Tax Incentives and the Location of R&D by American Multinationals

This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Tax Policy and the Economy, Volume 8 Volume Author/Editor: James M. Poterba Volume Publisher: MIT Press Volume ISBN: 0-262-66091-1 Volume URL: http://www.nber.org/books/pote94-3 Conference Date: November 16, 1993 Publication Date: January 1994 Chapter Title: No Place Like Home: Tax Incentives and the Location of R&D by American Multinationals Chapter Author: James R. Hines, Jr. Chapter URL: http://www.nber.org/chapters/c10885 Chapter pages in book: (p. 65 - 104) NO PLACE LIKE HOME: TAX INCENTIVES AND THE LOCATION OF R&D BY AMERICAN MULTINATIONALS James R. Hines, Jr. Harvard University and NBER EXECUTIVE SUMMARY This paper analyzes the effects of the U.S. tax treatment of the R&D activities of American multinationals. Recent evidence indicates that the level of R&D spending is highly sensitive to its after-tax cost. The U.S. Tax Reform Act of 1986 reduced the tax deductions that many American firms can claim for their R&D expenses incurred in the U.S., and on this basis, observers predicted that American firms would react to the tax change by significantly increasing the fraction of their R&D that they perform abroad. Aggregate data indicate that this fraction instead stayed roughly constant, at around 10 percent. An important reason why U.S. firms did not move more of their total R&D activity offshore is that U.S. tax law provides quite generous treatment of R&D performed in the United States for use abroad by firms with excess foreign tax credits, and the Tax Reform Act of 1986 significantly increased the number of Ameri- can firms with excess foreign tax credits. Hence, the 1986 tax change This paper was prepared for the NBER Tax Policy and the Economy conference, November 1993. I thank Jeffrey Geppert for excellent research assistance, and Harry Grubert and James Poterba for helpful comments on an earlier draft. Financial support from the Na- tional Science Foundation (Grant #SES-9209373) is gratefully acknowledged. 66Hines increased the cost of U.S.-based R&D for some American firms, and reduced it for others, with little net impact on the fraction of R&D spending that U.S. firms do abroad. One consequence of the tax law changes of the late 1980s is that, by 1991, the tax treatment of foreign-source royalties received by American firms with excess foreign tax credits has five times the tax-revenue impact of the Research and Experimentation Tax Credit. 1. INTRODUCTION The U.S. government expends considerable effort, on a regular cycle, to consider and reconsider the tax treatment of research and development (R&D). The Research and Experimentation (R&E) Tax Credit, introduced in 1981, is the most widely discussed tax-policy tool directed atR&D. The original R&E credit was temporarydesigned to expire in 1985 but since 1985 the credit has been sequentially extended on a temporary basis. As a consequence, the R&E credit has been extensively discussed, and changed several times, over the period 1985-1993. The same is true of several other tax provisions that affect R&D. For example, President Clinton's budget proposal of February 1993 included numerous recommended changes in the tax treatment of R&D activities, with special attention devoted to R&D performed by multinational corporations. The Omnibus Budget Reconciliation Act of 1993, passed by Congress and signed by the president in August 1993, contains many of the features of the president's proposal of February 1993, but does not embody the sweeping reforms of the taxation of the R&D activities of multinational corporations recommended by the president. Congress has struggled for years to design an approach to taxing R&D that is consistent with its tax revenue needs and its desire to encourage R&D. Concern over the responsiveness of R&D to tax rates is most acute in the case of multinational firms, since they have the ability, and often the incentive, to shift domestic operations to overseas locations in reaction to tax changes. Over the years, Congress has been particularly concerned that American firms might shift their R&D activities to offshore locations in response to tax changes that make it more expensive to undertake R&D in the United States. This concern is motivatedin part by the belief that R&D in the United States generates valuable external benefits for the United States economy, and in part by a sense of ur- gency fueled by frequent reminders from corporate taxpayers IGriliches (1991) surveys recent empirical measures of productivity spillovers from R&D