What Two Nobel Prize Winners Can Tell Us About R&E Expensing
Michigan, Pennsylvania, and the District of Columbia have decoupled from the OBBBA’s restoration of immediate expensing for research and experimentation (R&E) expenditures. This issue of The SALT Road explores that decision in light of this year’s Nobel Prize-winning work on innovation.
SALT News and Updates
Chicago’s Finance Committee soundly rejected a tax plan that included a business head tax, a social media tax, and a higher rate on cloud services.
Delaware’s Supreme Court upheld split roll taxation as consistent with the constitution’s uniformity clause, rejecting challenges to a new law permitting higher rates on commercial and industrial property (including apartment complexes) in response to a once-in-40-years statewide reassessment that saw residential property values rise more than commercial properties.
Many states are reporting Q3 tax collections well ahead of forecast and substantially above collections for the same period last year. New York’s tax collections grew by $5.2 billion, Virginia’s were up $509 million, Utah’s rose $109 million, and Pennsylvania’s were up $54 million, to name a few. Growth was not only higher than last year, but also outpaced forecasts made earlier this year. For instance, California beat its estimates by $6.3 billion, Georgia by $240 million, Ohio by $111 million, Oklahoma by $114 million, Florida by $86 million, and Mississippi by $29 million.
In Oregon, a $1.4 billion surplus over the past biennium will trigger the state’s “kicker,” providing a credit worth 9.863% of filers’ 2024 tax liability. The kicker goes into effect when revenues beat budget estimates by at least 2 percent. The state’s new chief economist has indicated that future estimates will be less conservative, making further kickers less likely.
Signature-gathering is underway for a proposed ballot measure to make California’s “temporary” higher rates—already extended once—permanent. Another measure in the works would create a one-time 5% wealth tax on billionaires. The former measure is championed by the teacher’s union, while the latter is the work of healthcare unions.
Worth Reading
Richard Pomp is in Bloomberg Tax with a critique of Washington’s expansion of its sales tax base to include digital advertising
NTUF’s Andrew Wilford has a new state-by-state playbook outlining reforms to reduce compliance burdens for remote sellers
What Two Nobel Prize Winners Can Tell Us About R&E Expensing
States spend tens of billions on targeted economic development incentives (in 2020, Tim Bartik estimated more than $60 billion per year), yet some states are now contemplating jettisoning a tax provision that is not an incentive, but merely the avoidance of a penalty against research and development. This makes very little sense for a host of reasons, not least that the provision in question is one of the few that benefits the most likely sources of innovation.
IRC § 174 provides immediate expensing of businesses’ research and experimentation expenditures. First implemented in 1954, it was a mainstay of corporate taxation until 2022, when the deduction was amortized across five years under a gimmicky pay-for in the latter half of the Tax Cuts and Jobs Act (TCJA)’s ten-year budget window, one that the bill’s drafters presumably believed would be fixed later. The gimmick backfired, and the fix only came with the enactment of the One Big Beautiful Bill Act (OBBBA) in 2025.
Before 2022, states universally conformed to § 174. Now, however, some lawmakers wish to decouple from restored first-year R&E expensing, even though much of the cost is a timing shift, doing little more than reversing the windfall they received under four years of amortization, and despite the fact that the corporate tax base remains significantly larger than it did pre-TCJA, as I noted in a recent Tax Foundation blog post.
But the point I want to make here is not just that immediate cost recovery is good policy (though it is), or even that it’s not unreasonable for states to return to a policy that was in place, with almost no opposition, since the Eisenhower administration. Instead I’d like to focus on what makes R&E expensing so uniquely valuable for innovation. And for that, there’s much that can be gleaned from this year’s Nobel prize winners, whose work examined the sources and drivers of innovation.
