Below are the first 10 and last 10 pages of uncorrected machine-read text (when available) of this chapter, followed by the top 30 algorithmically extracted key phrases from the chapter as a whole.
Intended to provide our own search engines and external engines with highly rich, chapter-representative searchable text on the opening pages of each chapter.
Because it is UNCORRECTED material, please consider the following text as a useful but insufficient proxy for the authoritative book pages.
Do not use for reproduction, copying, pasting, or reading; exclusively for search engines.
OCR for page 39
International Taxation and Corporate R&D:
Evidence and Implicationsi
JAMES R. HINES, JR.
University of Michigan and
the National Bureau of Economic Research
INTRODUCTION
Governments design tax systems to pursue multiple objectives, including
those of raising tax revenue, distributing tax burdens fairly, and providing appro-
priate economic incentives. Investment in research and development is generally
thought to create unusually large positive economic spillovers; accordingly, it is
afforded more favorable tax treatment than other investments such as those in
plant and equipment. In the United States, most R&D expenses are deductible
from current taxable income in calculating tax liabilities. In addition, enterprises
may qualify to receive the research and experimentation tax credit. Furthermore,
U.S.-based R&D directed at foreign markets for which American firms receive
payment in the form of foreign-source royalties may receive favorable tax treat-
ment in certain circumstances. Other advanced industrial countries offer similar
types of tax-based encouragement of private-sector R&D (U.S. Congress, 1995;
Organization for Economic Cooperation and Development, 1996~.2
The eagerness of governments to use their tax systems to encourage domes-
tic R&D, and thereby reap the economic benefits of R&D spillovers, is some-
times diminished by the multinational nature of modern businesses in high-tech-
nology industries. It is possible that the benefits of R&D undertaken in one
country may generate economic spillovers in another. If so, governments may be
somewhat less willing to grant as favorable tax treatment as if spillover benefits
iThe author thanks James Poterba for helpful comments on an earlier draft.
2Virtually all countries permit firms to deduct R&D expenses immediately against their taxable
incomes, and most provide supplemental credits, deductions, or other fiscal inducements to undertake
R&D. Germany and the United Kingdom are notable exceptions in providing no fiscal incentives
other than immediate deductibility of R&D expenses.
39
OCR for page 40
40
BORDERLINE CASE
were concentrated in the location in which R&D is undertaken. Since very little
is known about the nature of technology spillovers, it is also possible that the
local benefits generated by R&D performed by domestically owned firms are not
the same as those generated by R&D performed by foreign-owned firms. Since
the reality of modern industrial life is that most private-sector R&D is undertaken
by multinational firms, whether owned locally or by foreigners, government poli-
cies must be crafted in environments in which there are spillovers between do-
mestic and foreign markets but uncertainty concerning their magnitudes. The
purpose of this chapter is to review the history of U.S. tax policy toward research
activities undertaken by multinational firms in the United States and the available
evidence on its impact.
THE TAX TREATMENT OF MULTINATIONAL CORPORATIONS3
The United States taxes income on a residence basis, meaning that American
corporations and individuals owe taxes to the U.S. government on all of their
worldwide incomes. The top U.S. corporate tax rate is now 35 percent. Since
profits earned in foreign countries are usually taxed by host governments, U.S.
law permits taxpayers to claim tax credits for foreign income taxes and related tax
obligations in order to avoid subjecting American multinationals to double taxa-
tion. The foreign tax credit mechanism implies that a U.S. corporation earning
$100 in a foreign country with a 12 percent tax rate (and a foreign tax obligation
of $12) pays only $23 to the U.S. government, since its U.S. corporate tax liabil-
ity of $35~35 percent of $100) is reduced to $23 by the foreign tax credit of $12.
The foreign tax credit is, however, limited to U.S. tax liability on foreign income.
If, in the example, the foreign tax rate were 50 percent, the firm would pay $50 to
the foreign government, but its U.S. foreign tax credit would be limited to $35.
Hence, an American firm receives full tax credits for its foreign taxes paid only
when it is in a deficit credit position (i.e., when its average foreign tax rate is less
than its tax rate on domestic operations). A firm has excess credits if its available
foreign tax credits exceed U.S. tax liability on its foreign income. Firms combine
their taxable incomes and taxes paid in all of their foreign operations in calculat-
ing their foreign tax credits and the foreign tax credit limit.4
Portions of this description of U.S. tax law are excerpted from Hines (1991).
