Candice Horbacz
The United States tax code’s differential treatment of research and development (R&D) expenditures is a critical determinant of where, how, and whether American companies choose to innovate and invest. This disparity, particularly between domestic and foreign R&D, has far-reaching consequences for the nation’s economic dynamism and global standing, prompting calls for a more harmonized and competitive approach to innovation policy.
A Deep Dive into the Dual Tax Regimes
Currently, the US tax system presents a bifurcated approach to R&D costs. Under Section 174A of the tax code, domestic R&D benefits from a choice: taxpayers can either immediately deduct these expenditures, known as full expensing, or amortize them over a period of at least 60 months (five years). Full expensing, which allows businesses to immediately deduct the full cost of certain investments, is generally considered superior as it provides an immediate tax benefit, alleviating a bias in the tax code and incentivizing companies to invest more. However, a company might opt for amortization if it has a net operating loss (NOL) and cannot fully utilize the immediate deduction, choosing instead to smooth the tax benefit into future profitable years.
By stark contrast, foreign R&D faces a much more restrictive regime under Section 174. Companies have no option for immediate expensing; all foreign R&D expenditures must be capitalized and amortized over an extended period of 15 years. This significant divergence creates an uneven playing field, effectively penalizing innovation conducted outside US borders, even when such activities are integral to a company’s global strategy and domestic success.
The Historical Context: From Expensing to Amortization and Back (Partially)
The current differential treatment is a relatively recent phenomenon, born out of a series of legislative changes and attempted reversals. For decades prior to 2022, US tax law generally allowed businesses to immediately deduct all R&D expenses, recognizing their importance for economic growth and competitiveness. This policy was widely praised by industry and economists as a powerful incentive for innovation.
However, the landscape dramatically shifted with the passage of the Tax Cuts and Jobs Act (TCJA) of 2017. A key provision of the TCJA mandated that, for tax years beginning after December 31, 2021, all R&D expenses – both domestic and foreign – would no longer be immediately deductible. Instead, domestic R&D was to be amortized over five years, and foreign R&D over 15 years. The motivations behind this change were multifaceted, including a desire to broaden the tax base to offset other tax cuts and to align US tax treatment more closely with certain international norms regarding R&D capitalization.
This universal amortization provision was met with widespread criticism from the business community and tax policy experts, including the Tax Foundation. Critics argued that the change would significantly increase the cost of R&D, discourage investment, and harm US competitiveness. According to the Tax Foundation, requiring amortization over 5 or 15 years, rather than allowing immediate expensing, effectively creates a higher tax burden on R&D, thus raising the hurdle rate for innovative projects.
In response to sustained pressure and recognizing the potential adverse impacts, legislative efforts were made to reverse course. While a full, permanent reversal for all R&D has not yet been achieved, the situation for domestic R&D was partially addressed through subsequent legislation, often informally referred to as omnibus spending bills or similar acts. The Tax Foundation article refers to a reversal for domestic R&D under the "One Big Beautiful Bill Act (OBBBA)," which, while likely an informal or placeholder name used by the organization, signifies legislative action that restored the option for immediate expensing (or a 60-month amortization) for domestic R&D. Unfortunately, foreign R&D was largely excluded from this reversal, maintaining its mandatory 15-year amortization schedule.
The exclusion of foreign R&D from this partial reversal was likely driven by two primary considerations: reducing the budgetary cost of the law, as restoring expensing for all R&D would have a larger fiscal impact, and an implicit desire to encourage the onshoring of R&D activities, under the belief that domestic innovation solely benefits the US economy. However, as economic analysis suggests, these motivations may be short-sighted and counterproductive in a globally integrated economy.
The Economic Mechanics: Expensing vs. Amortization and the Cost of Capital
To understand why the timing of tax deductions—expensing versus amortization—is so critical, one must consider the time value of money. Firms evaluate potential investments by weighing present and future revenues, expenses, and tax payments. A foundational 1967 research paper by Robert Hall and Dale Jorgenson elucidated this concept, demonstrating how tax policy influences investment behavior through its impact on the user cost of capital.
The user cost of capital, often denoted as c, represents the minimum rate of return a project must generate to justify the investment. Anything that increases c effectively raises the hurdle rate, discouraging investment at the margin. In the Hall-Jorgenson framework, the standard formula for the user cost of capital incorporates the interest rate (r), the depreciation rate of the asset (δ), and the corporate tax rate (τ), interacting with a key variable z.