Joel Mokyr’s works explore the social conditions under which innovation is possible. Philippe Aghion augments this with a Schumpeterian framework that grants technological innovation pride of place as the driver of economic growth, arguing against what he perceives as an overemphasis on capital accumulation. The return to marginal units of capital investment eventually trends toward zero, so long-term growth requires shocks to the system in the form of creative destruction.
Expressed this way, that’s hardly novel or a challenge to neoclassical assumptions. But Aghion offers several insights, one of which is highly relevant here: established institutions tend to exhibit path dependency, seeking innovation in the same channels through which they’ve enjoyed previous success. That doesn’t mean that large firms don’t innovate, but it does mean that the most disruptive new technologies are likely to come from new market entrants. The most successful established firms often become those willing to make acquisitions. Think of how much new tech spun up by large corporations began with the acquisition of a startup with a great idea.
The upshot is that if you want growth, you need contestable markets. You need barriers to entry to be relatively low, and you don’t want to tilt the playing field to further favor the incumbents.
Tax systems, however, are often biased in favor of large established companies and therefore against the upstarts that fuel the churn of creative innovation. Investment and R&D credits frequently require that firms commit to specific investment and jobs targets, functionally limiting eligibility to companies whose most innovative days may be behind them.
At one level, this is understandable: lawmakers don’t want to take on risk, and governments are ill-equipped to evaluate it.
But innovation gains necessarily involve risk.
First-year expensing of R&E differs from investment incentives in two fundamental ways: one, it’s not an incentive or subsidy, but merely the elimination of a penalty against investments in R&D; and two, it’s available to any company engaged in research and experimentation, at least to the degree that they have profits to offset. It doesn’t just flow to the big players; it eliminates a bias in the tax code that also applies to the newcomers with the new ideas that move the economy forward.
Bob Tannenwald, in a recent reevaluation of R&D credits in Tax Notes State, highlighted several studies consistent with the notion that R&D credits and to an even greater extent investment credits benefit less innovative companies over more innovative ones. One study reviewed, by Fazio, Guzman, and Stern, found that R&D credits did have a positive effect on startups, but that investment tax credits inhibit the formation of startups and particularly penalize the most entrepreneurial ones. Another study, by Balsmeier, Kurakina, Stiebale, and Fleming, concluded that California’s R&D credit favors “exploitation” (refining existing technologies) over “exploration” (bolder and riskier investment to develop new goods, processes, and knowledge).
This aligns nicely with the distinction Joel Mokyr makes between propositional and prescriptive knowledge. Both represent genuinely useful knowledge, but propositional knowledge is the realm of principles, understanding, and groundbreaking research, whereas prescriptive knowledge consists of routines, techniques, and marginal improvements. Philippe Aghion, meanwhile, highlights the importance of frontier innovation and not just application and diffusion if an economy is to avoid stagnation.
Incremental improvements are valuable. But if paradigm-shifting innovation is associated with newer market entrants, then it’s vitally important that the tax code doesn’t discriminate against and shift resources away from them. There may be a place for investment incentives, and perhaps a stronger case for R&D incentives (which are better targeted at the creation of what Mokyr calls propositional knowledge, with its larger social spillovers), but § 174 is the best-calibrated of all. If states decouple from the restored provision, they’re choosing to penalize the next round of innovators necessary to drive the economy forward.
Obligatory Marketing Note
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Coming Up
A quick look ahead at issues I plan to cover in upcoming issues of The SALT Road:
analysis demonstrating that even with the tax cuts of 2021-2025, state tax collections are substantially up overall
summary of and commentary on a new paper indicating that remote workers’ location decisions are sensitive to income tax but not property tax burdens
an exploration of the trend toward income tax bracket consolidation and the adoption of single-rate income taxes
consideration of the trend toward market sourcing of services in corporate income tax apportionment
And with data taxes, wealth taxes, property tax elimination, worldwide combined reporting, and many other novel policies percolating in the states, I intend to touch upon these matters—and many more—in the coming weeks and months as well. Please subscribe (it’s free) and consider sharing this newsletter with others who may be interested as well.