Tax reform needs to keep R&D investment here in the US, not overseas

As President Donald Trump redoubles his efforts to fulfill campaign promises on tax reform, a critical part of his program is in jeopardy of being discarded, as a result of the efforts of uninformed or self-interested business lobbies.

The measure under attack is a proposal to increase taxes on importers of foreign goods and reduce taxes on exporters of American goods.  It must be restored if tax reform is to achieve its objectives of stimulating investment, preventing American companies from continuing to off-shore R&D and manufacturing, and avoiding increases in the deficit.

The fundamental problem to be fixed by overall tax reform is that American companies pay the highest taxes in the developed world.  As a result, U.S.-based multinationals have been moving their headquarters, research and development, and manufacturing activities overseas to lower-tax locales, forcing us to import goods that we used to produce at home.

Companies that do stay home get to keep such a small share of returns on their capital that they cannot afford to make investments that would be good for everyone.

This has other cascading effects. Research and development (R&D) is one of the most important categories of investment, in that it drives growth in productivity and wages as well as profits and output.  Without R&D and the innovations it produces, our standard of living would hardly be better than it was at the end of the nineteenth century.

According to the National Science Foundation, business R&D spending is now three times as large as government R&D, but since 2010 the basic research share of R&D has declined.   Basic research is the place where innovations start, and needs the most encouragement.

Lowering tax rates would improve the profitability of all long-term investments, and the payoffs from R&D are among the most long-term of all.

As happens too often in Washington, the one liner – border adjustments raise prices – seems to be winning, because it takes three sentences to prove it is wrong. And few politicians have a high enough opinion of the electorate to take that chance.

Another tax reform proposal, to eliminate the deductibility of interest paid by corporations, would level the playing field for high-tech companies with large R&D budgets, because these high-risk investments cannot be financed with loans.   Failures are as common as success in the early stages of innovation, and require investors to spread those risks across a portfolio of projects rather than lenders who require collateral and assurance of repayment.

The subsidy that the current tax code provides to banks and lenders by making interest but not dividends deductible therefore directs investment away from just the kind of innovative companies whose discoveries drive growth.

Finally, the R&D tax credit is one of the two current business tax credits retained in the reform proposals.

Unfortunately, these provisions are not sufficient to make the U.S. competitive with the inducements offered by other countries to attract R&D activities to their shores.  That difference was to be taken care of by border adjustment provisions in the original tax reform plan, which was presented to Congress by House Speaker Paul Ryan and Chairman Kevin Brady of the House Ways and Means Committee.

What the measure sought to redress is the fact that other countries try to attract R&D centers by offering extremely low tax rates on income generated by R&D activities, including income from patents and licensing of new products as well as income from manufacturing them.

The kicker is that the R&D and manufacturing must be done in the country offering the tax breaks.

When U.S. companies relocate overseas in response to these inducements, they avoid almost all taxes by hiring workers and keeping profits overseas while exporting manufactured goods back to the United States.

Not only that, companies that remain home must pay these off-shoring companies to use the patents that they registered overseas.  Even if some of the new products are manufactured in the U.S., a large part of the profits are thereby siphoned off to other countries.

The border adjustment was intended to fix this by eliminating the opportunity to deduct payments for imports, including payments for foreign patents, from business income.

At the same time, it would level the playing field with companies doing business in these low-tax nations by making income from exports tax-free.

The whole package of lower taxes, a level playing field in capital markets, continued R&D tax credits and the border adjustment would provide powerful incentives to invest in R&D within the United States and to produce here the new and better goods that are the fruits of R&D.

Unfortunately, the lobbying campaign against the border adjustment was underway long before anyone had a chance to explain how it would work.

Executives from Walmart, Target, and other big retail chains and off-shoring manufacturers like Nike descended en masse on Republican senators of the states in which they had headquarters to extract promises to oppose the border adjustments.

Their pitch was that the border adjustment would drive their prices up by 25 percent, because almost everything they sold was imported.

The damage had been done by the time Chairman Brady and a number of economists correctly pointed out that the brunt of the import adjustment would be borne primarily by foreign companies which would have to adjust their prices downward in order to maintain market share for the foreign-made products they sell into the United States.

Any residual upward pressure on prices in the U.S. would for the same reason be absorbed by retailers and other importers or quickly be neutralized by an increase in the value of the dollar in import transactions.

In other words, no real increase in consumer prices would be likely to  occur.

As happens too often in Washington, the one liner – border adjustments raise prices – seems to be winning, because it takes three sentences to prove it is wrong.  And few politicians have a high enough opinion of the electorate to take that chance.

We have a once-in-a-generation opportunity to reform the tax code in a way that will stimulate innovation and productivity growth for decades to come.

It is imperative that we not only move forward with tax reform, but ensure that it retains all the key provisions necessary to keep R&D happening here.

That includes the border adjustment.