and Demand of R&D
the Private Sector
Research and Experimentation Tax Credit
Orphan Drug Credit
Prospects: A Pessimistic View
Prospects: An Optimistic View
support of research and development is justified, in the view of
many policy-makers, by its ultimate effect on living standards.
R&D investment is the major factor contributing to long-term productivity
growth, which in turn enables growth of real wages. Empirical studies
show, furthermore, that the "spillover" benefits of R&D to the economy
as a whole greatly exceed privately appropriable returns, leading
to private underinvestment in a publicly beneficial activity.(2)
In the medical realm, R&D contributes to living standards in another
more literal sense. Coupled to the economic value of new therapeutic
products is the health value of the treatments they enable. This
relationship between economic value and health value is not perfect,(3)
but generally speaking, there are significant economic benefits
of health and costs of disease; likewise, rising living standards
in the purely economic sense have historically exerted a strong
positive influence on public health.(4)
often viewed as instruments of economic policy than science or health
policy, tax credits have been instituted in a variety of situations
to encourage private-sector investment directed toward public-policy
purposes. These incentives are most successful when they take advantage
of private-sector competencies and are sensitive to public and private
interests alike. This paper considers the publicly beneficial role
that private firms play in the larger medical R&D enterprise, and
the strengths and weaknesses of tax credits as tools to maximize
the value they create.
and Demand of R&D
In the portfolio of a profit-maximizing firm, R&D investments are
not treated fundamentally differently from other economic activities.
Investment levels are governed by the cost of the investment, its
expected privately appropriable returns, and the opportunity cost
associated with financing R&D instead of some other potentially
profitable activity. Investment decisions are therefore strongly
influenced by the marginal costs of possible activities: if the
cost of additional R&D is reduced by a tax credit or other discount,
the quantity of R&D demanded will increase.
At a regional or national level, R&D can also be thought of in terms
of a supply and demand analogy. The R&D enterprise as a whole is
enabled by a combination of the push of supply and the pull of demand,
where "supply push" includes fundamental discoveries, technologically
enabled opportunities, and scientific talent and curiosity; and
"demand pull" includes health, economic, and other public needs.
Within this system, push-pull interactions exist among activities
at every level. For example, new tools for diagnostic imaging depend
on advances in spectroscopy and computing; basic physiological sciences
in turn exploit advances in clinical instrumentation. Basic research
ultimately helps to maximize the value created by clinical development
and vice versa, particularly when those efforts are effectively
the Private Sector
Government, industry, and academic R&D performers concentrate their
efforts at different levels within this system, according to their
own institutional strengths. Private firms play a primary role in
clinical drug development, where enormous costs and risks preclude
major involvement by other types of organizations. From discovery
stage to FDA approval, development of a single new drug costs upwards
of $300 million, and for every five drugs in clinical testing, only
one will be approved for pharmaceutical sale.(6)
Private firms have the financial capacity to manage these costs
and risks, and the organizational capacity to focus large-scale
projects on marketplace needs.
private sector is also increasingly involved in earlier-phase basic
research, as a new generation of medical treatments develops on
the basis of more specifically targeted genetic, biochemical, and
physiological interventions. These research interests are being
pursued both in house and in collaboration with other institutions.
A recent survey of biomedical firms found that 58 percent were engaged
in research collaborations with academic institutions.(7)
credits should, in principle, be ideally suited as policy instruments
to encourage these and other forms of private-sector investment
in R&D. By lowering the marginal cost of R&D activities, tax credits
are designed to stimulate increased R&D investments in a manner
that fits in smoothly with other market influences. Firms that take
advantage of credits benefit from improved cash flow and increased
after-tax returns, both of which can be financially critical for
support of additional R&D projects or for survival of a start-up
firm. An efficient tax incentive can be an extremely cost-effective
means to leverage public and private resources for R&D. Studies
of the United States research credit in the 1980's indicated that
it stimulated as much as two dollars of additional R&D investment
for every dollar of tax expenditure.(8)
Under present law, four different tax credit provisions attempt
to stimulate increased investments in R&D, to encourage research
partnerships, and to correct for some of the economic disincentives
specific to clinical development of treatments for rare diseases.
The mechanics of these credits, as well as some of their current
implementation difficulties, are outlined below.