4In order to qualify for the foreign tax credit, firms must own at least 10 percent of a foreign
affiliate, and only those taxes that qualify as income taxes are creditable. Furthermore, income is
broken into different functional "baskets" in the calculation of applicable credits and limits. Income
earned and taxes paid in the conduct of most types of active foreign business operations are grouped
in one basket; petroleum industry income is grouped in a separate basket; and there are separate
baskets for items such as passive income earned abroad. The basket distinctions imply that a firm
might simultaneously have excess foreign tax credits in the petroleum basket (which is common,
since foreign tax rates on oil income are typically quite high) and deficit foreign tax credits in the
active income basket. Such a firm would have to pay some U.S. tax on its active foreign income, even
though it has excess foreign tax credits on its petroleum income.
OCR for page 41
INTERNATIONAL TAXATION AND CORPORATION R&D
41
Deferral of U.S. taxation of certain foreign earnings is another important
feature of the U.S. international tax system. Generally, an American parent firm
is taxed on its subsidiaries' foreign income only when this is repatriated to the
parent corporation. This type of deferral is available only to foreign operations
that are separately incorporated in foreign countries (subsidiaries of the parent),
not to consolidated (branch) operations. The U.S. government taxes branch prof-
its as they are earned, just as it does profits earned within the United States.
The deferral of U.S. taxation may create incentives for firms with lightly
taxed foreign earnings to delay repatriating dividends from their foreign subsid-
iaries.5 In some cases, firms expect never to repatriate their foreign earnings. In
other cases, they may anticipate that future years will be more attractive for repa-
triation either because domestic tax rates will be lower or because future sources
of foreign income will generate excess foreign tax credits that can be used to
offset U.S. tax liability on the dividends.6 It appears that in practice, U.S. multi-
nationals choose their dividend repatriations selectively, generally paying divi-
dends out of their more heavily taxed foreign earnings first.7 Consequently, the
average tax rate that firms face on their foreign income need not exactly equal the
average foreign tax rate faced by their branches and subsidiaries abroad.
Branch earnings and dividends from subsidiaries represent only two forms of
foreign income for U.S. income tax purposes. Interest received from foreign sources
also represents foreign income, although foreign interest receipts are often classified
in their own basket and hence are not combined with other income in calculating the
foreign tax credit. Royalty income received from foreigners, including foreign af-
filiates of U.S. firms, is also foreign-source income. Foreign governments often
impose moderate taxes on dividend, interest, and royalty payments from foreign
affiliates to their American parent companies; these withholdings taxes are fully
creditable against an American taxpayer's U.S. tax liability on foreign income.
5The incentive to defer repatriation of lightly taxed subsidiary earnings is attenuated by the subpart
F provisions introduced in U.S. law in 1962, that treat a subsidiary's passive income and income
invested in U.S. property as if they were distributed to its American owners, thereby subjecting such
income to immediate U.S. taxation. Subpart F rules apply to controlled foreign corporations, which
are foreign corporations owned at least 50 percent by U.S. persons holding stakes of at least 10
percent each. Controlled foreign corporations that earn and reinvest their foreign earnings in active
businesses can continue to defer their U.S. tax liability on those earnings. See Hines and Rice (1994)
and Scholes and Wolfson (1992) for the behavioral implications of these rules.
sit is interesting to note that the deferral of U.S. tax liability does not itself create an incentive to
delay paying dividends from foreign subsidiaries since the U.S. tax must be paid eventually (see
Hartman, 1985).
7See the evidence presented in Hines and Hubbard (1990), Altshuler and Newton (1993), and
Altshuler et al. (1995).
Taxes on cross-border flows, such as dividends, interest, and royalties, are known as "withhold-
ing" taxes due to some of the niceties of their administration. Strictly speaking, these taxes represent
obligations of the recipients and not the payors; this arrangement permits immediate crediting of
withholding taxes by recipients who are eligible to claim foreign tax credits. The taxes are called
withholding taxes because the local payor is the withholding agent for the tax and is therefore liable
to ensure that the taxes are paid.
OCR for page 42
42
BORDERLINE CASE
Royalties received by American parent firms for R&D used abroad represent
taxable foreign-source income of the American firms. American firms with defi-
cit foreign tax credits must pay U.S. income tax on these royalty receipts, whereas
firms with excess foreign tax credits may be able to apply the excess credits
against U.S. taxes due on the royalties, thereby eliminating the U.S. tax liability
otherwise created by the royalty receipts.
Most of the world's governments impose withholding taxes on cross-border
royalty payments from affiliates located within their countries. These royalty tax
rates are frequently reduced under the terms of bilateral tax treaties. For ex-
ample, the United States imposes a 30 percent tax on royalties paid to foreign
corporations, but this tax rate is often reduced, in some cases to zero, when recipi-
ents of royalty payments are located in countries with whom the United States has
a tax treaty in force.
