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Testimony on the Effectiveness of the Before the Committee on Science, July 1, 1999 By Laura P. Allbritten On Behalf of the R & D Credit Coalition and Mr. Chairman and members of the committee my name is Laura Allbritten and I am the Director of Tax For Peoplesoft, Inc., a software company located in Pleasanton, California. I thank you for the opportunity to testify this morning, and I applaud your leadership in introducing legislation that would make permanent the important Research and Experimentation Tax Credit (commonly known as the R & D credit) and in holding these hearings in order to gain more information about the Credit. This Committee has taken several steps to underscore the importance of research and development to the continued productivity of U.S. workers and in turn, a higher standard of living for all Americans. Your support for the R & D Credit is steadfast. Unfortunately, yesterday, as you know, the R & D credit expired for die ninth time. I am testifying today on behalf of the R & D Credit Coalition and the Software and Information Industry Association (SIIA). The R & D Credit Coalition urges Congress to pass a permanent, seamless extension of the R & D credit as contained in legislation recently introduced in both the House, H.R. 835, and the Senate, S. 680 (companion bills). H.R. 835 and S. 680 would permanently extend the R & D credit and make a modest, one percentage point increase in the alternative incremental research credit (AIRC) rates. The R & D Credit Coalition also supports the provisions of the recently filed "Networking and Information Technology Research and Development Act," (H.R. 2086) because it includes a provision that would permanently extend the R & D credit. The coalition also urges the members of the Science Committee also to include a provision that would increase the AIRC rates by one percentage point. The Coalition is comprised of companies and trade organizations representing a broad cross section of the most dynamic and fastest growing industries in the United States. Over one thousand companies and fifty-three trade associations are members of the Coalition. The Coalition represents the interests of companies that employ several million American workers. The companies of the coalition represent a broad range of industries including the software, electronics, chemicals, pharmaceuticals, biotechnology, automotive, and manufacturing industries. SIIA, comprised of 1400 member companies, is the leading trade association for companies involved in the creation and distribution of software and information products and services. Software companies especially rely upon their ability to conduct cost-effective research and development in order to bring innovative, productivity enhacing new products to the marketplace. SIIA's software membership includes leading and startup companies dedicated to developing and marketing business, entertainment and educational software. PeopleSoft, Inc. was established in 1987 to provide innovative software solutions that meet the changing business needs of enterprises worldwide. A client/server applications pioneer and market leader, Peoplesoft develops, markets, and supports a complete suite of enterprise solutions for finance, materials management, distribution, supply chain planning, manufacturing, and human resources. In addition, PeopleSoft provides industry-specific enterprise solutions to customers in select markets including telecommunications, financial services, health care, manufacturing, higher education, public sector, retail, services, transportation, U.S. Federal government and utilities. The company also offers "PeopleSoft Select," a complete packaged solution including software, hardware, and services that address the needs of medium-sized organizations. As the Committee members consider technology issues in the 106th Congress, I encourage them to endorse fiscal policies and initiatives that will fuel the U.S. economy, keeping American companies and their workers prosperous and competitive in the changing global marketplace as we enter the 21st century. Without a growing economy, Americans standard of living, and our ability to support the needs of our aging population, will be in jeopardy. Faced with a static or decreasing workforce as U.S. demographics shift U.S. lawmakers must focus also on encouraging technology development to increase productivity, enabling a smaller workforce to support a growing population of retirees. Increased technology development will help to ensure sustained economic growth and the prosperous environment needed to continue to improve our standard of living for current and future generations of Americans. Increased technology development also will permit additional individual tax reductions and will ensure a growing economy with resources necessary to adequately support the health and retirement needs of an aging U.S. population. Much of this activity, clearly, must be accomplished by the private sector. In addition to a permanent R & D credit, there are a number of things which federal government can do that will allow and encourage companies like PeopleSoft to continuously innovate. For instance, better intellectual property law protection, relief from the compliance burden imposed by federal regulations, and decreased tax rates on investment income all would allow PeopleSoft and other US high-tech firms to allocate more resources to research and experimentation. I. R & D CREDIT LEGISLATIVE HISTORY The R & D credit was enacted in 1981 to provide an incentive for companies