Twenty-eight of the 86 companies told us that the credit had encouraged them to intensify the level of their ongoing research efforts. For example, one cereal company told us that it applied the credit to ongoing research in food processes and products; another company applied it to developing drugs for use in the treatment of cancer and heart disease, and a third applied it to developing equipment in the orthopedic field. The value of the credit to these 28 companies for intensifying the level of ongoing research during the period 1981 through 1983 was about $132.4 million. Twenty-three of the 86 companies said that the credit encouraged them both to start new efforts and to intensify ongoing efforts. The companies used the research credit to develop such products as computer hardware/software, electronic banking equipment, and interior and exterior trim for automobiles. The value of the research credit to these 23 companies for the period 1981 through 1983 was about $394.6 million. Finally, 30 of the 86 companies told us that the credit had no effect on their research program. That is, company officials said that they would have increased their spending on research even if the credit had not been available. We also found that 71 potential users of the tax credit for which we gathered information had not claimed the credit for various reasons. Twenty-one corporations said that they had not claimed the credit because they had no tax liability. Most of these firms were involved in scientific research. The credit can, however, be carried forward for up to 15 years. Thirtyfive companies said that their research and experimentation expenses did not quality for tax credit purposes, as defined by law or the proposed Treasury regulations. Other reasons cited by the 15 remaining companies for not using the credit included a lack of incremental expenditures on research and experimentation and a lack of knowledge about the credit. Now, I would like to discuss the extent to which the credit has achieved its stated objective. Available statistical data indicate that research and experimentation expenditures have increased since the tax credit went into effect. Some statistical evidence indicates that the research and experimentation tax credit may have achieved, at least to some extent, its intended objective. That is, available statistics indicate that there has in fact been a substantial increase in expenditures for research and experimentation since the credit went into effect on July 1, 1981. Other evidence, however, indicates that the tax credit may not have been the only cause for these increased expenditures. In any case, we obtained evidence as to whether the tax credit had encouraged research and experimentation from corporate tax return data for tax years 1981 and 1982. Tax year 1981 information on 105 of our 209 tax credit users indicated that they had spent a total of $1.1 billion on qualified research and experimentation during the tax year 1980 base period. For the comparable 1981 period when the tax credit first went into effect, the 105 companies spent nearly $1.5 billion on research and experimentation, a 37-percent increase. For 1982, the second year in which the tax credit was in effect, we were able to obtain tax return data from 52 of our 209 users. These companies claimed an average of $664.8 million in research expenditures for base period years 1980 and 1981, but over $781 million in tax year 1982-$116.3 million or 17 percent increase. Thus available statistics show that since the tax credit went into effect, expenditures for research and experimentation have increased at least with respect to some of the major corporations included in our sample. In contemplating these statistics in terms of the contribution made by the tax credit, however, some consideration should be given to the effects of inflation and the possibility that taxpayer errors were made in computing both base period and incremental research and experimentation expenditures. Some firms may have been able to claim the tax credit by maintaining a level, real rate of expenditures on research and experimentation activities. This is because the law does not take inflation into account in terms of defining incremental expenditures. Also, there may be a question as to the extent that available statistics actually reflect increased spending on research as opposed to changes in taxpayers' classification of expenses incurred. Thus, Mr. Chairman, while we cannot specify the exact extent to which spending on research and experimentation has increased since enactment of the tax credit in 1981, it seems clear that there has been an increase in such spending. Available information indicates, however, that the tax credit may not have been the only reason for the increased spending and I would now like to discuss that issue. As I previously mentioned, we were able to obtain views from representatives of 86 of the corporations in our sample that used the credit. Thirty of the eighty-six corporations, or 35 percent, told us that the tax credit had not encouraged them to carry out any more research and experimentation than otherwise would have been the case. These companies were involved in such research activities as developing techniques for extraction of fuel, producing new products out of iron ore and nickel, and developing microelectronic and hydraulic equipment. Various company representatives told us that factors, such as enlightened management, the need to be competitive and to increase earnings, and the need for effective long-term planning affected decisions to increase research expenditures more so than did the tax credit. These 30 companies claimed about $26.8 million, or 5 percent, of the $564.5 million in tax credits claimed by the 86 companies which provided us with information in this area. Also, a change in economic conditions could have been a major impetus for increased research expenditures. We noted that corporate earnings were depressed in 1980 due to the most recent recession and as a result, corporate investments in research and