Interaction of R&D and Foreign Income Rules
American firms with foreign income are generally not permitted to deduct all
of their R&D expenditures in the United States against their domestic taxable
incomes. Instead, the law provides for various methods of allocating R&D ex-
penses between domestic and foreign income.
The intention of the law is to retain the relatively generous treatment of R&D
only for that part of a firm' s R&D expenditures that is devoted to production for
domestic markets. it&D-performing firms with foreign sales and foreign income
are presumed to be doing at least some of their R&D to enhance their foreign
profitability.
From the standpoint of taxpaying firms, U.S. tax law's distinction between
domestic and foreign R&D deductions is potentially quite important. If an R&D
expense is deemed to be domestic, it is deductible against the taxpayer's U.S.
taxable income. Alternatively, if it is deemed to be foreign, the R&D expense
reduces foreign taxable income for the purposes of U.S. income taxation only.
Foreign governments do not use U.S. methods of calculating R&D deductions
and generally do not permit American firms to reduce their taxable incomes in
foreign countries on the basis of R&D undertaken in the United States. Conse-
quently, an R&D expense deduction allocated against foreign income is valuable
to an American firm only if the firm has deficit foreign tax credits. If the firm has
deficit credits, then the firm pays some U.S. tax on its foreign income, and any
additional dollar of R&D deduction allocated against foreign income reduces the
firm's U.S. taxable income by a dollar.9 Firms with deficit foreign tax credits are
therefore indifferent between allocating R&D expenses against foreign income
Curiously, the law is written so that the additional dollar of R&D deduction reduces taxable in-
come without reducing the foreign tax credits available for foreign income taxes paid.
OCR for page 43
INTERNATIONAL TAXATION AND CORPORATION R&D
43
and allocating them against domestic income.l° By contrast, firms with excess
foreign tax credits pay no U.S. tax on their foreign income and therefore have no
use for R&D deductions allocated against foreign income. Consequently, firms
with excess foreign tax credits lose the value of any R&D deductions allocated
against foreign income.
It is important to consider the tax treatment of royalties together with any
evaluation of the impact of the R&D expense allocation rules. American firms
with excess foreign tax credits that undertake R&D in the United States directed
at enhancing profitability in foreign markets are unable to recieve full deductions
for their U.S. R&D expenses, but they are able to receive their returns in the form
of foreign-source royalty receipts that are untaxed by the United States due to
their excess foreign tax credits. Consequently, U.S. tax law discourages such
firms from undertaking R&D directed at domestic markets while encouraging
such firms to undertake R&D directed at foreign markets. Of course, in practice,
it&D-performing firms may not always be in positions to know whether particu-
lar R&D projects are more likely to generate domestic or foreign income when
and if ultimately successful.
HISTORY OF U.S. R&D ALLOCATION RULESll
The tax law governing the allocation of R&D expenses was for years rather
vague but was codified by U.S. Treasury Regulation section 1.861-8 in 1977.
The 1977 rules provide for several stages in allocating R&D expenses for tax
purposes. Research and development in the United States that is undertaken to
meet certain legal requirements such as complying with pollution standards can
be allocated 100 percent against domestic income. Firms that perform more than
half of their other than legally required R&D in the United States are permitted to
allocate 30 percent of that R&D against U.S. income. The remaining 70 percent
is then to be allocated between domestic and foreign sources on the basis of sales,
including the sales of controlled foreign corporations. Research and develop-
ment is generally allocated to activities within product lines (defined in a manner
comparable to two-digit SIC codes), so that a corporation need not allocate part
of its chemical R&D against foreign income simply because the electronics part
of its business has foreign sales.
There are several options available to taxpayers who are unsatisfied with
the outcome of the R&D allocation method just described. Firms are permitted
to apportion more than 30 percent of their domestic R&D against U.S. income if
i°This statement, along with much of the analysis described in this chapter, abstracts from the
ability of firms to carry excess foreign tax credits backward two years and forward five years. Firms
that can exploit carryforwards or carrybacks may (depending on specific circumstances) face incen-
tives that are intermediate between those of deficit credit and excess credit firms.
Apportions of this brief description of U.S. law are excerpted from Hines (1994).
OCR for page 44
44
BORDERLINE CASE
they can establish that it is reasonable to expect the R&D so apportioned to have
very limited application outside the country; the remaining portion of their R&D
expenses are then allocated on the basis of sales. Alternatively, firms are per-
mitted to allocate their R&D on the basis of total foreign and domestic income,
although without the 30 percent initial allocation to U.S. source, so that firms
with foreign operations that generate sales but not income relative to domestic
operations might prefer the income allocation method. There is, however, a
limit to the income allocation method: firms are not permitted to reduce their
foreign-source R&D expense allocation to less than 50 percent of the allocation
that would have been produced by the sales method, including the 30 percent
initial apportionment.
