The debate resumes over making credits for R&D investments permanent, as the U.S. House of Representatives endorsed a bill to that effect in May before it heads to the Senate and then maybe on to the White House.

Key questions on the best approach to credits, according to experts at Wharton and New York University, include: Should incentives encourage some kinds of research over others? Should investments simply be fully expensed when made? And, should the credits be made permanent?

Advocates of the tax credit maintain it fosters innovation and want it to become a permanent incentive in order to remove uncertainties about possible expiration or revocation down the road. Critics say it is a tax giveaway that some companies abuse and that it would come at the cost of other public programs the government ought to support.

President Barack Obama has said he is willing to make the tax break a permanent incentive, if only ways were found to finance the estimated $180 billion it would cost in taxes over a 10-year period. Otherwise, he has threatened to veto it.

The R&D tax credits have worked well in the past, according to Nirupama Rao, a visiting professor of business economics and public policy at Wharton and a professor at New York University. “The overwhelming evidence is that they are effective. If you make R&D cheaper for corporations, they seem to do more [of it].” Her research shows that “a 10% decrease in the price of R&D leads to a more than 10% increase in R&D spending.”

Rao, who has researched the impact of R&D tax credits for many years, spoke on where such measures need to be reworked on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

“Politicians on the left, politicians on the right — everybody loves the R&D tax credit,” Rao said. They support the tax credit in the run-up to elections, gladdening the hearts of businesses that benefit from it. Yet, they fail to make it permanent when they assume office. “To make it permanent would increase the budgetary expense and finding the pay-fors for it is hard, especially when you can do it this other way, where you just have it temporarily in place but would likely extend it every time.”

“If you make R&D cheaper for corporations, they seem to do more [of it].” –Nirupama Rao

Notwithstanding bipartisan support, since its inception in 1981 the R&D tax credit has expired eight times, been extended 16 times, and been modified on several occasions, as Rao points out in a brief published by the Penn Wharton Public Policy Initiative. Two attempts last year to make it permanent failed in the Senate. Meanwhile, in 2012, U.S. businesses secured R&D tax credits totaling $11.1 billion, and that will likely grow to between $12 billion and $14 billion this year, she added.

In order to get an unbiased estimate of the impact of the tax credits, one must account for other factors like supporting policy changes and the uncertainty businesses face over its continuation, said Rao. She recalled that in the 1980s, the credit had not been allowed to expire and therefore “corporations had a lot of faith that the credit would be in place [and that] even if it were temporarily legislated, it would be extended.”

Today, firms looking to spend R&D dollars with the incentive of the tax credits face a lot more uncertainty, said Rao. One year they will not easily forget is 1995, when the credit was allowed to lapse and it was not put in place retroactively, she noted. Firms did not receive tax credits they did for their research spending between June 1995 and June 1996.

“Having had that experience they might now be more nervous to spend, if the policy is uncertain,” Rao said. “The big question is how uncertainty affects corporate spending habits [in R&D].”

Wharton professor of business economics and public policy Kent Smetters said he is “not a fan” of the R&D tax credit, “because it distorts activity toward some industries.” It also makes fundamental tax reform harder, he added.

According to Smetters, what the U.S. really needs is comprehensive tax reform that would make the country’s corporate tax rates more competitive with other OECD (Organization of Economic Cooperation and Development) countries, whose 34 members are mostly developed countries. “Even better, we should allow all investments, and not just some, to be fully expensed when made. Selective credits undermine this effort by creating additional stakeholders in the status quo.”

Sizable Tax Savings

In her research into how firms benefit from the tax credits, Rao found flaws in existing methods that relied on 10K regulatory filings. Not only are they based on accounting — and not tax — measures, they also exclude R&D conducted in foreign countries or research spending that is not experimental enough or is not basic research, she said.

Rao therefore worked with the Treasury department to ferret out tax returns of firms to get a more accurate reading of the benefits. By her calculation, the savings for firms because of the tax credit was between 6% and 7% of their overall tax dues. “A 7% discount is not trivial,” she said. “My research and research by others have shown that that is enough of a discount to get the companies to spend more. We do get some bang for our bucks when we are dishing out these tax credits.”

Complex Metrics

If lawmakers make the credit a permanent, they should remove its complexities to make it more effective, said Rao. Firms only earn credit on their so-called “marginal spending,” spending above a “base” derived from historical R&D spending.

Rao further highlighted the complexities in computing two of the biggest types of R&D tax credits. In one called the “traditional credit,” beneficiary firms have to calculate the ratio of their total R&D spending divided by total sales between 1984 and 1988, which is roughly three decades ago. Firms that did not exist 30 years ago or do not have the data for all of those years are entitled to a flat 3% as their base to calculate their credits. “Having a base that is based on 30 years ago is silly,” she said. “It’s before the Internet, [and] before pharmaceutical innovation.”

“We should allow all investments, and not just some, to be fully expensed when made.” –Kent Smetters

Firms using the second method, called the “alternative simplified credit,” compute their credits based on their R&D spending over the preceding three years. However, that method drives firms to put off their investments for a later date “because every dollar you spend today becomes part of your base for the next three years,” said Rao. “That undermines the [R&D tax] credit.”

The “alternative simplified credit” route happens to be more popular among firms seeking R&D tax credits, but Rao cautions policy makers of its dangers. “[It] leaves a lot of firms out in the cold with negative [tax credit] rates or low rates and we are weakening the incentive for R&D,” she said.

Pointers for Policy Makers

The way to get around those complexities is to offer a flat tax credit of 4% on everything firms spend on research, according to Rao. “It’s simple, it doesn’t rely on data from 30 years ago and it doesn’t have that moving average base that leads to low and negative credit rates for many firms.”

Rao argued that when regulations disallow certain kinds of research spending and allow certain other kinds of get the credit, “we are also steering firms towards certain research activities.” She also saw a need for lawmakers to explore if and why startups and small businesses do not avail of the tax credits as much as large firms do. Such firms may not have the revenues to take advantage of the credits, or may not have sophisticated tax departments to help them secure the maximum benefits.

According to Rao, another aspect policy makers need to explore is the “spillover effect” of innovation, where other companies in an industry’s ecosystem or in a geographical neighborhood benefit from one firm’s R&D investments. “If we knew what types of research had more spillovers, we want to design the regulations so that that gets subsidized.”

All said, Rao did not see sufficient traction for making the R&D tax credits permanent. “A cynical observer looks at this as a temporary tax credit that has campaign cash returns every time it comes up for renewal,” she said. “That is one reason legislators might favor it being temporary.”