July 30, 2020
by Mark Everson, Former IRS Commissioner and alliantgroup Vice Chairman
Published in Tax Notes
Congress is to be commended for moving swiftly this spring to mitigate economic fallout from COVID-19, but the pandemic has exposed core vulnerabilities for the United States that require more than patchwork solutions. Now is the time to improve tools in the tax code that will make American businesses more competitive while increasing their ability to withstand the inevitable future economic shocks. We should start with the R&D tax credit. Let’s make it more generous, especially for U.S.-based manufacturers and small and mid-size businesses.
The Little Dutch Boy
Many Americans are familiar with the tale of the little Dutch boy who puts his finger in a dike and saves his village from certain disaster. In the story, a boy comes upon a leaking dike late in the day. He realizes the existential threat and acts immediately, sticking his finger in the dike to stop the flow of water and keep the dam from collapsing.
The boy suffers through a long, cold night until villagers arrive the next day in time to make repairs that save the dam and thus their community.
The story well summarizes where we stand now as a nation. We have our finger in the economic dike and have averted catastrophe thus far, but we are in desperate need of a lasting solution.
Continued Short-Term Assistance to Get Us Through the Night
There is a clear need for continued temporary relief to boost the economy and help the many millions in need stay afloat. Congress should extend supplemental unemployment benefits but put them on a path to normal benefit levels so people are not being paid more when out of work than they were in their jobs.
A compromise on this contentious issue would be to provide states with the full $600 in weekly funding for each unemployment insurance (UI) claimant, but allow states to set the amount of the incremental benefit and allocate any unused portion to replenish largely depleted UI trust funds. According to data from the departments of Labor and Treasury, 24 states saw their UI trust fund balances decline by more than 50 percent over the first six months of 2020.
Health benefits is another area that merits temporary assistance. Many who have lost health insurance during the pandemic simply cannot afford the high cost of COBRA payments. It would also make sense to offer short-term support to employers who scale back employee work hours because of reduced demand, but who still wish to provide a full suite of health benefits until revenues improve.
Any new round of stimulus payments should be more targeted, at the very least eliminating the deceased from receiving checks. And finally, additional general grants to cash-strapped states would be highly beneficial.
The next congressional package should also include measures fostering long-term growth of the economy, not just recovery. There is a viable tool in our tax code that policymakers are eyeing, and rightly so, one that can protect and grow jobs and serve as a building block for further economic policy initiatives.
The research and development tax credit1 applies to companies of all sizes, not just big business, and across a wide range of industries, including manufacturing, agriculture, technology, and others. Businesses that do any of the following (in the United States) likely qualify for the credit: develop or design new products or processes; enhance existing products or processes; or develop or improve existing prototypes or software.
Regarding the devastation brought on by the coronavirus, Neil Irwin recently wrote in The New York Times that industry experts are suggesting there will be “a rethink of how much any country wants to be reliant on any other country.”2 Given this dynamic, the case for strengthening the R&D credit is overwhelming. A more robust credit will improve our global competitiveness — something that is particularly important given China’s adversarial posture and control of critical supply chains. Our reliance on suppliers in distant countries has become a national security risk, one that could be mitigated by providing key sectors of the economy such as manufacturing with the support they need to thrive.
A Short History of the R&D Credit
The R&D incentive, offered under IRC section 41, has a long history of helping U.S. businesses of all sizes invest in innovation efforts. In the early 1980s, Japanese automakers were running circles around those in the United States. As many of us remember, our country faced a crisis of confidence. Congress stepped in with an incentive to help spur innovation in the auto sector and beyond.
The R&D credit was enacted as part of the Economic Recovery Tax Act of 1981. Since its inception, the incentive has been intended to reward American businesses for expending time and funds to improve products and processes, and it has proven its success many times over. That said, members of Congress have seen a need to improve it over the decades.
In 2003 Congress removed one of the biggest barriers to claiming the credit, the so-called discovery rule which required that to qualify for the credit the taxpayer would have to introduce innovations that were new to the world. Now, taxpaying businesses need only introduce activities that are new to their operations.
The incentive has evolved over time. It was extended on a temporary basis 16 times until 2015 when the Protecting Americans From Tax Hikes (PATH) Act solidified the credit as a permanent provision of the U.S. tax code.
Sadly, Congress took a big step backward on the credit when it passed the Tax Cuts and Jobs Act in 2017. Companies are currently able to use the credit in the same year the R&D cost is incurred, giving taxpayers access to immediate funds for reinvestment in their enterprise. Unfortunately, the TCJA will require amortization of this benefit over a five-year period starting in 2022, and this will make the credit less useful for businesses. Many enterprises will no doubt reduce R&D activities, to the detriment of our country, if the provision is allowed to stand. Amortizing the benefit will be particularly damaging to the small and mid-size businesses that make up the core of America’s economic engine.
Where We Stand Against Our Competition
Despite our tendency to consider innovation a deeply American quality, the U.S. credit is less generous than those offered by many other countries. In 2018 the Organisation for Economic Cooperation and Development (OECD) ranked the United States 26th out of OECD member countries in terms of the generosity of its R&D tax credit. According to the OECD the R&D tax subsidy rate for profit-making small and mid-size businesses in the United States is well below the OECD minimum. The OECD also found that the generosity of the incentive declined in the United States in the last two decades, “measured by the implied R&D tax subsidy rate” for businesses of all sizes.
