The growth in qualifying expenditures was greater for smaller corporations than larger corporations. In 1981, for example, qualifying expenditures increased by 104.5 percent for corporations with assets between $1 million and $10 million compared to an increase of only 32.2 percent for corporations with assets greater than $10 million. Although the 1982 data do not reflect the returns of very large corporations, preliminary indications are of a substantial increase in R&E expenses over 1981, although we suspect that when the final data are in, the increases will be somewhat less than the increase in 1981. Data relating to the growth of R&E expenditures obviously are critical in trying to determine whether the credit is effective and whether it is indeed performing its objective in encouraging these expenditures. The preliminary indication of substantial growth recorded by taxpayers does not at this time support firm conclusions about the effectiveness of the credit. The increase in expenses reported by taxpayers may indeed have come from the credit and we presume indeed that the credit has had some intended incentive effect. But it may also be that some of that increase came simply because taxpayers have had to reclassify costs as R&E in order to claim the R&E credit. Thus, significant conclusions about the credit's effectiveness as a spur to innovation simply must await collection of data for a larger number of years. Careful scrutiny of the credit and its effect on R&E expenditures also must take into account that the actual incentives supplied by the credit will vary among different taxpayers. The credit will be of maximum value only to taxpayers who have current tax liabilities against which to offset the credit or tax liabilities from prior years' gains which the credit could be carried. For 1981 we estimate that taxpayers were not able to utilize approximately 23 percent of the tenative credits against 1981 tax liability or liabilities for previous years. Of course taxpayers will be able to utilize those credits to the extent they do have tax liability in years subsequent to 1981, and again our data as it develops for subsequent years will give us a feel as to the extent to which those credits actually were utilized. As I indicated, Mr. Chairman, because we believe that the data is not complete and that although the data do show an increase in R&E expenses and may indeed indicate that the credit is having an incentive effect, we are supportive of extending the R&E credit beyond its current expiration date of December 1985 as part of the administration's general support of research and experimentation. Given our large limited experience, however, we would oppose, we opposed and we will continue to oppose, making the credit permanent at this time. Additional experience will enable us to make informed judgments, we believe, about the effectiveness of the credit. Current information simply is inadequate to do that. Although we favor extending the credit, we believe that as part of any extension, the range of expenses eligible for the credit must be reexam In our view, the current definition of qualifying expenses does not adequately target the credit for innovative R&E activities. The imprecision of current law has permitted taxpayers unwarranted flexibility in classifying costs as R&E expenses. The definition of qualifying expense for purposes of credit must not only identify those innovative R&E activities that merit Government support, but must incorporate sufficient subjective standards for taxpayers to plan their activities with reasonable certainty as to the credit's availability. We begin with the proposition that all costs incurred in conducting basic research should be creditable. However, the definition of R&E should continue to exclude basic research, as it does today, in social sciences or humanities or basic research conducted outside the United States. In identifying expenses for commercial research that should receive the credit, we believe as a first principle that research entitled to the credit must be designed to produce a significant technological improvement in a business component. A useful definition incorporating that principle can be found in the Senate amendment in H.R. 4170, the Deficit Reduction Act of 1984. Although the conferees agreed to defer consideration of the R&E credit, the Senate definition does in fact target technological innovation and provides taxpayers with relatively objective rules. The Senate concluded that the definition derived from section 174 is too broad. The new definition was developed by the Senate Finance Committee in consultation with representatives of Treasury and industry and we believe that this joint effort did in fact result in a definition which responds both to our concerns that the credit be targeted to R&E activities relating to technological innovation and industry's desire for definition with relatively objective standards. Under the Senate definition, a business component is technologically new and improved if the new and improved characteristic of the component is technological in nature and substantially all the development activities involve a process of experimentation relating to functional, rather than stylistic, aspects of the component. This requirement is designed to exclude nontechnological activities such as the development of financial products or activities relating to the provision of services. The term "business component" is designed to focus on the particular components of a product to which the R&E activities relate. This will prevent routine