Research and Experimentation Tax Credit
The research and experimentation tax credit(9)
allows firms to claim credit for in-house and some contract research
expenses according to either of two mechanisms: a regular credit
or an alternative credit. The regular credit is a 20 percent
incremental credit tied to a firm's increase in research intensity
(expressed as a percentage of revenues) compared to a fixed historic
base. If a firm's current ratio of R&D to sales is greater than
it was during the 1984 to 1988 base period, it is eligible for a
20 percent credit on the excess.(10)
The alternative credit allows firms to claim credit for research
expenses in a manner that is independent of their historic R&D spending
patterns. Under this mechanism, credit is awarded on a three-tiered
rate schedule, ranging from 1.65 to 2.75 percent, for all research
expenses exceeding one percent of sales.
fixed-base regular credit, introduced in 1990, was intended reward
firms with long-lasting tax benefits for proportionally increased
levels of R&D investment. In practice, it had the effect of creating
classes of credit winners and losers in short order. Many research-intensive
firms were effectively shut out from credit use for reasons ranging
from traditional commitments to R&D to temporary trade conditions
that affected their mid-1980's sales volumes. Other firms, for opposite
reasons, benefited by getting locked into a low base rate. Both
of these effects - subsidy of winners and exclusion of losers -
would be expected to reduce the credit's efficiency as a stimulus
for R&D.(11) The
alternative credit that came about in 1996 enabled a wider range
of firms to use the credit, but its marginal rate - less than three
cents of credit per dollar of additional R&D - offers minimal incentive
for alternative credit users to intensify their R&D.
special subsection of the research and experimentation credit, the
basic research credit(12),
is intended to stimulate research collaborations between private
firms and universities. This credit applies to incremental expenses
(over an inflation-adjusted fixed base period from 1981 to 1983)
paid to universities and other qualified nonprofit organizations
for contract research "not having a specific commercial objective."
The language barring specific commercial objectives is thought to
exclude significant amounts of R&D that by most standards would
be considered public-benefit research, including clinical testing
that is done with a commercial objective in mind. In addition, as
R&D partnerships play an increasingly important role in the larger
R&D enterprise, many are taking forms that fall outside the scope
of this credit.
administrative aspects of the research and experimentation credit
make it difficult to use, particularly by smaller firms with limited
accounting resources. Because qualified research activities are
defined in a manner that differs from accepted definitions for financial
accounting and survey purposes, firms must compile separate streams
of accounting data for current and base-period expenses just to
apply for the credit. In addition, special phase-in rules for the
base tend to adversely affect many research-intensive startup firms.
Depending on the trajectories of their research intensities over
their initial credit-using years, startups can be saddled with relatively
high fixed base intensities that reduce their future abilities to
apply for credit.
research and experimentation tax credit has never been made permanent,
and in recent years, even temporary extensions of the credit have
been difficult to obtain. This legislative unpredictability has
the adverse policy effect of making the credit difficult to use
for long-term investments and biasing credit use, instead, toward
near-term efforts involving less uncertainty and risk.
The Orphan Drug Credit
The orphan drug credit(13)
is part of a series of financial and regulatory incentives established
by the Orphan Drug Act in 1983, which was designed to encourage
development of treatments for rare diseases whose small market potentials
would otherwise be insufficient to justify development costs. The
credit is a 50 percent flat credit, applicable to the costs of human
clinical testing of drugs for diseases or conditions that affect
fewer than 200,000 people in the United States or are otherwise
designated under the Federal Food, Drug, and Cosmetics Act.
After a handful of temporary extensions, the orphan drug credit
was made permanent by the Taxpayer Relief Act of 1997. The relatively
small cost of this credit (about $40 million, as opposed to $2 billion
for the research and experimentation credit) and effective lobbying
by disease groups are both thought to be significant factors in
the legislative success of this provision.(14)
Prospects: A Pessismistic View
an important niche has been addressed by the orphan drug tax credit,
the vast majority of tax incentives for private-sector medical R&D
will rise or fall with the main research and experimentation tax
credit. After nine temporary extensions over the past 17 years and
a 12-month lapse in coverage from mid-1995 to 1996, each additional
extension of the research credit has become a chancy political exercise.
It is doubtful that sufficient political strength exists to make
this credit permanent in its present form.
the cost of the credit and current budget rules, legislators have
strong incentives to temporarily extend the credit rather than make
it permanent. Even though the long-term costs to the Treasury of
one five-year extension or five one-year extensions are the same,
a series of brief extensions allows current policy to be continued
without obliging tax-writers to find revenue offsets that balance
its long-term costs. Under current rules, the cost of a permanent
credit would need to be offset over five years in the House, and
ten years in the Senate. Since a five-year extension would require
the same offsets as permanence in the House, it is also unlikely
that the credit would ever be extended for much more than a year
or two at a time.