The variable z captures the present value of the tax deductions a firm can claim on an investment. When z equals 1, meaning the firm recovers the full value of its investment in tax deductions immediately (as with full expensing), the tax term in the cost-of-capital formula effectively cancels out. In this scenario, the user cost of capital collapses to what it would be in a no-corporate-tax environment, determined solely by the interest rate and the depreciation of the investment. This implies that the effective marginal tax rate on a break-even investment is zero. Full expensing achieves this by providing an immediate tax benefit that offsets the government’s future collection of tax on the income generated by a marginal project.
Amortization, however, has the opposite effect. By spreading deductions over an extended period—five years for domestic R&D choosing amortization, and a mandatory 15 years for foreign R&D—the value of z is pushed below 1. This delay in tax relief means that firms receive the tax benefit later, diminishing its present value. Consequently, amortization drives the user cost of capital above the no-tax baseline, thereby raising the hurdle rate for R&D projects. This increased cost acts as a disincentive, leading to some projects being abandoned purely for tax reasons, even if they are otherwise economically viable.
Under the current US tax system, domestic R&D often has the advantage of avoiding this disincentive through expensing, while foreign R&D cannot. This creates a significant bias. In 2022, US businesses invested approximately $660 billion in R&D, representing a substantial portion of the nation’s total R&D expenditure of over $800 billion. The economic literature consistently demonstrates that R&D investment has a high social return, generating innovation, productivity growth, and high-quality jobs. By raising the cost of foreign R&D, the US risks stifling a crucial component of this innovation ecosystem.
It is important to note that while full expensing makes the effective marginal tax rate on a break-even investment zero, it does not mean the tax system generates no revenue. Inframarginal investments—those whose benefits significantly exceed their costs—still incur a positive tax burden. Moreover, pre-existing investments continue to generate taxable income regardless of the depreciation schedule, contributing to overall tax revenues. The focus of expensing is on encouraging new investment at the margin, not eliminating taxes entirely.
Foreign R&D: A Complement, Not a Competitor
A common underlying assumption for taxing foreign R&D more heavily is that it competes with domestic R&D, and thus, discouraging the former will "onshore" R&D activities and boost domestic innovation. However, this view fundamentally misunderstands the nature of global innovation. Economic research overwhelmingly indicates that international R&D activities are typically complementary to domestic operations, enhancing and scaling them rather than displacing them.
For instance, much foreign R&D is dedicated to market adaptation. This involves tailoring US-developed products or services to suit specific foreign languages, climates, infrastructure, payment systems, or cultural preferences to facilitate their export. This can also include navigating complex foreign regulatory systems, such as obtaining approvals for pharmaceuticals or adhering to local workplace safety standards. Without such localized R&D, US companies would struggle to access international markets, limiting the global reach and profitability of domestically developed innovations.
Another prevalent pattern for foreign R&D involves the acquisition and integration of foreign research teams and intellectual property. A valuable idea, perhaps a software algorithm or a pharmaceutical patent, generated outside the US, might prove incredibly useful to a large US company. By acquiring the foreign entity or its R&D capabilities, the US company can leverage its substantial infrastructure and resources to further develop, scale, and commercialize these innovations, often leading to subsequent investments and job creation within the United States.
Both academic research institutions and prominent business organizations have underscored this complementarity. Economists Gary Hufbauer, Theodore Moran, and Lindsay Oldenski, in their extensive work on outbound foreign direct investment (FDI) and its interaction with the US economy, specifically studied R&D complementarity. Their findings suggest that "global R&D expenditures and operations of US MNCs may create complementary capabilities and interdependent competencies, rather than simply displacing one capability or competency from location A to location B." Moran and Oldenski further argued that "measures to hinder or slow the globalization of R&D by US [multinational corporations] will stifle R&D by those multinationals in the United States."
Similarly, the Information Technology and Innovation Foundation (ITIF) has published research demonstrating that offshore research tends to complement domestic innovation rather than compete with it. This occurs through various mechanisms, including accelerating localized product adaptation, expanding a firm’s broader knowledge network, and fostering a global exchange of ideas that ultimately benefits the parent company’s domestic R&D efforts.
In essence, by penalizing foreign R&D, the US tax code is more likely to reduce a US company’s total cross-border knowledge production and innovation capacity, rather than simply shifting those activities back home. This ultimately diminishes the global competitiveness and innovative output of US-headquartered multinationals.
The Global Race: Impact on US Competitiveness and Mergers & Acquisitions
The harsher US tax rules on foreign R&D have a direct and detrimental impact on the ability of US companies to compete in cross-border mergers and acquisitions (M&A). Consider a foreign acquisition target that is highly R&D-intensive. If a US acquirer must amortize the target’s future R&D spending over 15 years, while a foreign competitor, operating under a more favorable tax regime, can expense those same costs immediately, the US firm’s after-tax valuation of that target will be structurally lower. This disadvantage can easily lead to the US firm losing bidding wars for innovative foreign assets.
The Semiconductor Industry Association (SIA) has vociferously argued that US chip firms face a significant disadvantage when competing globally for innovative assets because foreign rivals often receive more favorable tax treatment for research spending. This insight, however, is not confined to the semiconductor industry; it applies equally to many other R&D-heavy sectors, such as the pharmaceutical industry, which relies heavily on M&A to acquire new drug pipelines and research capabilities.
According to data from PwC, cross-border M&A deals consistently represent a significant portion of global M&A activity, with sectors like technology, media, and telecom (TMT) and healthcare often leading the charge. If US companies are less competitive bidders in this arena, they lose opportunities to integrate cutting-edge research, expand their technological base, and achieve economies of scale. This loss not only harms the US economy through the aforementioned complementarity effects but also reduces the global reach and revenue-generation capacity of US firms. Over time, this could even discourage companies from maintaining their US tax residence, opting instead for domiciles with more innovation-friendly tax policies, thereby shrinking the very tax base the US government seeks to protect.
Furthermore, other major economies actively use R&D tax incentives to attract and retain innovative businesses. Countries like Canada, the UK, France, and Australia offer generous R&D tax credits, often alongside immediate expensing provisions, making them attractive locations for R&D investment. For example, Canada’s Scientific Research and Experimental Development (SR&ED) program provides billions in tax incentives annually. The divergence in US policy puts American companies at a distinct disadvantage in this global competition for innovation and talent.
Industry Voices and Policy Debates
The criticisms of the current R&D tax treatment are broad and consistent across various industry sectors and economic analyses. Groups like the Semiconductor Industry Association, the Pharmaceutical Research and Manufacturers of America (PhRMA), and the Information Technology Industry Council (ITI) have consistently advocated for the restoration of full R&D expensing for all R&D, regardless of location. They highlight the immediate increase in tax burdens, the disincentive for future investment, and the erosion of global competitiveness.
From a policy perspective, the debate often centers on balancing immediate budgetary considerations against long-term economic growth. Policymakers who resist universal expensing for R&D might point to the direct revenue cost of such a measure. However, economists argue that these immediate costs are often offset by the long-term benefits of increased innovation, higher productivity, and a stronger tax base from a more dynamic economy. The budgetary cost of immediate expensing for R&D, while significant in the short term, is an investment in future prosperity.
There is a growing consensus among economists and business leaders that the US cannot afford to hobble its innovative companies through suboptimal tax policy. The global race for technological leadership is intense, and tax policy is a powerful tool in attracting and retaining R&D investment.
Charting a Path Forward: Towards Neutrality and Enhanced Innovation
To truly foster innovation and maintain its global competitive edge, the United States should move decisively toward a neutral tax treatment of R&D expenditures, irrespective of where they occur. Policymakers must avoid creating disadvantages that disproportionately burden foreign R&D performed by US multinational enterprises.
This approach would yield several significant benefits:
- Increased Overall Innovation: By reducing the tax hurdle for all R&D, US companies would be incentivized to undertake more innovative projects, both domestically and abroad, leading to a greater pipeline of new products, services, and technologies.
- Stronger Global Competitiveness: A neutral R&D tax regime would level the playing field for US firms, allowing them to compete more effectively with foreign rivals for R&D talent, intellectual property, and market share globally.
- Improved M&A Prospects: US companies would become more competitive bidders in cross-border M&A, enabling them to acquire valuable foreign research teams and technologies that can be integrated and scaled through their US operations.
- Enhanced Economic Growth and Job Creation: By promoting overall innovation and competitiveness, a neutral R&D tax policy would ultimately lead to higher productivity, more high-paying jobs, and stronger economic growth within the United States.
In an increasingly interconnected and innovation-driven global economy, US tax policy must reflect the realities of modern business. The current divergence in R&D tax treatment creates an unnecessary impediment to American ingenuity and competitiveness. Reforming Section 174 to allow immediate expensing for all R&D expenditures, regardless of their geographic location, is a critical step toward ensuring that the United States remains a global leader in innovation and economic prosperity. The choice is clear: embrace a tax policy that empowers innovation everywhere, or risk falling behind.
