Liquidity, cash flow, and R&D

In addition to affecting the required pre-tax return which must be earned by investments in depreciable assets, ACRS will also affect corporate cash flows and, hence, corporate liquidity. Cash flow, F, defined as:

(3) F1=(R-D1)(1−u)+D+ITC1 =R1(1−u)+uD1 + ITC,

where R is corporate profits before depreciation deductions, u is the corporate tax rate, D is depreciation deductions allowed for tax purposes, and ITC is the investment credit. From equation (5) it is readily seen that the change in cash flow due to a change in capital cost recovery rules is:

(4) AF=uAD+AITC

where AD is the change in depreciation and AITC is the change in the investment tax credit.

It has been argued that because of the uncertain payoff to investment in innovation, firms will be reluctant or unable; to obtain external funds to finance the development of a new product or process. Therefore, it is argued, a substantial R&D effort is more likely to be undertaken by firms which can draw on a substantial pool of internally generated funds-i.e., on cash flow. If R&D spending responds positively to cash flow, the liquidity effect of ACRS described in equation (4) should, therefore, have a positive impact on R&D outlays.

Empirical evidence on the relationship between R&D spending and liquidity is mixed. Mueller (1967) and Grabowski (1968) both find a significant positive relationship between R&D expenditures and liquidity variables. However, other studies by Hamberg (1960), Scherer (1965), Elliott (1971), and Smyth, et al. (1972), fail to detect a significant relationship between R&D and liquidity. In summarizing this evidence, Kamien and Schwartz (1975) conclude that the evidence in favor of the hypothesis that liquidity will significantly effect R&D is, at best, mixed. However, they caution (1975, p.26) that "failure to support the hypothesis may not indicate the lack of importance of this variable. Liquidity or profitability may be threshold factors', necessary is some degree for R&D activity, but not linearly related to the amount of innovative activity".

Thus, whether the liquidity effects of ACRS will have a favorable impact on R&D spending depends on whether there is a positive and significant relationship between R&D outlays and liquidity. To date, the empirical evidence on this point is mixed. However, to the extent there is some positive relationship, the liquidity effects of ACRS may vary among industries.

An approximate indication of how different depreciation schemes will affect cash flows may be obtained by estimating and comparing the present value of tax cash flow per $1 of new investment, defined as:

(5) PVP uZ+k

where u is the tax rate, Z is the present value of depreciation deductions generated by $1 of new investment, and k is the investment tax credit; per $1 of new investment. Table 6 presents estimates of (5) by industry under both ADRS and under the TEFRA version of ACRS. The values of Ž and k are taken from estimates calculated by the Treasury Department depreciation model of the present value of depreciation deductions under both sets of depreciation rules. Columns (5) and (6) rank the industries by the projected absolute and percentage increase, respectively, in liquidity due to the enactment of ACRS.

It is interesting to compare the rankings in columns (5) and (6) of Table 6 with a grouping of industries according to R&D intensity. This is done in Table 7. The first three columns of Table 7 are taken from Science Indicators 1976, while columns (4) and (5) are taken from Table 6. The data in Table 7 show that the cash flow benefits of ACRS will not favor R&D-intensive industries. Indeed, the most R&D intensive industries are ranked relatively low in terms of the cash flow benefits of ACRS.

TABLE 7.-MEASURES OF R&D INTENSITY, BY INDUSTRY, 1961-74, COMPARED WITH INDUSTRY

$ Data for company funds are not available for several years. Means computed using only those years for which data is available. • Separate rankings for textiles and apparel, respectively.

Source: Table 4-16, Science Indicators 1976 and table 14.