to increase their U.S. R & D activity. As originally passed, the R & D credit was to expire at the end of 1985. Recognizing the importance and effectiveness of the provision, Congress decided to extend it. In fact since 1981 the credit has been extended nine times. In addition, the credit's focus has been sharpened by limiting both qualifying activities and eligible expenditures. With each extension, the Congress indicated its strong bipartisan support for the R & D credit. In 1986, the credit lapsed, but was extended with continuity and the rate cut from 25 percent to 20 percent. In 1988, the credit was extended for one year. However, decreasing the deduction for R & D expenditures by 50% of the credit further reduced the credit's effectiveness. In 1989, Congress extended the credit for another year and made changes that were intended to increase the incentive effect for established as well as start-up companies. In the 1990 Budget Reconciliation Act, the credit was extended again for 15 months through the end of 1991. The credit was again extended through June 30, 1992, by the Tax Extension Act of 1991. In OBRA 1993, the credit was retroactively extended through June 30, 1995. In 1996, as part of the Small Business Job Protection Act of 1996, the credit was extended for eleven Months through May, 31, 1997, but was not extended to provide continuity over the period July 1, 1995 to June 30, 1996. This one-year period, July 1, 1995 to June 30, 1996, was the first gap in the credit's availability since its enactment in 1981. As part of the 1996 legislation, the elective Alternative Incremental Research Credit ("AIRC") was added to the credit, increasing its flexibility and making the credit available to R & D intensive industries which could not qualify for the credit under the regular criteria. The AIRC adds flexibility the credit allowing for changes in business models and R & D spending patterns which are a normal part of a company's life cycle. The sponsors of S. 680 and HR 835 recognize the importance of the AIRC. Their legislation, in addition to making the credit permanent, provides for a modest increase in the AIRC rates that will bring the AIRC's incentive effect more into line with the incentive provided by the regular credit to other research-intensive companies. This is the only change to the existing credit that the R & D Credit Coalition has endorsed.The Congress next approved a thirteen-month extension of the R & D credit that was enacted into law as part of the Taxpayer Relief Act of 1997. The credit was made available for expenditures incurred from June 1, 1997 through June 30, 1998, with no gap between this and the previous extension. Most recently, the Congress approved a one year extension of the credit, until June 30, 1999. According to the Tax Reform Act of 1986, the R & D credit was originally limited to a five-year term "in order to enable the Congress to evaluate the operation of the credit." While it is understandable that the Congress in 1981 would want to adopt this new credit an a trial basis, the credit has long since to be an excellent highly leveraged investment of government and private sector resources. It provides an effective incentive for companies to increase their U.S.-based R & D. The historical pattern of temporarily extending the credit combined with the first gap in the credit's availability reduces the incentive effect of the credit. The U.S. research community needs a stable, consistent R & D credit in order to maximize its incentive value and its contribution to the nation's economic growth and to sustain the basis for ongoing technology competitiveness in the global arena. II. WHY DO WE NEED AN R & D CREDIT? A. The credit offsets the tendency for under investment in R & D The single biggest factor driving productivity growth is innovation. As stated by the Office of Technology Assessment in 1995- "Much of the growth in national productivity ultimately derives from research and development conducted in private industry." Sixty-six to eighty percent of productivity growth since the Great Depression is attributable to innovation. In an industrialized society, R & D is the primary means by which technological innovation is generated. Companies cannot capture fully the rewards of their innovations because they cannot control the indirect benefits of their technology on the economy. As a result, the rate of return to society as a whole from innovation is twice that which accrues to the individual company that conducted the original R & D. This situation is aggravated by the high risk associated with R & D expenditures. As many as eighty percent of such projects are believed to be economic failures. Therefore, economists and technicians who have studied the issue are nearly unanimous that the government should intervene to increase R & D investment. The most recent study, conducted by the Tax Policy Economics Group of Cooper & Lybrand (now called PriceWaterhouseCoopers), concluded "absent the R & D credit, the marketplace, which normally dictates the correct allocation of resources among different economic activities, would fail to capture the extensive spillover benefits of R & D spending that raise productivity, lower prices, and improve international trade for all sectors of the economy." Stimulating private sector R & D is particularly critical in light of the decline in government funded R & D over the years. Direct government R & D funding has declined from 57% to 36% of total R & D spending in the U.S. from 1970 to 1994. Over this same period, the private sector has become the dominant source of R & D funding, increasing from 40% to 60%. B. The credit helps U.S. business remain competitive in the world marketplace The R & D credit has played a significant role in placing American businesses ahead of their international competition. In developing and marketing new products, it has assisted in the development of new and innovative products, increased technological advancement, more and better U.S. jobs, and increased domestic productivity and economic growth. This is increasingly true in our knowledge and information-driven world marketplace. Research and development must meet the pace of competition. In many instances, the life cycle of new products is continually shrinking. As a result, the pressure of getting new products to market is intense. Without robust R & D incentives encouraging these efforts, the ability to compete in world markets is diminished. Continued private sector R & D is critical to the technological innovation and productivity advances that will maintain U.S. leadership in the world marketplace. Since 1981, when the credit was first adopted, there have been dramatic gains in R & D spending. Unfortunately, our nation's private sector investment in R & D (as a percentage of GDP) lags far below many of our major foreign competitors. For example, U.S. firms spend (as a percentage of GDP) only one--third as much as their German counterparts on R & D, and only about two-thirds as much as Japanese firms. This trend must not be allowed to continue if our nation is to remain competitive in the world marketplace. Moreover, we no longer may assume that American companies will automatically choose to site their R & D functions in the United States. Foreign governments are competing aggressively for U.S. research investments by offering substantial tax and other financial Incentives. Even without these tax incentives, the cost of performing R & D in many foreign jurisdictions is lower than the cost to perform equivalent R & D in the U.S. An OECD survey of sixteen member countries found that thirteen offer R & D tax incentives. Of the sixteen OECD nations surveyed, twelve provide R & D an tax credit or allow a deduction for more than 100% of R & D expenses. Six OECD nations provide accelerated depreciation for R & D capital. According to the OECD survey, the U. S. R & D tax credit as a percentage of industry-funded R & D was third-lowest among nine countries analyzed. Making the U.S. R & D tax credit permanent, however, would markedly improve U.S. competitiveness in world markets. The 1998 Coopers & Lybrand study found that with a permanent credit, annual exports of goods manufactured here would increase by more than $6 billion, and imports of goods manufactured elsewhere would decrease by nearly $3 billion. Congress and the Administration must make a strong and permanent commitment to attracting and retaining R & D investment the United States. The best way to do that is to extend permanently the R & D credit. C. The credit provides a targeted incentive for additional R & D investment, increasing the amount of capital available for innovative and risky ventures The R & D credit reduces the cost of capital for businesses that increase their R & D spending, thus increasing capital available for risky research ventures. Products resulting from R & D must be evaluated for their financial viability. Market factors are providing increasing incentives for controlling the costs of business, including R & D. Based on the cost of R & D, the threshold for acceptable risk either rises or falls. When the cost of R & D is reduced, the private sector is likely, to perform more of it. In most situations, the greater the scope of R & D activities, or risk, the greater the potential for return to investors, employees and society at large. The R & D credit is a vital tool which keeps U.S. industry competitive because it frees-up capital to invest in leading edge technology and innovation. It makes available additional financial resources to companies seeking to accelerate research efforts. It lowers the economic risk to companies seeking to initiate new research, which will potentially lead to enhanced productivity and overall economic growth. D. Private Industrial R & D spending is very responsive to the R & D credit, making the credit a cost effective tool to encourage economic growth Economic studies of the credit, including the Coopers & Lybrand 1998 study, the KPMG Peat Marwick 1994 study, and the article by K. Hall entitled: "R & D Tax Policy in the 1980s: Success or Failure?" Tax Policy and the Economy (1993), have found that a one dollar reduction in the after-tax price of R & D stimulates approximately one dollar of additional private R & D spending in the short-run, and about two dollars of additional R & D In the long run. The Coopers & Lybrand study predicts that a permanent R & D credit would cause U.S. companies to spend $41 billion more (1999 dollars) on R & D for the period 1998-2010 than they would in the absence of the credit. This increase in private U.S. R & D spending, the 1998 study found, would produce substantial and tangible benefits to the U.S. economy. Coopers & Lybrand estimated that this permanent extension would create nearly $58 billion of economic growth over the same 1998-2010 period, including $33 billion of additional domestic consumption and $12 billion of additional business investment. These benefits, the 1998 study found, stemmed from substantial productivity increases that could add more than $13 billion per year of increased productive capacity to the U.S. economy. Enacting a permanent R & D credit would