The Economic Recovery Tax Act in 1981 changed these rules by permitting
American firms to allocate 100 percent of the expense of R&D performed in the
United States against U.S. taxable income. This change was intended to offer
strong R&D incentives while affording Congress the opportunity to rethink its
R&D policy for two years. At the end of that time, the U.S. Department of the
Treasury (1983) produced a study concluding that the tax change presented a
small R&D incentive to U.S. firms and was desirable on that basis. In 1984 and
1985, Congress extended the temporary change permitting 100 percent allocation
of U.S. R&D expenses to U.S. income, so these rules remained in place until the
end of the 1986 tax year.
The Tax Reform Act of 1986 removed the 100 percent allocation of U.S.
R&D expenses, replacing it with a new, and again temporary, system of R&D
expense allocation.~3 Under the 1986 act, 50 percent of U.S. R&D expense (other
than for R&D to meet regulatory requirements) was allocated to domestic-source
income, with the remaining 50 percent allocated on the basis of sales or income,
at the taxpayer's choice. There was no limit imposed on the degree to which
allocation on the basis of gross income could reduce foreign allocation relative to
the sales method.
The Technical and Miscellaneous Revenue Act of 1988 changed the R&D
expense allocation rules for the first part of 1988. For the first four months of the
year, firms were permitted to allocate 64 percent of U.S. R&D expense against
U.S. domestic income, with the remaining 36 percent allocated between foreign
and domestic sources on the basis of either sales or income, at the taxpayer's
choice. The 1988 act further provided that if the 36 percent was allocated on the
i2The Treasury Department (1983) study based its conclusions on a range of assumed elasticities of
R&D with respect to price changes; no attempt was made to ascertain how firms responded to the
changes introduced in 1981.
i3The Tax Reform Act of 1986 also introduced a number of other changes relevant to R&D invest-
ment decisions, including reducing the statutory corporate tax rate from 46 percent (the tax rate from
1979 to 1986) to 40 percent in 1987 and 34 percent for 1988 and subsequent years. The 1986 act also
removed a number of investment incentives such as accelerated depreciation of capital assets and the
investment tax credit for new equipment purchases.
OCR for page 45
INTERNATIONAL TAXATION AND CORPORATION R&D
45
basis of income, the R&D allocation against foreign income must equal at least
30 percent of the foreign allocation that would have been produced by the sales
method. For the remaining eight months of the year, taxpayers were required to
use the allocation method described in section 1.861-8 as of 1977 and also de-
scribed above.
The Omnibus Budget Reconciliation Act of 1989 again changed the R&D
allocation rules, this time reintroducing the same rules that applied for the first
four months of 1988. The Omnibus Budget Reconciliation Act of 1990 and the
Tax Extension Act of 1991 extended this treatment of R&D expenses until a date
that depends on a taxpayer's choice of fiscal year, but in no case later than
August 1, 1992. Consequently, 64 percent of domestically performed R&D in
1989-1992 could be allocated against domestic income, with the remaining 36
percent allocated on the basis either of sales or of income, although use of the
income method could not reduce foreign-source allocation to less than 30 per-
cent of the foreign-source allocation that would have been produced by the sales
method.
Expiration of the R&D expense allocation legislation in the summer of 1992
motivated an extensive reconsideration of the issue of the appropriate tax treat-
ment of R&D expenditures by multinational firms. In June 1992, the Treasury
Department temporarily suspended its section 1.861-8 allocation rules (the 1977
regulations), replacing them with an 18-month moratorium in which taxpayers
could continue to use the system in effect from 1989 to 1992: 64 percent place-
of-performance allocation, with the remaining deductions allocated on the basis
of sales or income. The department was to reexamine its section 1.861-8 regula-
tions during the 18-month period. The explanation for the moratorium was "to
provide taxpayers with transition relief and to minimize audit controversy and
facilitate business planning during the conduct of the regulatory review" (U.S.
Congress, 1993~. Some contemporaneous observers noted that extension of the
R&D allocation rules through Treasury Department moratorium instead of legis-
lation made the rules less costly from the standpoint of federal budget targets
since regulatory changes are exempt from the budget agreement limits. What
role, if any, such considerations played in the decision to suspend the section
1.861-8 rules is not clear. In any case, the moratorium did not run its full course,
being supplanted in 1993 by new legislation.
