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Why Does the U.S. Tax Code Penalize R&D? Hold it, I'm getting close!

It's on the tip of my tongue. Err. I know this one.

That's it! Our legislators have s-it for brains! Did I get it right?

China on the other hand actually provides incentive to invent sheet!

Why Does the U.S. Tax Code Penalize R&D?

Spreading deductions for research investments across five years instead of one is an innovation killer.

By Alex Muresianu, WSJ

Jan. 22, 2023 3:20 pm ET

Silicon Valley has been alternately deified and demonized for two decades. Cheerleaders laud it for innovation and rapid technological change. Critics lament the social costs associated with such rapid development. Productivity data tell a nuanced story: Since 2005, total factor productivity growth—that is, productivity growth driven by technological change—has been slow in the U.S., with high-tech industries such as computer design and production, as well as software development, the rare bright spots. But so far in 2023, these industries have been struggling, with substantial layoffs at big tech companies.

Manufacturing, meantime, has experienced slow productivity growth since 2005. Republicans and Democrats have sought to bring manufacturing jobs and production back, with mixed results. Ideally, manufacturing and digital technology would both grow rapidly. But one recent tax change could be making that harder.

Starting in 2022, businesses had to spread their deductions for research-and-development investments over five years, instead of taking them all at once. Before last year, if a company made a $1 million investment in R&D, it would take a $1 million deduction that same year. Today, that company must spread that deduction out, taking $200,000 deductions each year over the next five.

This change creates a tax penalty for two reasons. First, inflation means a deduction five years from now is worth less than a deduction today. Second, companies face an opportunity cost from being forced to spread cost savings over time. In real terms, these two factors create an 11% penalty on R&D investment under low, stable inflation. The higher inflation is, the higher the penalty becomes.

This tax penalty puts an acute burden on R&D-intensive industries, which are on the cutting edge of technological innovation.

Take semiconductors. The chip subsidies passed in 2022, coupled with soaring semiconductor prices and shortages in 2021, have helped spur a rise in industry investment. Yet Congress neglected to fix the R&D penalty when putting together a package to support semiconductors last summer—leaving the U.S. in the odd position of both subsidizing and penalizing the industry.

What’s more, R&D investment isn’t equally distributed across industries. Instead, it’s heavily concentrated in two sectors: manufacturing and information. Of the $429 billion in private domestic R&D in 2019, manufacturing and information made up $248 billion and $109 billion, respectively—83% of the total.

R&D is even more concentrated in specific industries and subindustries within those sectors. Chemical manufacturing, computer and electronics manufacturing, software publishing and transportation-equipment manufacturing combine for over half of the domestic privately funded and performed R&D in the U.S. And semiconductor and other component manufacturing (one part of the computer and electronics industry) alone spent almost $32 billion in R&D in 2019.

While the tech layoffs are primarily attributable to recent interest-rate increases intended to reduce inflation, amortization of R&D is likely making them worse. The provision costs around 20,000 full-time equivalent jobs across the economy.

Returning to R&D expensing—by which investments are written off immediately—makes sense. Virtually every single country around the world allows companies to deduct the full cost of R&D—and many subsidize it heavily. China, among other countries, does so using a “super-deduction,” allowing companies to deduct more than 100% of their R&D costs. In China, companies may deduct 175% of R&D expenses. The U.S. is the outlier; it punishes investment by not letting companies deduct even 100% of R&D costs.

Putting American companies at a disadvantage is a mistake already. But putting America’s most innovative companies at a disadvantage is even worse.

Mr. Muresianu is a policy analyst at the Tax Foundation.

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