the remaining countries. When compared with each of the 12 countries on a relative basis, the growth rate in R&D performed by foreign affiliates of U.S. firms in Japan, Mexico, Ireland, and Brazil were also higher than the growth rate of R&D investments by foreign affiliates of U.S. firms in the remaining 8 countries, including investments in the United States.

These results have implications for U.S. tax policy regarding attracting R&D investments of foreign affiliates of U.S. firms to the United States and for keeping existing R&D investments of U.S. interests in the United States. The location of R&D facilities in the United States has important benefits for the American economy. Firms performing R&D hire technical personnel and generate manufacturing jobs that produce employment tax receipts and other favorable economic consequences. Moreover, the location of R&D facilities in the United States is conducive to keeping technology ownership in the United States rather than in foreign countries that may offer more generous levels of R&D-related tax incentives. One way of making the United States a more attractive place for performing R&D is to increase the level of tax-based incentives for R&D in line with other nations that are attracting U.S. R&D investments.

This article first discusses export share of technology-intensive products. It next examines the role of tax-based incentives in the location of R&D investment and discusses the research design. Finally, it discusses the results and advances several tax policy recommendations.

1. Export Share of Technology-Intensive Products

   With the explosive growth in global competition and the erosion of U.S. market share of technology-intensive products over the last 2 decades, the stimulation of R&D activity, particularly in the private sector, has become a staunchly embraced policy tool of governments worldwide. Table 1 shows that since 1980 the United States has lost about 6 percentage points of global market share in technology-intensive products. The affected industries are the aerospace, computers and machinery, communications equipment, and pharmaceuticals industries. (4) Closer examination of Table 1 shows that lesser-developed countries such as Singapore and Mexico have increased their market share at the expense of other countries such as the United States, United Kingdom, Germany, and Italy.

   Concomitant with the observed decline in U.S. market share of technology-intensive products is evidence that U.S. R&D expenditures have remained relatively flat over the 1980-1998 period, as have such expenditures for the major industrialized nations. An increasing amount of R&D financed by U.S. firms, however, is being performed in foreign countries. One reason for choosing locations other than the United States to perform R&D may be differences in the level of incentives offered for encouraging R&D by individual countries. Governmental subsidies are invaluable in stimulating R&D investments because of the uncertainty in the payoff from R&D and market rivalry.

   Research has shown that national governments can help private industry increase their global market share of products under imperfectly competitive market conditions. (5) Alternative governmental actions include (1) imposing tariffs on imports, (2) offering export incentives, (3) forming export cartels, and (4) subsidizing technological innovation. The offering of tax incentives to encourage technological innovation may be the most effective of the alternatives because it is an indirect support and, therefore, would not be in violation of the World Trade Organization (WTO) agreement that prohibits direct tax incentives for exports. (6) Apart from affecting the market share of technology-intensive products, the level of tax incentives offered for R&D is expected to influence where firms locate R&D facilities.

   A growing number of countries from both the major industrialized nations and smaller emerging economies are enacting tax-related subsidies to attract R&D facilities of foreign multinationals. Of the 7 major industrialized nations, 4 countries along with the United States have some type of tax incentives and/or other non-tax programs for R&D expenditures. France and the United States have a tax credit based on increases in R&D in excess of historical levels. In contrast, Japan is moving from an incremental credit to a non-incremental credit, whereas Canada has an investment tax credit (ITC) of 20 percent of capital expenditures for R&D. Countries such as Singapore, India, Mexico, and Australia also have enacted generous R&D subsidies to attract foreign R&D facilities. A brief summary of the credit provisions for the United States and several other countries is provided in Appendix 1.

2. The Role of Tax-Based Incentives in the Location of R&D Investments

   The site of production facilities alone may not explain where firms locate R&D facilities. Firms are expected to choose among alternative sites to perform R&D based on their derived user-cost of in-house R&D. The user-cost of in-house R&D is the amount of gross revenues that must be earned to pay for the amount invested in R&D and to achieve firms' required rate of return (Cordes, et al., 1987). The user-cost of R&D may be expressed as follows (Equation 1):

   (1) [C.sub.t] = [P.sub.r]/[P.sub.Y] * (1 - [tau] - k)(r + [delta]/(1 - [tau]

   In Equation 1, [P.sub.r]/[P.sub.Y] is the true purchase price of a unit of R&D, and (1 - [tau] - k)(r+[delta]) is the opportunity cost of adding one unit of R&D input. (7) In Equation 1, [tau] is the corporate tax rate on income, k is the tax incentive for R&D, [delta] is the rate of obsolescence, and r is the discount rate or the weighted cost of debt and equity financing.

   Of the elements used to derive the user-cost, k (the tax incentive for R&D) may be the most significant element with respect to where firms locate R&D facilities or where they invest the marginal dollar of R&D investment (United States or foreign locations). The rationale is that the uncertain payoff from R&D may lead firms to choose locations with the highest level of R&D incentives to lower the user-cost of R&D.

   R&D incentives lower the user-cost and may make the difference in whether or not firms pursue certain risky projects with low expected values or projects with significant lags in revenue streams from product or process research. The uncertainty inherent in the payoff from R&D arises from 2 sources (Huchzermeier and Loch, 2001) (8) First, R&D investments do not guarantee that profitable innovation will result from product or process-related research projects. Because the payoff from R&D lags other investment alternatives, R&D incentives may increase the net present-value of R&D sufficiently to make the incentives economically plausible. Second, rivalry among firms to be the first to innovate may reduce the payoff from successful outcomes because of price competition among rival innovators.

   Table 3 provides an illustration of inter-country differences between special tax incentives for R&D, or k, which influence the user-cost of R&D and possibly the location of R&D investments. For purposes of illustrating country-level differences in tax-based R&D incentives, data for 20 research-intensive firms in the U.S. are used to simulate effective rates of...