lead U.S. companies to perform significantly more R & D, substantially increase U.S. workers' productivity, and dramatically grow the domestic economy. E. Research and Development is About U.S. Jobs and People Investment in U.S. R & D is ultimately an investment in the American people, their education, their jobs, their economic security, and their standard of living. Dollars spent on R & D primarily are spent on salaries for engineers, researchers and technicians. When taken to market as new products, incentives that support R & D translate to salaries of employees in manufacturing, administration and sales. Of exceptional importance to PeopleSoft and the other members of the R & D Credit Coalition, R & D success also means salaries to the people in our distribution channels who bring our products to customers as well as service providers and developers of complementary products. Our customers ultimately drive the entire process by the value they put on the benefit to them of advances in technology (benefits that definitely translate into improving their ability to compete). By making other industries more competitive, research within one industry contributes to preserving and creating jobs across the entire economy. My experience has been that more than 85 percent of expenses qualifying for the R & D credit go to salaries for researchers and technicians, providing high-skilled, high-wage jobs to U.S. workers. Investment in R & D, in people working to develop new ideas, is one of the most effective strategies for U.S, economic growth and competitive vitality. Indeed, the 1998 Coopers & Lybrand study shows improved worker productivity throughout the economy and the resulting wage gains going to hi-tech and low-tech workers alike. U.S. workers' personal income over the 1998-2010 period, the 1998 study predicts, would increase by more than $61 billion if the credit were permanently extended. F. The R & D credit is a market driven incentive The R & D credit is a meaningful, market-driven tool that encourages private sector investment in research and development expenditures. Any taxpayer that increases its R & D spending and meets the technical requirements provided in the law can qualify for the credit. Instead of relying on government-directed and controlled R & D spending, businesses of all sizes, and in all industries, best determine what types of products and technology to invest in so that they can ensure their competitiveness in the world marketplace. III. THE R & D CREDIT SHOULD BE MADE PERMANENT TO HAVE MAXIMUM INCENTIVE EFFECT As the Joint Committee on Taxation points out in the Description of Revenue Provisions in the President's Fiscal Year 2000 Budget Proposal (JCS-1-99), "If a taxpayer considers an incremental research project, the lack of certainty regarding the availability of future credit increases the financial risk of the expenditure." Research projects cannot be turned off and on like a light switch. If corporate managers are going to take the benefits of the R & D credit into account in planning future research projects, they need to know that the credit will be available to their companies for the years in which the research is to be performed. Research projects have long horizons and extended gestation periods. In order to increase their R & D efforts, businesses must search for, hire, and train scientists, engineers and support staff. They must invest in new physical plants and equipment. There is little doubt that the incentive effect of the credit has been diluted or lost over the past seventeen years as a result of the constant uncertainty over the continued availability of the credit. If the credit is to provide its maximum potential for increased R & D activity, the practice of periodically extending the credit for short periods, and then allowing it to lapse, must be eliminated, and the credit must be made permanent. Only then will the full potential of its incentive effect be felt across all the sectors of our economy. No one has said this more effectively that Federal Reserve Chairman Alan Greenspan. At the high-technology summit conducted by the Joint Economic Committee two weeks ago, his testimony was emphatic that if there is to be a credit, it should be permanent. IV. CONCLUSION Making the existing R & D credit permanent best serves the country's long term economic interests. It will eliminate the uncertainty over the credit's future and allow R & D performing businesses to make important long-term business decisions regarding research spending and investment in the U.S. Private sector R & D stimulates investment in innovative products and processes that greatly contribute to overall economic growth, increased productivity, new and better U.S. jobs, and higher standards of living in the United States. By creating an environment favorable to private sector R & D investment, jobs and economic value will remain in the United States. Investment in R & D is an investment in people. A permanent R & D credit is essential for the United States economy in order for its industries to compete globally, as international competitors offer direct financial subsidies and reduced capital cost incentives to "key" industries. PeopleSoft, SIIA and the R & D Credit Coalition strongly support the permanent extension of the R & D credit, and increasing the AIRC rates by one percentage-point. These measures will help keep high-skill, high paying technology jobs in the United States. Again Mr. Chairman and members of the Committee, I applaud your leadership on this important issue.
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