Relative value of R&D eexpensing

The impacts of different tax regimes, including ACRS, on the relative value of R&D expensing are easily evaluated using the concept of the required pre-tax return. The basic relationship to be used for this purpose is equation (6). Equation (6) defines the real pre-tax return, p which must be earned in order to earn a desired, or "target", after-tax return of r on an investment which is partially expensed. The fraction of the investment which may be expensed equals a, while (1-a) is the fraction of the investment subject to normal capital cost recovery rules. The effective mariginal tax rate on the entire investment equals m, while e and s are the effective marginal tax rates on the expensible and non-expensible portions of the investment, respectively. The real pre-tax return is then

Under expensing, it can be readily shown that the effective marginal tax rate is zero, so that e=0, while for the portion of the investment which cannot be expensed, s+0. Thus, if we let R=r/(1−s) represent the required real pre-tax return

which must be earned in order for the non-expensible portion of the investment to earn an after-tax real return of r, equation (6) may be rewritten as

Because R&D is a much more important input into investments in innovation than into other, more traditional investments, a is likely to be greater for investments in innovation than for other investments. Indeed, a reasonable first approximately may be to assume that a>0 for investments in innovation and a=0 for other, non-innovation-oriented, investment activities. Under this assumption, the real pre-tax returns which must be earned by innovation and non-innovation-oriented investments are given by

(8) pi=arı+(1 − a)R1, (a>0)

(9) ρT=агT+(1− a)RT=RÂ(α=0)

where p is the real pre-tax return which must be earned by an innovation-oriented investment in order to earn a real after-tax return of r1, and pr is the corresponding real pre-tax return which must be earned by a "traditional" (i.e. non-innovation-oriented investment) in order to earn a real after-tax return of г. Because innovationoriented investments are riskier than traditional investments, it is plausible to assume that the former type of investment must earn a higher real after-tax return than the latter type of investment-i.e., that r1>IT.

Form (8) and (9), the relative required pre-tax return which must be earned by an innovation-oriented investment as compared to another investment is

Expression (10) can be used to evaluate how various tax regimes affect the relative attractiveness of innovation-oriented as compared to traditional investments. As the ratio (p1/p1) increases, the rate of return threshold, p, which innovation-oriented investments must meet or exceed increases relative to the corresponding threshold, pr, which more traditional investments must meet or exceed. That is, as (p1/PT) increases, innovation-oriented investments become relatively less attractive. Conversely, as (p1/PT) decreases, innovation-oriented investments must meet a relatively less stringent rate of return test, and hence become relatively less attractive.

From (10) it is readily seen that the ratio (p1/PT) increases as RT falls and decreases as RT rises. Because Rr is the required pre-tax return which must be earned by traditional investments in depreciable capital. RT will decrease as capital cost recovery provisions become more generous, and increase as capital cost recovery provisions become less generous. Thus, a change in tax regime, such as substitution of ACRS for ADRS, which permits non-R&D capital to be recovered more rapidly, can have the effect of increasing the ratio (p1/pÅ), thereby reducing the relative attractiveness of R&D-intensive investment projects.

The estimates in Table 8 illustrate the impact of ACRS on the relative position of R&D-intensive investments. In these calculations, we allow the share of total innovation costs which qualify for R&D expensing to vary from 0.1 to 1.0. The required real after-tax return is assumed to be 6 percent for innovation-oriented investments, 4 percent for traditional investments, and the average pre-tax returns which must be earned under different tax regimes if depreciable capital used in U.S. manufacturing is to earn an after-tax return of 6 precent. The values used for R, are the corresponding pre-tax returns when the required after-tax return is 4 percent.

a=0.1.

a=0.4.

a=0.8..

a=1.0..

TABLE 8.-RELATIVE POSITION OF R&D INTENSIVE INVESTMENTS

As is seen in Table 9, the required pre-tax return which must be earned by R&Dintensive investment projects either has not been affected by ACRS (the case where 100 percent of the inputs are expensible R&D) or is lower after ACRS. However, the required pre-tax return which must be earned by more traditional investments, PT, has also been reduced, indeed has been reduced proportionately more than has pr The net impact of ACRS therefore is a scale effect favorable to all investment projects using depreciable-i.e., both p, and pr are lower under ACRS—and a substitution effect which tends to favor non-R&D intensive investments. Because the qualitative impact of the substitution effect is the opposite of that resulting from the scale effect, the ultimate impact of ACRS on the share of total investment dollars allocated to R&D-intensive investments is ambiguous. Table 8 also illustrates the differing impacts of the TEFRA version of ACRS as opposed to the ERTA version. Specifically, both the scale and the substitution effects of TEFRA are more modest than those resulting from ERTA.

