By Professor Jeffrey A. Maine
I’ve been spending a lot time these days studying the recent Tax Cuts and Jobs Act (TCJA) passed in December 2017. It represents one of the most significant overhauls of our tax code in more than three decades. Among the many changes made, the TCJA lowered tax rates for all of us and expanded tax breaks for investments in manufacturing equipment and machinery. Proponents of the TCJA argue that these changes will ultimately stimulate the economy; indeed House Ways and Means Committee Chairman Kevin Brady (R-Texas) noted that full and immediate expensing of tangible assets is the best way to expand the economy.
In providing tax rate cuts and enhanced tax breaks for tangible assets, the TCJA had to amend or repeal a number of provisions to help make up tax revenue loss. Most of us have focused on those tax law changes that will impact us directly, e.g., repeal of the employee expense deduction and cut back of the state and local tax deduction. I would like to highlight, however, some TCJA changes that may impact all of us indirectly – deliberate steps that will affect American innovation:
- FIRST, the TCJA eliminated the research and development (R&D) tax deduction (starting in 2022). Nothing in the legislative history explains why the government eliminated 100% expensing for R&D, which has been a feature of our tax system for over 60 years and was adopted specifically to “stimulate the search for new products and new inventions upon which the future economic and military strength of our Nation depends.”
- SECOND, the TCJA changed a 1950 rule that gave inventors preferential rate treatment when they sold their inventions. Now, under general tax principles, gains from the sale of self-created patents will no longer be eligible for preferential capital gains rate treatment, which was designed to “foster the work of . . . inventors.”
- THIRD, the TCJA did not, as some had predicted, enhance the research tax credit, which was enacted in 1981 to incentivize increased research activity within the United States. Before the TCJA was passed, House Republicans had their own tax reform blueprint, which promised to make the research credit “more efficient and effective” as is the case in many other countries. Despite calls for further enhancements, the TCJA made no changes to the credit.
- FINALLY, the TCJA did not adopt a so-called “patent box,” which provides a reduced effective tax rate on income associated with eligible intellectual property. Despite widespread adoption of patent boxes in Europe and China, the U.S. has failed to create its own despite several calls for one by members of Congress. There are several reasons why the U.S. has resisted. But, the U.S. cannot ignore the fact that competitor countries are utilizing patent boxes as tools to compete for global innovation.
With the TCJA, we have seen a weakening of tax policy tools to encourage new innovation. Other countries, on the other hand, have been enhancing their tax incentives for innovation – e.g., creating super deductions for R&D spending, enhancing their tax credits for innovation, and adopting patent boxes. As a result, the U.S. has dropped among nations from #1 in 1990 in terms of R&D tax incentive generosity, to #25 in 2016.
I have two major concerns. For starters, the TCJA’s reliance on tax incentives for machinery and equipment (immediate expensing) to boost the economy is short-sighted. Despite the political mantra that full and immediate expensing of tangible assets is the best way to expand the economy, econometric analysis reveals there is only a short-term increase in private investment in tangible property in response to these incentives. Firms may accelerate their investment, but they do not change their aggregate investment in tangible assets over time. A more long-term focus on economic expansion would focus more on innovation and intangible capital investments rather than on tangible capital investments. Innovation is the key driver of economic growth. Indeed, 90% of the rise in U.S. prosperity during the 1st half of the 20th Century came from technological growth, and not from the mere accumulation of machinery.
More significantly, the recent tax changes will encourage firms to move their R&D offshore. The research credit, untouched by the recent TCJA, is now the U.S. government’s main tax policy tool to spur innovation. This does not place the U.S. in a competitive posture relative to other nations. The result is a risk of losing American innovation to other countries, including China, which is now the second largest research performer. R&D has become more global over the past two decades as more countries have developed the technical talent to conduct R&D and firms operate in more markets around the world. And, studies show that innovation tax incentives clearly affect the location of research activities, and not just the amount. Sadly, the offshoring of innovation is already happening. In 2017, 15% of U.S. research was conducted by foreign affiliates (a substantial increase from ten years ago). China and other countries have vigorously pursued strong innovation policies. We as a nation can no longer afford to take an “exceptionalism” approach to tax policy and ignore the policies of other nations.
These and other thoughts are reflected in an article with Professor Xuan-Thao Nguyen (Indiana), entitled “Attacking Innovation,” which is forthcoming in the Boston University Law Review. I would welcome any thoughts you might have.