experimentation may have been lower than otherwise would have been the case. In late 1982 and 1983, however, corporate profits increased substantially and thus more funds were available for research. Given that, it is possible that some firms increased their spending on research because higher profits made funds available for that purpose, not solely because of the tax credit. On a related matter, we noted that several studies, including a Congressional Budget Office analysis, have indicated that the tax credit may not be sufficient to stimulate significant incremental investment in research and experimentation. Also, the tax credit provides only a prospective benefit for those firms that did not incur a tax liability in the current year and 3 prior years. This was the case for 21 of the 71 companies included in our sample that had not claimed the credit, including several computer, genetic, and biotech firms. Now I would like to discuss the tax credit in terms of forgone revenues and administrative issues. According to the latest Treasury Department estimates, at least the most recent ones we are aware of, the tax credit will result in about $7 billion in forgone tax revenues during July 1981 through December 1989. In its anticipated peak year, 1985, Treasury expects the credit to result in forgone tax revenues of over $1.5 billion. Information we developed from tax returns showed that at least 36 of the 209 tax credit users included in our sample had claimed the tax credit for each of the 3 years we covered-1981, 1982, and 1983-and we found that tax credit claim amounts increased substantially each year for these companies. The 36 companies claimed about $89 million in tax credits for tax year 1981. In tax year 1982, the same companies claimed over $122 million in tax credits. In tax year 1983, the 36 companies claimed over $193 million in credits. Thus, the research and experimentation credit already has resulted in millions of dollars in forgone tax revenue. From a tax administration perspective, the credit has caused some difficulties for both IRS and taxpayers. IRS, for example, has experienced difficulties in the form of unagreed examination cases. Through May 1984, seven IRS district offices we contacted had initiated or completed 83 examinations involving the credit. In 30 of the 83 cases, IRS examiners believed that taxpayers had overstated their tax credit claims. But 10 of the 30 involved taxpayers have disagreed with IRS' findings. The disagreements between IRS and the taxpayers seem to stem basically from the ambiguity of the law regarding certain qualified research expenditures. For example, 8 of the 10 unagreed cases involved issues pertaining to computer software expenses. Basically, under present law, innovative software products would seem to qualify for the tax credit. But neither the law nor the proposed regulations define the term "innovative." Thus, it is not surprising that taxpayers would liberally classify new software as innovative whereas IRS would tend toward a more conservative interpretation of innovation. In summary, Mr. Chairman, we have some data and information on the effectiveness of the tax credit, but some of that data and information can lead to conflicting conclusions. Given that, on the basis of our work, we cannot now recommend that the credit be made permanent. We recognize, however, that as an alternative to making the tax credit permanent, the Congress may decide to extend the expiration date. Should this be the case, we believe that the Congress should include an important proviso, that Treasury and/or IRS systematically gather data on the tax credit so a more informed decision on its effectiveness can be made in the future. If the decision is made to extend the credit, the Congress may also want to consider making policy revisions. The Congress may want to consider issues raised by CBO as to whether the size of the credit is appropriate. The Congress may also want to consider whether the law should take inflation into account so as to limit the tax credits to real increases in spending on research. Finally, the Congress may want to clarify the law where possible. For example, we found that there is a need for clarification as to whether certain computer software-related expenses qualify for tax credit purposes. Other witnesses may point out some additional areas where clarification of the law may be appropriate. This concludes my prepared statement, Mr. Chairman. We will be pleased to respond to any questions you might have. [The prepared statement follows:] STATEMENT OF JOHNNY C. FINCH, SENIOR Associate DirecTOR, GENERAL Mr. Chairman and members of the subcommittee, we are pleased to be here today to assist the Subcommittee in its inquiry into the use and effectiveness of the research and experimentation tax credit. The credit, which was enacted as part of the Economic Recovery Tax Act of 1981, authorizes certain taxpayers to reduce their income tax liabilities by a percentage of the amount spent on qualified research and experimentation. Through this legislative provision, the Congress sought to encourage business firms to perform the research and experimentation necessary to increase the overall competitive stance of the U.S. economy. The tax credit is scheduled to expire on December 31, 1985. Today, this Subcommittee is holding hearings with a view toward determining whether the credit should be retained beyond 1985 and, if so, whether the credit should be modified to make it more effective. In preparation for this hearing, the Subcommittee asked us to gather certain information in industry and IRS experience with the credit. Due to time constraints, we did not attempt to develop a complete, scientific analysis of the use and effectiveness of the research and experimentation tax credit. We tried instead to quickly identify, and then gather information on, a judgemental sample of companies that were potential users of the tax credit. In so doing, we recognized that any data we developed would not be projectable to larger populations. Although the information we