President Clinton's budget proposal of February 1993 recommended a major
change in the allocation of R&D expenditures and the treatment of royalty re-
ceipts by U.S.-based multinational corporations. The President proposed that
American firms deduct 100 percent of their U.S. R&D expenditures against U.S.
income but that the same firms no longer be permitted to use foreign tax credits
generated by their active foreign operations to reduce U.S. tax liabilities on roy-
alty income from foreign sources. Instead, firms would be required to allocate
foreign-source royalty income to the passive basket in determining their foreign
tax credit limits. The administration's intention was to limit severely the ability
OCR for page 46
46
BORDERLINE CASE
of American firms to use excess foreign tax credits to reduce their U.S. tax liabili-
ties on foreign-source royalty income. Very few firms have excess foreign tax
credits in the passive basket.
Instead, the Omnibus Budget Reconciliation Act of 1993 (OBRA 93) contin-
ued the pattern of allowing U.S.-based multinational firms to allocate only a frac-
tion of their U.S. R&D expenses to U.S. income and, at the same time, permited
firms to use foreign tax credits to eliminate U.S. tax liabilities on foreign-source
royalty income. OBRA 93 permitted firms to allocate 50 percent of U.S.-based
R&D expenses to domestic source, with the remaining 50 percent allocated be-
tween domestic and foreign source based either on sales or on income, at the
taxpayer's option-subject to the restriction that income-based allocation not re-
duce foreign-source allocation to less than 30 percent of that produced by the
sales method. The allocation rules under OBRA 93 were temporary, expiring one
year after they took effect. Many observers attributed the temporary nature of the
allocation rules to the mechanics of compliance with federal budget targets. If
Congress were to pass permanent legislation covering the R&D allocation rules,
the "cost" to the current-year budget of any treatment more generous than the
1977 regulations must include costs incurred in future years. By instead passing
temporary legislation, Congress incurs budgetary costs only for the current year.
Of course, budgetary costs need not bear any relation to the economic conse-
quences of permanent legislation covering the allocation of R&D expenses.~4
During 1995, the Treasury Department reconsidered the appropriateness of
its 1977 R&D expense regulations. Based on newer analysis (U.S. Department of
the Treasury, 1995), the regulations were amended roughly along the lines of
recent legislative developments. Specifically, the 1995 regulations permit firms
to select one of two allocation methods, the first allowing firms to allocate 50
percent of U.S.-based R&D expenses to domestic source with the remaining 50
percent allocated between domestic and foreign sources based on sales, and the
second method permitting firms to allocate 25 percent of U.S.-based R&D ex-
penses to domestic source with the remaining 75 percent allocated between do-
mestic and foreign source based on gross income. Under these regulations, in-
come-based allocation is not permitted to reduce foreign-source allocation to less
than 50 percent of that produced by the sales method.~5 Since the OBRA 93
i4Some people strongly believe that permanent legislation creates a more predictable environment
for businesses, thereby making the United States a more attractive location for R&D. Turro (1993, p.
436) quotes one tax practitioner, who describes the Congress's decision to make the OBRA 93 R&D
allocation rules temporary an "absurd tax policy decision."
i5The new regulations amend the previous rules in certain, more minor, ways. Specifically, firms
generally are required to make their elections permanent, so it is not possible to use the sales method
in one year and the income method in the next. In addition, the new regulations specify that firms
allocate R&D expenses based on three-digit SIC activities, rather than the two-digit SIC activities
provided in the previous regulations.
OCR for page 47
INTERNATIONAL TAXATION AND CORPORATION R&D
47
R&D allocation rules have expired, the 1995 Treasury Department regulations
now govern the allocation of U.S. R&D expenses.
Quantitative Impact of Tax Rules
The tax treatment of R&D and royalty income clearly influences the incen-
tives American and foreign firms face in undertaking R&D in the United States
and abroad. There remains the question of the extent to which levels of R&D
activity respond to these incentives. This is a difficult question to evaluate fully,
since R&D activity depends not only on the tax treatment of R&D per se but also
on the tax treatment of other domestic and foreign investments, government-spon-
sored R&D efforts, the technological sophistication of local economies, the cost
of technology inputs, and a host of other variables. In spite of these contributing
factors, it is nevertheless possible to find quantitative evidence of the responsive-
ness of R&D to its tax treatment.
For years the received wisdom of the academic literature was that the own-
price demand elasticity of R&D was relatively small in absolute value, on the
order of 0.5 or smaller.~7 More recent estimates of Hines (1993) and Hall (1993)
find elasticities of unity or greater in absolute value. The significance of an
elasticity larger than unity in absolute value is that it implies that a tax benefit for
R&D stimulates more additional private-sector R&D than the amount of forgone
tax revenue.
Hines (1993) uses firm-specific changes after 1986 in the tax cost of under-
taking R&D in the United States, based on changes in the R&D expense alloca-
tion rules, to estimate the responsiveness of R&D spending to its after-tax cost.
