U.S. Congress allows R&D tax credit to expire

U.S. Congress allows R&D tax credit to expire

If the credit is extended sometime in 2014 it may not affect companies’ research departments, but it still will throw uncertainty into earnings reports and tax management.

On January 1, the federal tax credit for companies performing research and development was allowed to expire. Without it, firms as diverse as software start-ups and oil giants will lose out on an estimated $8 billion in tax credits during 2014.

The Research and Experimentation Credit (usually just called the R&D credit) dates back to 1981. Although it has always been just a temporary credit, it has been extended each of the 14 times it was set to expire – until this year.

In a tax environment where there are all sorts of questionable credits for niche interests, the R&D credit was one that received nearly universal praise. Presidents from both sides of the aisle have supported making the credit permanent, especially because it is seen as a way to create high paying jobs and new technologies in the US.

Economists also widely support the credit. In a seminal paper, Nobel Prize winner Kenneth Arrow argues that without these types of incentives, companies would greatly underinvest in discovering new technology. More recent studies show that the credit spurs a 10% rise in R&D and that its benefits outweigh the costs of the credit.

Expired tax credit causes market confusion

Coverage of the issue has been scant, perhaps because most politicians and corporate tax advisors expect it to be renewed at some point during 2014. However, it will quickly have an impact on firms and investors.

Jeffrey Hoopes of The Ohio State University has shown that uncertainty surrounding the R&D credit could have an immediate impact on corporate earnings reports. Following previous expirations of the credit expirations, earnings forecasts were less accurate than usual, leading to confusion in the markets. In the three days surrounding earnings announcements, bid-ask spreads can jump by 25%.

Stocks of technology, medical and energy companies, among others, could temporarily become more costly to trade with the future of the R&D credit still up in the air.

Part of the uncertainty comes from how these firms manage their estimated tax payments throughout the year. Corporations will have to decide whether to pay the IRS based on the credit being renewed or not. The differences are significant: the credit lowers the average tax rate of S&P 500 corporations by 5.6%.

For large public companies the R&D tax credit may make up only a relatively small portion of overall tax liability. But for SMEs – especially those that are conducting significant R&D but not generating much revenue – the impact is magnified since their entire tax liability (and more) can be erased by the credit.

The risk for them is that if they bet on the wrong outcome, their cash on hand will suffer. It will suffer all year long if they pay the higher rate and the credit is renewed. So too will it suffer in early 2015 if they are hit with fines for insufficient estimated payments.

Feeling the expiration twice

Although this R&D credit was part of federal tax laws, businesses in certain states will also lose their state R&D credit. Minnesota bases its R&D tax credit entirely on the federal credit, making it unclear whether companies will be able to file the state credit without an extension of the federal credit. Even if the state changes policies to deal with the uncertainty coming from Washington, state officials and companies will have to navigate uncharted territory to decipher what to do next.

Not all states set up their R&D credits based on the federal credit. New York gives credit based on purchases of tangible property such as buildings and capital – which is not part of the federal credit. Because of the different state laws, companies in some parts of the country will be affected more than others. All companies may be looked at similarly by the markets, however, since gathering all of this information is tedious – if possible at all – for investors trying to respond to the R&D credit lapse.

If we look at this R&D situation in isolation, it raises its own issues for short-term equity prices and taxes. But this is just another chapter in a line of US policies that fail to undergird R&D. Grants for R&D are dwindling – and the sequester has not helped that trend.

While markets may feel some slight bumps from the lapse right now, more may be on the way in the future in the form of fewer technologies coming to market. Extending the R&D credit before we are too far into 2014 will be at least a sign that policy makers are aware of the problem on their hands.

Categories: North America, Politics
Tags: IRS, Minnesota, SME

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, Oilprice.com & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.