product development cost from qualifying for the credit. In order to exclude from the credit activities that would not, by their nature, result in technological innovation, the Senate definition also denies the credit for certain activities regardless of whether a new or improved business component is involved. This exclusion is designed, among other things, to prevent costs incurred in reverse engineering from qualifying for the credit. In addition, the Senate definition specifically excludes activities relating to the adaptation of existing products to particular requirements of one customer and provides that any costs incurred with respect to business components after the beginning of com mercial production are not eligible for the credit. We believe this exclusion is intended and will have the effect of preventing costs associated with certain postresearch activities such as debugging or retooling from qualifying for the credit. We think the Senate definition is an important effort to improve the effectiveness of the credit. It more precisely targets the credit to innovative R&E activities while providing taxpayers with objective standards for the credit's availability. In addition to the definition of qualifying R&E expenses, we think there are certain other issues relating to the credit which should be considered as part of the subcommittee review of the credit. Some of these issues were addressed in the Senate amendment. In connection with startup companies, current law provides that R&E credit is available in connection with qualifying amounts paid or incurred in connection with the carrying on of any trade or business of the taxpayer. This requirement is intended to serve two purposes. First, it prevents tax shelters from receiving the benefit of the credit by denying to entities conducting research and development for others. Second, serves to protect the incremental feature of the credit. We think it is very important that an extension of credit retain the requirement that the R&E expenses or credit will only be allowed in connection with an ongoing trade or business. The Senate amendment did adopt a special rule for corporate taxpayers designed to address in part the availability of the credit for startup companies. In certain cases, new corporations or corporations beginning a new line of business cannot claim the credit under current law for qualifying R&E expenses because the expenses do not relate to an ongoing trade or business. Under the Senate amendment any corporation other than a corporation, personal holding company or personal service corporation would be able to claim the credit if it intends to use the results of the research in active conduct of present or future trade or busi ness. This approach would continue the current law's denial of the credit to taxpayers which merely lease or license research results, but would extend the credit to research expenses to true startup corporations not engaged in trade or business or an existing corporation entering a new business. We think this modification is a worthwhile change in the credit. The credit currently has an incremental aspect; that is, the credit is only available to the extent that qualifying expenses exceed the average of expenses over the 3 previous years. In addition, the credit has a limit on it which in effect says that the credit for expenses cannot exceed 50 percent of the taxpayer's qualifying expenses for the current year. We recognize that the base period limit on qualifying expenses under the incremental requirement makes the true value of the credit dependent on the relative growth or decline in the taxpayer's expenses from one year to another. For example, for firms which have a growth rate of somewhere between zero and 100 percent over the base period, the credit will provide a full 25-percent tax benefit. On the other hand, if the growth rate increases over 100 percent, the 50-percent cap will gradually reduce the tax benefit from 25percent benefit to as little as 122 percent. The base period limitation is appropriately intended, however, to target the credit to new or additional R&E expenses. Although the limit may introduce, as I have indicated, some disparities in the incentive effect of the credit, we continue to support the incremental focus of the credit and believe the base period limitation should be retained if the credit is extended. In addition, it might be desirable to refine the base period limit to assure that the incremental focus is not eroded by inflation. In an inflationary period a portion of additional R&E expenses will be attributable to inflation rather than to real increases in the level of R&E activity. We think it might be appropriate to consider whether a taxpayer's base period expenses should be indexed to account for the effect of inflation. In this way the credit would be provided only for real increases in R&E expenses. In connection with university basic research, Mr. Chairman, we oppose creating a separate credit for contributions to universities to conduct basic research as was proposed in the Senate amendment. However, although we do not favor creating additional incentives for contributions for research through a separate credit, we do believe the committee should examine whether the current structure of credit discourages corporations from entering into commitments with universities to fund multiyear basic research projects. A straightforward change in the law could remove the potential effect under current law that limits these multiyear grants by corporations and other businesses to universities. Such an