developed is not statistically projectable, we nonetheless believe that it provides some insight into issues relating to the tax credit which should prove helpful in the congressional decisionmaking process. We identified our sample of companies through several different sources including (1) data filed by public corporations with the Securities and Exchange Commission concerning their expenditures on research and development activities, (2) IRS-provided information pertaining to taxpayers who had claimed the tax credit, and (3) a listing of high technology companies provided to us by a trade association representative. In total, we identified and sought to obtain information on 316 companies. Of these, 209 had claimed the tax credit during tax year 1981, 1982, and/or 1983. We used the information obtained from these 209 companies to ascertain who used the credit, for what activities, and at what cost to the government. Seventy-one companies told us that they had not claimed the tax credit during those years. We used information from these 71 companies to explain why the credit was not claimed. The remaining 36 companies did not respond to our inquiries. We interviewed representatives for 92 of the 209 companies that had claimed the tax credit. We also obtained tax return information from IRS for 45 of these 92 companies. IRS was unable to provide us with tax return information on the remaining 47 companies within the relatively short time period during which we carried out our study. For the remaining 117 of the 209 companies, we relied solely on tax return information supplied to us by IRS. Where feasible, we used the tax return information to (1) verify the information provided to us by certain companies and (2) obtain more detailed information on research and experimentation costs incurred both by companies that we contacted and by other companies that were potential users of the tax credit. Before discussing our findings, Mr. Chairman, I think it would be helpful to provide some background information on the tax treatment of research and experimentation expenses. BACKGROUND INFORMATION Section 174 of the Internal Revenue Code offers taxpayers an option as to how they treat certain funds invested in research and experimentation activities. Taxpayers may elect to capitalize these investments and may write-off the amounts invested over a minimum 5-year period. Alternatively, taxpayers may elect to deduct on a current year basis the costs of "research and experimental expenditures" incurred in connection with a trade or business. Treasury regulations under section 174 define the above statutory phrase to mean "research and development costs in the experimental or laboratory sense." This generally includes all costs incurred when developing or improving an experimental or pilot model, a plant process, a product, a formula, or an invention. The regulations further provide that qualifying research expenditures do not include costs for the ordinary testing or inspecting of materials or products for quality control or costs for efficiency surveys, management studies, consumer surveys, advertising, or promotion. Also, section 174 elections cannot be applied to costs of acquiring another person's patent, model, or production process or to research expenditures incurred in connection with literary, historical, or similar projects. Finally, expenditures to ascertain the existence, location, extent, or quality of mineral deposits, including oil and gas, are excluded. Besides capitalizing or expending funds invested in research and experimentation activities, taxpayers also can claim a tax credit for certain incremental investments in such activities. The tax credit was enacted as part of the Economic Recovery Tax Act of 1981 and included as section 44F of the Internal Revenue Code. The credit applies only to the extent that the taxpayer's qualified expenditures for the taxable year exceed the average amount spent for research and experimentation during a base period. The rate of the credit is 25 percent of the incremental expenditure amount. Under present law, the section 44F credit applies to research expenditures paid or incurred after June 30, 1981, and before January 1, 1986. In enacting the section 44F credit, however, the Congress expressly excluded some expenditures from the definition of qualified research. These were expenditures for: Research conducted outside the United States; research in the social sciences or humanities; and research funded by any grant, contract, or any governmental entity.1 Proposed Treasury Department regulations under section 44F seek to implement the Congress' intent that the credit generally be allowed for those costs allowed under section 174. That is, the regulations permit use of the tax credit for expenditures directed at developing innovative products and/or processes. But the proposed regulations are more descriptive than the section 174 regulations. For example, the section 44F regulations specifically exclude use of the credit for: The routine, periodic, or cosmetic alternation or improvement of existing products commercial production lines, or other ongoing operations; the routine design of tools, jigs, molds, and dies; the construction of copies of prototypes after construction and testing of the original prototype has been completed; planning for commercial production and trial production _runs; engineering follow-through or trouble shooting during commerical production; adapting an existing capability to a particular requirement or customer's need as part of a continuing activity; and routine date collections. Under section 44F, eligible expenditures consist of both in-house and contract costs. In-house costs consist of research-related wages, supplies, and rental expenses. Contract costs refer to expenses associated with research conducted for the taxpayer 1 The party that actually carries out research for a contractor generally is not eligible to claim the tax credit. Rather, it is the party which elects to fund research via contract that is eligible to claim the tax credit. |