The Tax Break That Pays Companies to Do Research
The research and development tax credit reduces the tax of companies that spend on innovation, aiming to encourage research that benefits society beyond the company. It is popular, costly, and hard to target.
Subsidizing Innovation Through the Tax Code
Governments want companies to do research, because innovation drives economic growth and its benefits often spread beyond the company doing it. To encourage research, many governments offer a research and development tax credit, reducing the tax of companies that spend on qualifying research, effectively subsidizing innovation through the tax code.
The credit lowers the after tax cost of research, making it more attractive for companies to invest in it, on the logic that companies would otherwise do less research than is socially optimal, since some of the benefits spill over to others. By reducing the cost, the credit aims to encourage more research than companies would do on their own, capturing the broader benefits of innovation for society. It is a widely used and popular policy, and also a costly and contested one, raising questions about what it actually encourages.
Research benefits more than the company that does it, so companies do less than society wants. The credit tries to close that gap by paying part of the bill, betting the extra research is worth the cost.
The Spillover Rationale
The core justification for the credit is that research produces spillovers, benefits that extend beyond the company doing the research to competitors, other industries, and society. Because the company cannot capture all the benefits of its research, it does less than would be socially optimal, underinvesting from society perspective.
| Who benefits from research | Captured by the company? |
|---|---|
| The company itself | Yes |
| Competitors and other firms | No, spills over |
| Society broadly | No, spills over |
The spillovers mean the social return to research exceeds the private return, so companies, capturing only the private return, underinvest relative to what would benefit society. The credit addresses this by subsidizing research, raising the private return closer to the social return and encouraging companies to do the research whose broader benefits they cannot capture. This spillover rationale is the economic case for the credit, grounded in the idea that research benefits society beyond the company, justifying a subsidy to encourage more of it.
The Targeting Problem
A central difficulty is defining what qualifies as research and ensuring the credit actually encourages additional research rather than rewarding research companies would have done anyway. Defining qualifying research is genuinely hard, since research shades into ordinary product development and other activities, creating disputes over what counts and opportunities to claim the credit for activities that are not really the innovation the credit intends to encourage.
The deeper problem is additionality, whether the credit encourages new research or merely rewards research that would have happened regardless. If a company would have done the research anyway, the credit is a windfall that reduces its tax without encouraging any additional research, failing its purpose. Ensuring the credit encourages genuinely additional research, rather than subsidizing existing research, is difficult, since it is hard to know what a company would have done without the credit. These targeting problems, defining qualifying research and ensuring additionality, are central to the debate over the credit, since a poorly targeted credit costs revenue while encouraging little additional research, rewarding companies for what they would have done anyway.
The Design Choices
The design of the credit affects how well it targets additional research, and various approaches try to improve it. An incremental credit, rewarding only research above a baseline of past spending, aims to encourage additional research rather than subsidizing all research, targeting the increase rather than the total. This improves additionality but is complex and can be gamed by manipulating the baseline.
Other design choices affect who benefits, since a credit against tax owed helps only profitable companies, while young research intensive companies without profits may not benefit unless the credit is refundable or can offset other taxes. Making the credit useful to loss making startups, which do much valuable research, requires design features like refundability or offsetting payroll taxes, extending the benefit to companies that would otherwise be unable to use it. These design choices, incremental versus flat credits, refundability, and the definition of qualifying research, determine how effectively the credit targets additional research and reaches the companies whose research the credit most wants to encourage, shaping whether the credit achieves its purpose or merely reduces taxes for research companies would do regardless.
The Bottom Line
The research and development tax credit reduces the tax of companies that spend on research, aiming to encourage innovation whose benefits spill beyond the company to society, addressing the underinvestment that results from companies capturing only part of the return. Its central difficulties are defining qualifying research, which shades into ordinary development, and ensuring additionality, encouraging new research rather than rewarding research companies would have done anyway. Design choices, incremental credits, refundability, and the definition of research, determine how well it targets additional research and reaches the companies whose innovation it most wants to encourage, making the credit a popular but contested policy whose effectiveness depends heavily on its design.