The study analyzes two samples of large firms between 1984 and 1989 the first,
a sample of 40 firms that experienced no merger activity, and the second, a sample
of 116 firms that includes those with minor merger activity. In both samples, the
R&D expenditures of firms with significant foreign sales and excess foreign tax
credits grow systematically more slowly after 1986 than do the R&D expendi-
tures of other firms. The implied price elasticity of R&D is -1.8 in the 40-firm
subsample and -0.8 in the 116-firm sample. Given the omission of variables to
i6It is noteworthy that the 1995 revisions to the R&D cost allocation regulations were not "costly"
from the standpoint of federal budget targets since regulatory changes are not budgeted.
i7See, for example, Bernstein and Nadiri (1989), who estimate R&D price elasticities to be between
-0.4 and -0.5 for a sample of manufacturing firms, whereas Nadiri and Prucha (1989) find the R&D
price elasticity to be much closer to zero for the U.S. Bell System. In a study of Canadian firms,
Bernstein (1985) reports estimated R&D price elasticities of between -0.1 and -0.4. Mansfield (1986)
and the U.S. General Accounting Office (1989) summarize the literature with the conclusion that the
consensus range of price elasticities is -0.2 to -0.5.
i8A literature survey by the U.S. General Accounting Office (1996) concludes that on the basis of
these and other recent studies, the consensus range of price elasticities of demand for R&D in the
United States was higher by 1996 than it was in 1989.
OCR for page 48
48
BORDERLINE CASE
control for merger effects in the larger sample, the true elasticity is probably
closer to -1.8 than to -0.8. An own-price elasticity of R&D in that range is much
larger than those reported by earlier studies but is consistent with Hall's (1993)
firm-level study of domestic responses to incentives created by the research and
experimentation tax credit.
The available evidence indicates that there is little change over time in the
fraction of total R&D that American firms perform abroad, which is roughly
constant at about 10 percent.~9 One might wonder why this ratio would remain
constant over a period that includes the 1986 U.S. tax changes that reduce the
deductibility of domestic R&D expenses if indeed there is an elasticity of demand
for R&D in the neighborhood of unity. Hines (1994) argues that such a large
elasticity is consistent with an unchanged ratio of foreign to domestic R&D by
American firms because the same 1986 tax change that reduced the deductibility
of domestic R&D expenses also made foreign-source royalty income more attrac-
tive by increasing the number of American firms with excess foreign tax credits.
The tax change discouraged American firms from undertaking R&D in the United
States directed at domestic markets and encouraged R&D directed at foreign
markets. There was little net effect of these two changes on the total volume of
R&D in the United States, although of course firms with different tax situations
and those operating in distinct markets were affected differently.
It is possible to use estimated response elasticities to project the effects of
various possible tax reforms on tax revenue and R&D activity. Although such
exercises are of necessity partial equilibrium in nature and rely on imprecisely
estimated parameters, they offer the benefit of illustrating the trade-offs implicit
in the current tax treatment of R&D. Table 2.1, which is drawn from Hines
(1993), indicates changes in U.S. corporate tax revenue and U.S.-based R&D
activity that would accompany two alternative reforms, if prevailing corporate
activity and U.S. tax law as of 1989 are assumed. The first reform is one in
which American multinational firms would be permitted to deduct 100 percent
of their domestic R&D expenses against their taxable U.S. incomes; the second
is one in which the R&D expenses of American multinationals would be allo-
cated between domestic and foreign sources on the basis of relative sales with-
out any adjustment for place of R&D performance. Complete domestic deduct-
ibility of R&D expense reduces corporate tax collections by $1.2 billion while
encouraging an additional $2.2 billion of private-sector R&D by affected firms.
The alternative of R&D expense allocation on the basis of sales generates an
additional $2.5 billion of tax revenue while reducing private-sector R&D by
$2.6 billion.
These results suggest that the current tax treatment of R&D expenses of U.S.-
based multinational firms displaces private-sector R&D by an amount that is
roughly the same order of magnitude as the tax revenue it generates. Although
i9See the evidence presented in Hines (1994).
OCR for page 49
INTERNATIONAL TAXATION AND CORPORATION R&D
TABLE 2.1 Estimated Effects of Two Policy Reforms on R&D and Tax
Revenuea
49
Change in Tax Revenue Change in R&D
Contemplated Reform (million dollars) (million dollars)
100 percent domestic deductibility of R&D expenses
Pure sales apportionment of R&D expenses
-1,166
2,542
2,230
-2,590
Figures are based on an analysis of 189 multinational firms with $41 billion of R&D expenditures in
1989, as reported in Hines (1993). Firms are assumed currently to use the sales apportionment method
to allocate their R&D expense deductions.
aNote: Entries are millions of current dollars in 1989.
the details of alternative tax reform proposals differ in many particulars including
their treatment of average and marginal R&D expenses, the trade-off of private-
sector R&D for tax revenue is unlikely to differ greatly from the range of, say, 1-
2.5 due to the approximately unit elastic responsiveness of R&D to its after-tax
price. Although this calculation omits various important considerations such as
the long-run effect of the tax treatment of R&D on the entry and exit of firms into
technology-intensive industries, the taxation of alternative uses of resources that
would otherwise be devoted to R&D, and others, it captures one of the important
considerations in the design of R&D tax policy: the trade-off between private
incentives and public tax revenues.