activities. Norton (1993, p. 38) quotes Intel's vice president for tax on the government's unwillingness to enact a permanent tax policy toward R&D: "The signal such constant uncertainty sendsa U.S. multinational is, do your R&D offshore." No Place Like Home 67 A growing body of evidence suggests that the level of R&D activity in the U.S. may be quite sensitive to its tax treatment. This evidencecomes from observing the reaction of U.S. R&D expenditures to the tax changes of the 1980s. In turn, the discussion of proposed tax reforms is, at times, informed by the evidence of the responsiveness of R&D to its after-tax cost. This paper examines the issues that arise in designing the U.S. tax treatment of R&D performed by multinational corporations, in the light of what now appears to be strong evidence concerning the responsiveness of R&D to its after-tax cost. Specifically, the paper considers the question of why U.S. multinationals did not expand their foreign R&D activities more rapidly after passage of the U.S. Tax Reform Act (TRA) of 1986. The TRA provisions reduce the tax deductions that many Ameri- can firms can claim for their R&D expenses incurred in the United States. For these firms, the TRA increases the relative attractiveness of doing R&D in foreign locations, and on this basis, many observersex- pected that U.S. firms would significantly increase the fraction of their R&D that they perform abroad.2 As it happens, the evidence indicates that this fraction changed very little after 1986. The explanation for the difference between the expected and realized behavior after 1986 lies partly in the changing foreign tax credit status of firms that perform R&D in the United States for use in foreign markets. The 1986 TRA lowered the statutory U.S. corporate tax rate from 46 percent to 34 percent, thereby greatly increasing the number of U.S. corporations with excess foreign tax credits. American law has always afforded very favorable tax treatment to R&D performed in the United States for use abroad when the company undertaking R&D in the United States has excess foreign tax credits. Hence the firms that moved from deficit foreign tax-credit status to excess foreign tax-credit statusas a result of the TRA faced new, and stronger, incentives to do R&D in the United States for use abroad. Firms with excess foreign tax credits both before and after passage of the TRA faced higher tax costs of doing R&D in the United States after passage of the TRA. Calculations indicate that the reactions of the two groups of firms should roughly balance each other out, with some firms moving additional R&D offshore and others intensifying their domestic R&D activities, the net result being that the aggregate fraction of R&D performed abroad by U.S. companies should be little affected by the 1986 tax act. Section 2 of this paper reviews some recent trends in the level of R&D 2See, for example, Baily (1987, P. 139), who predicts that "The response of the U.S. companies to this overtaxation [the changes in the U.S. R&D cost allocation rules introduced by the Tax Reform Act of 1986] will be to cut back on their U.S. R&D, where the costs are not fully deductible, and expand R&D overseas where they are." 68Hines spending in the United States. The evidence indicates that American firms perform a significant fraction of their R&D abroad, but that the large offshore migration of R&D that some feared might materialize in reaction to changes in U.S. tax law in the late 1980s failed to take place. Section 3 describes the tax changes introduced in the 1980s and the incentives they create for American firms that undertake R&D in the United States. Section 4 considers the evidence on the responsiveness of R&D to tax changes. Section 5 analyzes the reaction of R&D activity to the 1986 Tax Reform Act, and examines the impact of the generous tax treatment of R&D performed in the United States and used abroad. Section 6 is the conclusion. 2. TRENDS IN R&D The U.S. tax incentives for R&D introduced in 1981 reflect government concern over lagging U.S. R&D efforts in the1970s. Table 1 describes the trends in the R&D/GNP ratios for the United States, France, Germany, Japan, and the United Kingdom over the 1961-1989 period. The U.S. R&DIGNP ratio declined from 2.9 percent in 1964 to 2.1 percent in 1978. This ratio then climbed steadily in the 1980s, peaking at 2.8 percent in 1985-1987. Over the same time period, France and the United Kingdom had steady (and somewhat lower) R&DIGNP ratios, while Germany and Japan exhibited growing R&D intensity.

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