Capitalize Research and Experimentation Costs and Amortize Them Over Five Years

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

Billions of Dollars 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues 31.3 42.6 33.6 24.4 14.8 8.4 6.9 7.2 7.6 8.0 146.7 184.9

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

Under current tax law, companies can deduct the costs of research and experimentation from their income in the year those costs are incurred. (Other cost-recovery methods are allowed but rarely used.) By allowing an immediate deduction, the tax code treats costs associated with research and experimentation as current expenses (the same way that wages of production workers are treated, for instance) rather than as an investment (which is how the purchase of a machine or a building is characterized, for example). Doing so is consistent with the way research and development expenses are treated under the generally accepted accounting principles used in the United States by corporations to report income and assets to shareholders in their financial statements. Companies can also claim a tax credit for certain research costs in excess of a base amount that represents the company’s historical level of such spending.

In recent years, some organizations have challenged the characterization of research and development costs as current expenses instead of investment. In 2013, the Bureau of Economic Analysis began treating research and development costs in the national income and product accounts as investments. Under the new approach, an investment in research and development creates an asset (generally referred to as intangible to distinguish it from tangible assets such as equipment and structures) that declines in value over time. That approach has been partially adopted by the International Financial Reporting Standards Board (which established the accounting standards used outside the United States). Under those standards, qualifying development costs—but not research costs—are capitalized (that is, added to the value of assets) and amortized (that is, deducted from both the value of assets and from current income) in equal annual amounts over the useful life of the asset.

This option would require the costs of both research and experimentation to be capitalized for tax purposes and amortized over five years. In other words, costs would be deducted in equal amounts over five years instead of all at once in the year the expenses were incurred. The existing credit for research and experimentation expenses would remain in place. The staff of the Joint Committee on Taxation estimates that, if implemented, the option would increase revenues by $185 billion between 2017 and 2026.

One argument in favor of the option is that it would treat investments in different types of assets more alike. The rationale is that investments in research projects that have a high probability of success and short development periods are comparable to investments in equipment and structures. Because the tax code is more favorable to those types of research and experimentation projects than it is to investments in equipment and structures, companies have an incentive to direct more of their resources toward such research and experimentation. Unless such research and experimentation generates benefits for people other than the company’s investors (such as customers who benefit from an upgraded email application, for example), that favorable tax treatment results in a misallocation of resources that leads to lower output. However, high risk of failure and lengthy development periods more frequently characterize investments in intangible assets than investments in tangible assets, offsetting to some degree the favorable tax treatment of research and experimentation.

Another rationale is that the option would reduce an advantage that established companies, especially larger ones, have over newer businesses. Under current law, newer companies often do not have any income from which to deduct their research and experimentation costs and therefore must effectively defer their deduction—for up to 20 years—until they have income from which to subtract their deductible costs. That delay lowers the value of the deduction. Large, established firms, in contrast, generally have income from other projects, allowing them to immediately claim the deduction and thus realize its full value. Under this option, however, the deductions of the large, established companies would be spread out over time, and the realized value of those deductions would more closely match the realized value for newer companies.

An argument against the option is that it would reduce the incentive to conduct research and experimentation that generates benefits for people outside of the firm that incurs the costs. By reducing the incentive to engage in research and experimentation, this option would, to some extent, discourage those activities and thus curtail those external benefits. For example, if the costs arising from the option were to deter the development of a drug that would improve public welfare, the public would never realize that improvement in welfare. The disincentive is magnified in cases involving a high risk of failure or a long development period.

Another argument against the option is that it would increase companies’ recordkeeping burden. Because the option diverges from generally accepted accounting principles, businesses would have to maintain separate tax records for their research and development operations in addition to their records for financial-reporting purposes.