INTERNATIONAL TECHNOLOGY FLOWS
AND GOVERNMENT POLICY
Government policy has the ability to influence the incentives firms have to
undertake R&D and to use the technology produced by research in domestic and
foreign markets. One of the lively policy questions is the degree to which tech-
nology developed in one country influences economic activity in another. A
related question is one of the degree to which R&D activities undertaken in dif-
ferent countries substitute for each other.
The limited available evidence suggests that there is extensive international
use of locally developed technology. American firms perform only about 10
percent of their R&D abroad, but foreign-source royalties received by Americans
for technology and know-how exported abroad greatly exceed their foreign R&D.
In 1991, American firms received $17.8 billion in foreign-source royalties while
spending $8.7 billion on R&D abroad. Over recent years the difference between
these two figures has grown every year.20
20See the evidence reported in Hines (1994).
OCR for page 50
so
BORDERLINE CASE
Foreign investors in the United States transfer technology to their U.S. op-
erations in two forms, through technology for which royalties are paid and also
through R&D performed locally in the United States. The magnitude of the latter
is quite large, reflecting the technological nature of the industries in which for-
eign investors concentrate. In every year since 1982, foreign investors have per-
formed more R&D in the United States than American firms have undertaken
abroad.2i
The linkage between technology transfer and accompanying royalties pro-
vides an opportunity to draw useful inferences about the degree of substitutability
between domestic and foreign R&D. Domestic R&D generates technologies that
foreign affiliates can use in return for paying royalties. Policies that make royalty
payments more expensive thereby reduce the usefulness of domestic R&D for
foreign operations. Hence, to the extent that foreign operations respond to higher
costs of royalty payments by increasing their own R&D intensities, it follows that
domestic and foreign R&D are substitutes. In such circumstances, domestic policies
that increase the cost of R&D have the effect of driving R&D activity offshore.
Hines (1995) investigates these issues by estimating the effect of royalty
withholding taxes on R&D performed by foreign subsidiaries. Since foreign sub-
sidiaries are required to pay royalties to their parent companies for imported tech-
nology, higher royalty taxes, even if partly avoided by adept transfer pricing,
raise the cost of technology imports. Higher costs of imported technology stimu-
late local R&D if the two are substitutes and discourage R&D if they are comple-
ments. Cross-sectional estimates of R&D intensities of the foreign operations of
U.S. firms in 43 countries in 1989 indicate a cross-elasticity of 0.16, suggesting
that R&D and imported technology are substitutes. Cross-sectional estimates of
the R&D activities of foreign-owned firms in the United States in 1987 indicate a
somewhat larger cross-elasticity, 0.30, which likewise suggests that imported
technology and locally produced technology are substitutes. The implication of
these results is that R&D cost allocation rules, the tax treatment of royalties, and
other tax policies that influence levels of domestic R&D also influence the for-
eign R&D activities of American firms.
It is a mistake to evaluate tax policies or any other government policies in
isolation since so many things that governments do influence economic behavior
in general and R&D activity in particular. The purpose of this chapter is to re-
view some of the U.S. international tax policies that most directly affect domestic
and foreign R&D. The R&D expense allocation rules and the tax treatment of
royalties recieved from abroad are two of the most important of these policies.
The quantitative evidence indicates that tax policies influence significantly the
level, composition, and location of R&D activity. Those who design future U.S.
tax policy toward R&D are well advised to bear in mind the responsiveness of
this activity in selecting the direction of U.S. policy.
2iSee the evidence reported in Hines (1995).
OCR for page 51
INTERNATIONAL TAXATION AND CORPORATION R&D
REFERENCES
51
Altshuler, R., and T.S. Newton. 1993. "The effects of U.S. tax policy on the income repatriation
patterns of U.S. multinational corporations." Pp.77-115 in Studies in International Taxation, A.
Giovannini, R.G. Hubbard, and J. Slemrod, eds. Chicago, Ill.: University of Chicago Press.
Altshuler, R., T.S. Newton, and W.C. Randolph. 1995. "Do repatriation taxes matter? Evidence from
the tax returns of U.S. multinationals." Pp. 253-272 in The Effects of Taxation on Multinational
Corporations, M. Feldstein, J.R. Hines Jr., and R.G. Hubbard, eds. Chicago, Ill.: University of
Chicago Press.