TABLE 9.-VALUE OF R&D CREDIT WHICH MAINTAINS THE RATIO OF p 1 ΤΟ ρτ BEFORE AND AFTER

The calculations presented above show only the indirect effects on the non-capital (Section 174) portion of R&D resulting from the enactment of ACRS. However, the non-capital portion is also directly affected by the new R&D tax credit, and therefore these calculations do not capture the full extent of recent tax policy changes on R&D.

Modeling the impact of the R&D tax credit in its current form is complicated by two factors. First, the R&D credit is temporary rather than permanent. Second, it is based on incremental rather than total R&D expenditures. Both the timing and the applicable expenditures factors must be considered in order to access the impact of the R&D tax credit. In light of the recent emphasis on distinguishing between permanent and temporary policy changes, it is useful to organize the discussion around this distinction. Thus, we first examine the impact of enacting a permanent nonincremental tax credit for R&D, and then consider the impact of making such a tax credit temporary.

Permanent R&D tax credit

Equation (11) defines the pre-tax return, r,required to earn after-tax real return, r, when both expensing is allowed and an investment qualifies for a tax credit of v percent;

Equation (11) implies that combining a tax credit with expensing is tantamount to providing a rate of return subsidy equal to v(r+8)/(1−u). Substituting Ŕ for the term a r/1-e) in equation (6) yields:

where is the statutory marginal tax rate, da is the economic depreciation rate of the expensible portion a of the investment, and R is the pre-tax return to the nonexpensible portion (1-a). Equation (13) defines the pre-tax return required to earn a real after-tax return, r, when the portion of an investment project which can be expensed, a, also qualifies for a tax credit of v percent.

Two main conclusions can be drawn from (13). First, while extending a tax credit will generally lower p, a given credit of v will reduce p more the greater is the value of a. The greater the value of a, the greater is the share of the expensible asset in the investment project. Because the R&D credit is essentially limited to expenditures which also qualify for expensing under Section 174, such a credit would favor investment projects (i.e. lower p more) the greater the share of Section 174 R&D in total project costs. Section 174 includes only labor and other variable R&D inputs, and therefore the current R&D credit favors labor-intensive R&D, and more generally, innovation activities in which labor intensive R&D is a relatively important input. Second, the greater is the value of 8, the more a given credit of v will reduce p. Moreover, the greater is the value 8, the more rapid is the rate at which an asset depreciates. Hence, (13) shows that a permanent R&D tax credit will favor both shorter-lived R&D, and innovation projects which are relatively dependent on short-lived R&D as an input.8 Of course, other tax structures can have a similar effect. In fact, as equation (13) shows, the greater the value of 8, the more a given corporate tax rate, μ, will reduce p. In effect, any tax system which introduces a subsidy will have similar effect on p.

7

Temporary R&D tax credit

Enacting a permanent tax credit for R&D stimulates R&D spending in two distinct ways. First, as shown in (11), by reducing R such a credit encourages firms to substitute investments in R&D for other investments in every period subsequent to enactment of the credit. Second, by subsidizing one of the firm's inputs, such a credit would have a wealth effect which would encourage the firm to purchase more of all capital inputs, including R&D in every period subsequent to enactment of the credit.

These impacts may be compared with those of a credit which, say, was enacted to take effect at time t, and then was scheduled to expire at time t+1. Such a credit would still encourage firms to substitute R&D for other investments at time t. However, because R&D would be subsidized in time t, but not time t+1, firms would also have an incentive to substitute R&D undertaken in time t for R&D undertaken in subsequent periods. This incentive for intertemporal substitution would be stronger the longer-lived the R&D. The reason is straightforward. The slower the rate at which a unit of R&D depreciates, the more productive a unit of R&D purchased at time t will be subsequent periods. In the limiting case in which a unit of R&D did not depreciate at all, a unit of R&D purchased at time t would be a perfect intertemporal substitute for a unit of R&D purchased at time t+1 insofar as its ability to

'The total amount of R&D could still increase, even if the share of R&D in total capital outlays decreased.

8 This is a standard result in the literature on the economic effects of investment tax credits and is not unique to the R&D credit. The point is also recognized by Gravelle (1981).