Prospects: An Optimistic View
Despite those difficulties, recent legislative activity suggests
that there is strong Congressional interest in addressing substantive
improvements in R&D tax policy. Bills introduced in the 105th Congress
have proposed ways that the credit can be structured to be more
efficient and equitable for all R&D-performing firms. There has
also been strong interest in extending the credit to better reflect
contemporary R&D business arrangements, which include greater participation
by small businesses, universities, and various forms of collaborative
A bill introduced by Reps. Houghton (R-N.Y.) and Levin (D-Mich.)(15)
would extend a 20 percent flat credit to firms for their contributions
to broad-based public benefit research consortia. Companion bills
introduced by Sen. D'Amato (R-N.Y.) and Rep. Sam Johnson (R-Tex.)(16)
are designed to improve tax incentives for partnerships in clinical
research. Each of these proposals is designed to reach a specific
class of partnerships that is of growing importance to the R&D enterprise
but receives little incentive under present law.
more recent proposals have taken more comprehensive approaches to
improving R&D tax policy. Bills introduced by Sen. Domenici (R-N.M.)(17)
and Sen. Bingaman (D-N.M.)(18)
would make the research credit permanent and also take measured
steps to address difficulties inherent in the present credit structure
and improve its applicability to partnerships. The Domenici proposal
would allow historically research-intensive firms, who were previously
shut out from the regular credit, to benefit from a 20 percent incremental
rate by selecting a more recent period for their base. It would
also expand the credit for research partnerships by modifying the
commercial objective exclusion of the basic research credit to accommodate
university-industry partnerships, and by expanding the range of
qualifying partnerships would be to include those involving federal
laboratories and consortia.
Bingaman's proposal is similar in spirit, incorporating features
from all of the foregoing proposals. Instead of changing the base
rules for the regular credit, the Bingaman bill retains the regular
credit without modification, and focuses improvements on the alternative
credit. Users of an improved alternative credit would have access
to a 20 percent marginal rate, plus a three-percent credit for their
maintained levels of R&D intensity. The improved alternative credit
is designed to combine the immediate cash flow benefit of the regular
credit with the accessibility of the present alternative credit.
In order to simplify compliance, the definition of qualifying activities
for the improved credit is aligned with the Financial Accounting
Standards definition of R&D, which is based on the NSF survey definition
and is familiar to business accountants. To improve the credit for
research partnerships, the Bingaman bill redefines qualifying activities
for the basic research credit in a manner following Domenici. In
addition, the basic research credit and a credit for research consortia
are restructured as flat credits, as in the Houghton bill. Small
firms would benefit from the above definitional simplifications,
as well as an improved credit phase-in schedule for start-ups.
analyses by the Joint Committee on Taxation suggest that comprehensive
improvements of the sort envisioned by the Bingaman bill can be
implemented without substantially increasing the credit's revenue
cost, in part because legislative changes are restricted to aspects
of present law that account for small fractions of current tax expenditures.
Politically, however, those improvements could be expected to have
an important impact. They are sufficiently comprehensive to address
the most common criticisms that are leveled at the credit under
present law. In addition, they might engage sufficient numbers of
R&D performers who are disenfranchised under current R&D tax policy
to broaden and strengthen the political constituencies in favor
of a permanent research credit.
R&D tax policy in the manners that have been proposed would be beneficial
both to medical and other forms of private-sector R&D. In keeping
with general trends, medical R&D depends on increased levels of
investment and the interlinking of research endeavors at large and
small firms, academic institutions, and other types of research
organizations. With longer development times than other sectors,
medical R&D stands to benefit in particular from the more stable
long-term tax environment that would result from improved tax incentives.
Recent legislative developments offer encouraging signs that long-standing
R&D tax policy issues may finally be effectively addressed, to the
benefit of all forms of private sector R&D.
(1) Kenneth C. Whang analyzed
R&D tax policy for the Joint Economic Committee, Minority Staff,
during the 105th Congress, and is now a science policy fellow at
the National Science Foundation. The opinions expressed in this
paper are solely those of the author and do not represent the views
of the Joint Economic Committee or the National Science Foundation.
This paper was prepared for the AAAS/Funding First workshop, "How
to Fund Science: The Future of Medical Research," February 14-16,
1999, Wye River Conference Centers, Queenstown, Md.
