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Tucked into page 59 of the 2017 Tax Cuts and Jobs Act was a short but consequential section titled “amortization of research and experimental expenditures.” It changed how companies operating in the U.S. are taxed for their spending on research and development. Before the amendment, they could deduct 100 percent of R&D expenses every year; after the change, this deduction was spread over five years, which would ultimately make R&D more expensive.

The provision was never meant to be permanent. “Congress put it in simply to make the math work,” says Rebecca Lester, an associate professor of accounting at ��ɫApp Graduate School of Business and a senior fellow at the ��ɫApp Institute for Economic Policy Research (SIEPR). The overall tax package would cost $1.3 trillion, and this change, she explains, was meant to defray its cost on paper. “They kicked the effective date to 2022, much later than other pieces of the bill, with the idea that they would come back and fix it later.”

But politics got in the way, and the amendment was never undone. Come 2022, the new rule kicked in, and the cost of R&D skyrocketed, much to the surprise of business leaders who’d expected the law to be fixed.

New research by Lester, of Arizona State University, and of Michigan State University details the costs of letting the new rule go into effect. Among the most research-intensive companies, they found a $12 billion drop in R&D investment after the rule kicked in — “and that’s a fraction of the total impact,” Lester says.

A new tax burden

The first companies subject to the R&D change were those whose fiscal year ended in December 2022. This bright demarcation between the old and new rule offered the researchers a natural experiment. By combing through 10-Ks, they found a set of companies whose fiscal years ended in December that reported being impacted by the R&D tax change. Companies whose fiscal years ended in other months were not affected until the subsequent year, providing a control group that took deductions under the old rules.

Domestic firms were particularly hard hit, as U.S. multinational companies conducting R&D operations overseas were not impacted to the same extent. The end of the R&D deduction also had significant effects on financially constrained companies that lacked extra cash and companies in research-intensive sectors such as pharmaceuticals and technology.

“You would normally expect the U.S. to enact policies designed to increase investment in research and innovation,” Lester says. “In this case, we saw an 11 percent drop in R&D investment among the most research-intensive firms.” To further compensate for the increased tax costs, some firms also reduced capital expenditures and share repurchases.

Lester emphasizes that these results reflect a subset of companies that concluded their fiscal year at the end of 2022. The amendment’s impact on R&D investment undoubtedly grew larger as more companies were affected throughout 2023.

This decrease in R&D spending was not a foregone conclusion, she notes. Corporate leaders had assumed that going into 2022 and even 2023, Congress would repeal the amendment and restore the full deduction. With this in mind, they were inclined to weather the storm — absorb the increased costs for a short time until the old rules returned. That the companies studied slashed R&D as much as they did when the rule stuck suggests the magnitude of the new tax burden.

Stifling domestic innovation

The researchers looked into whether this decline in R&D spending came at the expense of more innovative research. If the policy had targeted less ambitious incremental research, Lester says, it could arguably be a way to prevent companies from taking advantage of tax breaks without investing in truly groundbreaking research. “The evidence that we find, though, doesn’t lend support to this idea,” she says. “We see the effect on both forms of research, which means the policy doesn’t appear to work as a form of discipline.”

In January 2024, the House of Representatives approved legislation that would have, among other things, repealed the amendment and returned the deduction to its prior state. The Senate voted the bill down in July. There is hope that the provision will be revisited in 2025 after the fall election cycle.

In the short term, Lester suggests that companies that want to continue investing in R&D may consider reclassifying expenses into a different category. However, any long-term solution lies with lawmakers in Washington, D.C.

“We’ve created an incentive structure that disadvantages domestic innovation, which, it’s worth noting, potentially has a lot of spillover effects on local economies,” Lester says. “Other countries are passing tax policies that provide benefits for innovation — the European Union is doing this with , and China is providing super deductions. We’re really going in the opposite direction of the rest of the world.”

This story was October 18, 2024 by ��ɫApp Graduate School of Business Insights.