Some countries, such as Austria, Belgium, Denmark, and the United Kingdom, have made their R&D credit refundable or redeemable against payroll or social security taxes — a move that has helped bolster the credit’s impact. The size of available credits varies widely. The R&D credit amongst countries varies widely. Ireland is at 25 percent, Italy up to 12 percent, and the U.S. net benefit is merely 6.5 percent. This is bad public policy. Analyses continue to show that investment in R&D activities has a direct impact in terms of driving business growth.
As Treasury has said, “In the absence of such intervention, a market economy would tend to underinvest in research that leads to new ideas, discoveries and knowledge that are helpful in supporting a growing economy.” Treasury went on to say that the “empirical literature generally finds evidence that the R&D credit has increased research spending by private businesses in the U.S.”
By encouraging the U.S. private sector to invest more in research, we are strengthening our foundation and reducing the chances of a hole in the dike down the line.
Bipartisan Support for Innovation
Members of Congress, Democrats and Republicans alike, have proposed multiple enhancements to the R&D credit to support U.S. businesses in the long term. For instance, the FORWARD Act was recently proposed by Sens. Chris Coons, D-Del; Pat Roberts, R-Kan.; Catherine Cortez Masto, D-Nev.; Todd Young, R-Ind.; Maggie Hassan, D-N.H.; and Steve Daines, R-Mont. Also behind the proposal were Reps. Suzan DelBene, D-Wash., and Jackie Walorski, R-Ind.
Coons released a synopsis of the legislation, highlighting the reason for its proposal and saying that the “COVID-19 pandemic has highlighted critical vulnerabilities in the U.S. economy, many of which are due to under-investment in research, workforce training, and domestic supply chains.” The bill aims to open up the availability of the credit by allowing firms with up to $20 million in gross receipts to claim the credit to reduce their payroll tax obligation for a span of eight years — an increase from the previous $5 million threshold for five years. Significantly, the bipartisan, bicameral proposal would also increase the credit up to 25 percent for businesses that opt to manufacture domestically, while also improving Small Business Administration and IRS outreach and education surrounding the credit.
In another bipartisan show of effort, Reps. John Larson, D-Conn., and Ron Estes, R-Kan., introduced the American Innovation and Competitiveness Act of 2019. The bill seeks to eliminate the five-year amortization requirement for R&D expenditures that is scheduled to begin in 2022. Rep. Kevin Brady, R-Texas, ranking member of the House Committee on Ways and Means, recently went on record that our credit should be doubled.
This wave of bipartisan support in a time of sharp political discord is no accident. It is indicative of both the potential behind this incentive and the immediate need to improve the credit to bring it up to par with other global research incentives.
The proposals already on the table certainly address some of the improvements that must be made. We need to ensure that core upgrades are addressed to make the incentive as effective as possible. Here’s what I would suggest.
First, make the credit more generous. Like the move to reduce corporate income tax rates to make U.S. businesses more competitive globally, we should aim to be in the top tier of countries in our support of innovation.
Second, as the FORWARD Act would, let’s augment the credit for businesses that conduct R&D in the United States and manufacture here as well. This boost will increase our global competitiveness while encouraging domestic production and job creation.
Third, we should broaden accessibility to the credit by making it refundable. As noted above, the credit is partially refundable against employer payroll tax, but only for small businesses. Raising this cap will offer an immediate realization of the credit and will encourage more research in the short term. This move is needed now but will also make a long-term, positive impact. When considering this improvement, however, it must be carefully drawn so that it can be effectively administrated by the IRS.
Fourth Congress at a minimum should strike the TCJA’s amortization provision, particularly for small and medium-size businesses, which are fighting for survival during these tough economic times. This change would hold significant value.
The Path of Sustainable Growth Begins With Reinvesting in Innovation
Innovation should be a foundational element of any long-term strategy for sustained economic growth and will involve a mixture of several policy initiatives beyond just augmenting the credit. Most agree there should be a greater focus on encouraging students to pursue STEM educational and career choices. Plans to bolster our country’s economic prosperity will require the marrying of several policy initiatives that support businesses of all sizes, helping Americans gain access to high-skilled jobs. This will only work if we help the private sector do something at which it naturally excels: innovate.
The problems in our manufacturing sector have been long coming, with acute challenges arising even before the pandemic hit. This sudden and dramatic threat is our breach in the dam. Capital spending has failed to keep pace with innovation efforts, with a lack of investment in automation technologies being just one example. The stark reality of the pandemic offers an open door for substantial policy reforms that will get us back on the right track and yield real growth. Now is the time to pivot and work together. Let’s all put our shoulders to the wheel and get started.
The Honorable Mark W. Everson served as Commissioner of Internal Revenue from 2003 until 2007. Prior to joining the IRS, Everson held Bush administration posts as Deputy Director for Management for the Office of Management and Budget (OMB) and Controller of the Office of Federal Financial Management. Everson also served in the Reagan administration, holding several positions at the United States Information Agency and the Department of Justice. In the private sector, Everson served as Group Vice President of Finance at SC International Services, Inc., a $2 billion food services company, and as an executive with the Pechiney Group, one of France’s largest industrial groups.
As Vice Chairman of alliantgroup, Mark is responsible for strategic and operational planning for the firm; advising the Executive Committee on numerous industry issues; and, educating U.S. businesses (and their CPA firms) as to the many credits & incentives available to them. Mark is passionate about helping U.S. businesses and travels throughout the country giving lectures and educational sessions, and is a frequent speaker in the media.