(2) According to studies
reviewed by Griliches (1992), Jarboe (1998), and Department of Finance
Canada (1998), social returns exceed private returns by two to five
times. Because they cannot capture most of these benefits, private
firms cannot afford to invest in R&D at levels that would maximize
overall economic benefit.
Notable counterexamples at the microeconomic level include research
on rare diseases (whose small markets for therapeutics are insufficient
to exceed development cost thresholds), and some vaccines for communicable
diseases (where benefit to an individual customer, and consequent
willingness to pay, is far exceeded by collective public benefit).
Fuchs (1974) cites the decline of infant mortality in New York City
in the early part of this century: "It is important to realize that
medical care played almost no role in this decline. While we do
not know the precise causes, it is believed that rising living standards,
the spread of literacy and education, and a substantial fall in
the birth rate all played a part."
In the abstract, the ecosystem of interactions among activities
is somewhat like the informational equivalent of a supply chain
network: value added at each level has maximum impact on the system
as a whole when capacity across levels is balanced and communications
between levels are facilitated. Similar balance and coordination
issues arise in the stewardship of early-, mid-, and late-phase
industrial R&D; preventive medicine vs. treatment; education and
workforce training; and human resources flow within and beyond the
DiMasi et al. (1991) estimate that the average development cost
of a new drug is approximately $326 million (adjusted to 1997 dollars).
A more recent study by PhRMA (1997) estimates a cost of $500 million
over 15 years, and reports that the pharmaceutical industry spends
$20 billion per year on R&D.
Blumenthal et al. (1996).
Reviewed by Hall (1993), Office of Technology Assessment (1995),
and Whang (1998). Note that as it was originally introduced in 1981,
the credit was substantially different from its present structure.
A 25 percent incremental credit applied to annual increases in R&D
spending compared to base R&D spending levels averaged over the
three preceding years.
26 U.S.C. 41, also known as the R&D tax credit, the R&E tax credit,
the research credit, and the Credit for Increasing Research Activities.
The marginal credit rate is halved if current research intensity
is more than double the 1984 to 1988 fixed base. In that case, under
the ÿ50 percent rule," the base is taken to be half of the current
research intensity, and the regular credit essentially acts like
a 10 percent flat credit instead. Special rules for calculating
the base apply to startup companies, mergers, and spinoffs.
These effects were predicted in an early analysis by the Joint Committee
on Taxation (1992), and then documented in a subsequent study by
the General Accounting Office (1995).
26 U.S.C. 41(e).
26 U.S.C. 45C.
The orphan drug designation itself is not without controversy. Many
drugs have received orphan status on the basis of a single "use"
that affects fewer than 200,000 people, even though the drug's overall
target market is in fact much larger.
105th Cong. H.R. 3857.
105th Cong. S. 1885 and H.R. 3815.
105th Cong. S. 2072.
105th Cong. S. 2268.
Blumenthal, D., Causino, N., Campbell, E., and Louis, K.S., 1996.
"Relationships between academic institutions and industry in the
life sciences: an industry survey." New England J. Med. 13:
Department of Finance Canada, 1998. Why and How Governments Support
Research and Development. Ottawa: Department of Finance.
DiMasi, J.A., Hansen, R.W., Grabowski, H.G., and Lasagna, L., 1991.
Cost of innovation in the pharmaceutical industry. J. Health
Econ. 10: 107-142.
Fuchs, V., 1974. Who Shall Live? New York: Basic Books.
Accounting Office, 1995. Additional Information on the Research
Tax Credit. GAO/T-GGD-95-161.
Z., 1992. "The Search for R&D Spillovers." Scand. J. Econ.
94 supp.: 29-47.
B., 1993. "R&D tax policy during the eighties: success or failure?"
Tax Policy and the Economy 7: 1-36.
K., 1998. "Technology and economic growth." Working Paper Series
offered to the Joint Economic Committee Minority.
Committee on Taxation, 1992. Description and Analysis of Tax
Provisions Expiring in 1992. JCS-2-92.
of Technology Assessment, 1995. The Effectiveness of Research and
Experimentation Tax Credits. OTA-BP-ITC-174.
1997. PhRMA Annual Survey. Washington: Pharmaceutical Research
and Manufacturers of America.
K., 1998. "A guide to the research tax credit." Working Paper Series
offered to the Joint Economic Committee Minority
1999 American Association for the Advancement of Science