approach would prvoide that the total research ad experimentation credit allowed with respect to a binding multiyear funding commitment to a university would not be reduced below the amount of the credit that would have been available had the company made the contribution in only 1 year. Of course, we would not be in favor of allowing the credit until the contribution actually was made. In conclusion, Mr. Chairman, the administration does continue to support the R&E credit, believing it can provide an important incentive to the innovative activities that are critical to these companies' economic future. In order to make the credit accomplish that objective in the most efficient method possible, the definition of qualifying expenses should be modified so as to target the credit to innovative research activities. We look forward to working with the subcommittee to improve and extend the credit. We appreciate the opportunity to offer our comments. [The prepared statement follows:] Statement of Ronald A. Pearlman, Acting Assistant SECRETARY (Tax POLICY), DEPARTMENT OF THE TREASURY Mr. Chairman and members of the subcommittee, I am pleased to have the opportunity to present the views of the Administration on the tax credit for certain research and experimental ("R&E") expenses. The need for and the appropriate form of the R&E credit is a matter of continuing interest to the Administration, and an inter-agency working group has been established to study various aspects of the credit. My testimony today will summarize our current views based on the data available at the present time. In its press release announcing these hearings, this Subcommittee raised several issues regarding the R&E credit that are of interest to the Administration. The press release focused on the effectiveness of the present credit in terms of Congress' original intention to provide an incentive for technological innovation. We believe that the central question with respect to the R&E credit's effectiveness is whether the definition of expenses qualifying for the credit has been drawn so as to target the credit most efficiently. The Administration remains committed to the R&E credit and favors extending it for an additional three years through December 31, 1988. As part of any extension of the R&E credit, however, we strongly support tying the credit more closely to those private R&E activities that are likely to result in technological innovations. With a more carefully drawn definition of qualifying expenses, the R&E credit can provide an important incentive for taxpayers to undertake essential R&E. I would like to note that my testimony will not touch upon certain topics typically associated with the R&E credit, such as the enhanced charitable deduction for certain contributions of property to universities. As we have indicated in previous testimony, the Treasury Department has strong opinions regarding the types of property which would be eligible for this enhanced deduction. Objectives of the credit I. BACKGROUND The Administration is determined to encourage continued growth of domestic R&E activity. The technological invocation necessary to the long-term vitality of the American economy will come only from a substantial commitment to R&E. Without that commitment, our competitive position in the world economy will inevitably decline. The term "R&E" in ordinary usage describes a broad variety of research activities by commercial as well as non-profit organizations. Thus, R&E embraces both basic research, i.e., research tied to general scientific, rather than specific, commercial objectives, and research activities for commercial product development. Broad government support of R&E is particularly essential in the area of basic research, which, by its nature, cannot be expected to be self-supporting. Although the scientific and technological advances from basic research ultimately may prove to have commercial applications, such applications are typically too remote to permit private investors profitably to support the research. For this reason, the Federal government has traditionally taken a lead role in funding basic research, primarily through grants to universities and other non-profit organizations. Government support of R&E also is appropriate with respect to certain forms of research with direct commercial applications. A business will invest in R&E only to the point that the expected commercial returns are at least equal to that available from alternative investments. Although opportunities for commercial profit ordinarily may reflect society's desired allocation of resources, the return to the private investor from R&E expenditures may not reflect society's true benefit from resulting innovation. If a business invests a new type of product, or "builds a better mousetrap," imitators will appear and share the profits to be realized from this innovation. This will occur in many cases despite the fact that a business patents a new product or attempts to keep an innovative process secret. To the extent the investor does not fully capture the commercial returns from technological innovation, businesses may spend less than optimal amounts for R&E. Where market rewards for R&E expenditures do not match society's need for technological innovation, it falls appropriately upon government to supply additional incentive. Existing law The federal income tax system currently provides two incentives for qualifying R&E expenditures. Section 174 allows a taxpayer to deduct currently "research or experimental" expenses incurred in connection with the taxpayer's trade or busi |