different investments; losses from a few bad guesses can be averaged in with the gains from others." 21/

The corporate bias against long-term, risky

investments in R&D is reinforced by the fact that every additional dollar spent on R&D means a dollar less in pre-tax corporate earnings per share in that same year, since R&D costs are generally expensed in the year incurred for financial accounting purposes. While this treatment is entirely proper, it does place R&D at a disadvantage as against investments, for example, in plant and equipment, the cost of which may be spread out over any period from 5 to 40 years for financial accounting purposes.

Most high technology companies always will have more potentially productive R&D projects than can be properly financed at any one time. Management faces the very difficult task of allocating limited budgetary resources among R&D projects seeking to develop new products, investment in plant and equipment to expand production of existing products, R&D projects attempting to modernize production processes, more vigorous marketing efforts, and a host of other competing needs. Faced with these alternatives, the long-run nature of most R&D projects, their riskiness of commercial success, and their short-run impact on corporate earnings, it is not surprising that U.S. corporate investments in R&D would tend to fall short of the levels needed to maintain U.S. technological leadership.

21/ Id.

THE ADVANTAGES OF TAX-BASED R&D INCENTIVES

Because of the gap between the overall economic

benefits and the private benefits in undertaking R&D, the existence of major incentives available to foreign competitors, and the competing needs for the scarce capital of U.S. corporations, the free market if left alone will produce a less than optimal, or even competitively acceptable, level of industrial R&D in the United States from the perspective of both the individual company and the U.S. economy generally. Governmental policies can address this R&D shortfall through either of two ways. First, the Government can attempt to isolate its causes and influence the market processes to enhance the market's efficiency. Alternatively, Government can take the matter directly into its own hands, replace the market, and directly determine the R&D investments it desires, though direct expenditures, grants and subsidy loans, which are currently included under the rubric of "industrial policies." 22/

22/ See Schultze, Public Use of the Private Interest, supra, 28-30. See also, as an example of the industrial policy approach, H. R. 4360, the "Industrial Competitiveness Act," introduced in the 98th Congress by Congressman LaFalce and others. This approach was also embraced by Professor Eisner in his testimony before the Subcommittee (see Prepared Statement of Robert Eisner, "The Research and Experimentation Tax Credit," for the Subcommittee on Oversight, Committee on Ways and Means, U.S. House of Representatives, August 2, 1984, at 14).

It is the strongly held view of the associations

preparing this paper, and of their collective membership, that the industrial policy approach is fatally flawed. Expanding industrial R&D through Government grants and loans forfeits all of the important strategic advantages of free market arrangements. Centralized and government-directed R&D programs will inevitably miss important market opportunities and will lead to ineffective and inefficient solutions to our vital economic problems. Such programs can tax the ability of the Government beyond its limit to make complex resource allocation decisions. 23/ Grantsmanship rather than technical promise can dominate resource allocations. Given the dramatic

technological change experienced by high technology companies and the tremendous rate at which those changes occur, it would be exceedingly difficult even to accumulate the necessary information at a central level to permit direct Government

"The

23/ For example, the Washington Post recently noted that: Pentagon's Strategic Computing Program, widely seen as a response to Japan's highly touted Fifth Generation computer project is rapidly falling behind schedule because of logistical problems and internal squabbling, according to several Defense Department sources. The program already has undergone at least one major reorganization designed in part to minimize personnel disputes [A]gency officials have serious questions about how to measure progress in the program, that the perception of the program by the academic research community is negative, and that it is doubtful that the disparate technologies can be integrated for demonstrable programs in the allotted time." Washington Post, September 5,

intervention. It would be even more difficult to assume that governmental investments would be made on the basis of this information rather than through more politicized processes.

On the other hand, utilizing the tax system to provide incentives for industrial R&D does not replace market decisions, but merely influences the factors which underlie those decisions. The principal advantage of a tax incentive mechanism to encourage R&D spending lies precisely in the ability of such an incentive to affect the manner in which thousands of separate private decisionmakers, who possess the most relevant information and who are best positioned to act, balance the benefits and costs of specific alternatives under the particular circumstances actually confronting them. The areas for research spending are chosen by those most knowledgeable as to the technology and the economics of the market. The innovations that do arise must then surmount the rigorous test of the marketplace, rather than satisfying arbitrary or politically motivated Government criteria.

In short, R&D incentives operating through the tax system promote market solutions based on decisions by those individuals most familiar with market needs and innovative responses. It is the only practical way for the Government to encourage expanded industrial R&D without impeding the

decisionmaking flexibility necessary to maintain U.S.

competitiveness in world markets.

EFFECTIVENESS OF THE CURRENT

R&D TAX CREDIT AS AN INCENTIVE

The R&D Credit and Levels of R&D spending

The R&D credit was enacted in mid-1981. It was not fully phased in until 1983, and regulations for applying the credit were not proposed until that year. From its enactment the credit has been scheduled to expire at the end of 1985. Moreover, in 1981 and 1982 this country faced the most severe downturn in economic activity it has experienced since the 1930's. All of these factors, combined with the long-run nature of the R&D planning process, make it unlikely that the true impact from the R&D credit can now be measured precisely. Nonetheless, a careful review and analysis of the data

available to date suggests the positive conclusion that the credit may well have been a significant factor in increasing R&D spending since 1980.

Overall R&D Spending During the 1981-1982 Recession

The most important indication that the credit may have significantly influenced R&D spending levels since 1980 is the fact that R&D spending remained strong in the 1981-1982 economic recession. As is documented below, R&D spending in real terms generally declines during a serious recession. despite the relatively severe 1981-1982 recession, total corporate R&D spending increased from $30.5 billion in 1980 to

But