Kenneth C. Whang(1)

1. Supply and Demand of R&D
2. Encouraging the Private Sector
3. The Research and Experimentation Tax Credit
4. The Orphan Drug Credit
5. Political Prospects: A Pessimistic View
6. Political Prospects: An Optimistic View
7. References

Public 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)

More 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.

Supply 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 interlinked.(5)

Encouraging 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.

The 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)

Tax 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.

The 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.

The 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.

A 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.

Other 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.

The 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)

Political Prospects: A Pessismistic View
While 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.

Given 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.

Political 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 partnerships.

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.

Two 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.

Sen. 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.

Unpublished 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.

Strengthening 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.

(3) 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).

(4) 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."

(5) 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 R&D enterprise.

(6) 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.

(7) Blumenthal et al. (1996).

(8) 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.

(9) 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.

(10) 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.

(11) 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).

(12) 26 U.S.C. 41(e).

(13) 26 U.S.C. 45C.

(14) 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.

(15) 105th Cong. H.R. 3857.

(16) 105th Cong. S. 1885 and H.R. 3815.

(17) 105th Cong. S. 2072.

(18) 105th Cong. S. 2268.

References
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: 146-158.

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.

General Accounting Office, 1995. Additional Information on the Research Tax Credit. GAO/T-GGD-95-161.

Griliches, Z., 1992. "The Search for R&D Spillovers." Scand. J. Econ. 94 supp.: 29-47.

Hall, B., 1993. "R&D tax policy during the eighties: success or failure?" Tax Policy and the Economy 7: 1-36.

Jarboe, K., 1998. "Technology and economic growth." Working Paper Series offered to the Joint Economic Committee Minority.

Joint Committee on Taxation, 1992. Description and Analysis of Tax Provisions Expiring in 1992. JCS-2-92.

Office of Technology Assessment, 1995. The Effectiveness of Research and Experimentation Tax Credits. OTA-BP-ITC-174.

PhRMA, 1997. PhRMA Annual Survey. Washington: Pharmaceutical Research and Manufacturers of America.

Whang, 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