Bernstein, J. I. 1985. "Research and development, patents, and grant and tax policies in Canada." Pp.
1-41 in Technological Change in Canadian Industry, D.G. McFetridge, ed. Toronto: University
of Toronto Press.
Bernstein, J. I. and M.I. Nadiri. 1989. "Rates of return on physical and R&D capital and structure of
production process: Cross section and time series evidence." Pp. 169-187 in advances in Econo-
metrics and Modeling, Baldev Raj, ed. Dordrecht, the Netherlands: Kluwer.
Hall, B.H. 1993. "R&D tax policy during the 1980s: Success or failure?" Pp. 1-35 in Tax Policy and
the Economy, J. M. Poterba, ed. Vol. 7. Cambridge, Mass.: MIT Press.
Hartman, D.G. 1985. "Tax policy and foreign direct investment." Journal of Public Economics
26: 107- 121.
Hines, J.R., Jr. 1991. "The flight paths of migratory corporations." Journal of Accounting, Auditing,
and Finance 6:447-479.
Hines, J.R., Jr 1993. "On the sensitivity of R&D to delicate tax changes: The behavior of U.S.
multinationals in the 1980's." Pp. 149-187 in Studies in International Taxation, A. Giovannini,
R.G. Hubbard, and J. Slemrod, eds. Chicago, Ill.: University of Chicago Press.
Hines, J.R., Jr. 1994. "No place like home: Tax incentives and the location of R&D by American
multinationals." Pp. 65-104 in Tax Policy and the Economy, J. M. Poterba, ed. Vol. 8. Cam-
bridge, Mass.: MIT Press.
Hines, J.R., Jr. 1995. "Taxes, technology transfer, and the R&D activities of multinational firms."
Pp. 225-248 in The Effects of Taxation on Multinational Corporations, M. Feldstein, J.R. Hines,
Jr., and R.G. Hubbard, eds. Chicago, Ill.: University of Chicago Press.
Hines, J.R., Jr., and R.G. Hubbard. 1990. "Coming home to America: Dividend repatriations by U.S.
multiationals." Pp. 161-200 in Taxation in the Global Economy, A. Razin and J. Slemrod, eds.
Chicago, Ill.: University of Chicago Press.
Hines, J.R., Jr. and E.M. Rice. 1994. "Fiscal paradise: foreign tax havens and American business."
Quarterly Journal of Economics 109:149-182.
Mansfield, E. 1986. "The R&D tax credit and other technology policy issues." American Economic
Review 76:190-194.
Mansfield, E., D. Teece, and A. Romeo. 1979 "Overseas research and development by U.S.-based
firms." Economica 46: 187- 196.
Nadiri, M.I. and I.R. Prucha. 1989. "Dynamic factor demand models, productivity measurement, and
rates of return: Theory and an empirical application to the U.S. Bell System." Working paper
no. 3041. Cambridge, Mass.: National Bureau of Economic Research.
Organization for Economic Cooperation and Development. 1996. Fiscal Measures to Promote R&D
and Innovation. ODCE/GD(96)165. Paris: OECD.
Scholes, M.S. and M.A. Wolfson. 1992. Taxes and Business Strategy: A Planning Approach.
Englewood Cliffs, N.J.: Prentice Hall.
Turro, J. 1993. "U.S. enacts controversial budget legislation." Tax Notes International 16(7):435-
438.
U.S. Congress, Joint Committee on Taxation. 1993. Summary of the President's Revenue Proposals.
Washington, D.C.: U.S. Government Printing Office.
U.S. Congress, Office of Technology Assessment. 1995. The Effectiveness of Research and Experi-
mentation Tax Credits. Washington, D.C.: U.S. Government Printing Office.
OCR for page 52
52
BORDERLINE CASE
U.S. Department of the Treasury. 1983. The Impact of the Section 861-8 Regulation on U.S. Research
and Development. Washington, D.C.: U.S. Government Printing Office.
U.S. Department of the Treasury. 1995. The Relationship Between U.S. Research and Development
and Foreign Income. Washington, D.C.: U.S. Department of the Treasury.
U.S. General Accounting Office. 1989. The Research Credit Has Stimulated Some Additional Re-
searchSpending. Report GAO/GGD-89-114. Washington,D.C.:U.S.Government Printing
Office.
U.S. General Accounting Office. 1996. Review of Studies of the Effectiveness of the Research Tax
Credit. Report GAO/GGD-96-43. Washington, D.C.: U.S. Government Printing Office.
Representative terms from entire chapter:
tax credits
