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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
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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.
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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.
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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.
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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).
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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.
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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
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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.
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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.
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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).
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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).
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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).
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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: