Lack of R&D Spending Links To Job Loss

Innovation drives growth and lifts living standards. For that reason, most governments incentivize businesses to innovate.

I say ‘most governments’ because that is currently not true in the United States.

The Tax Cuts and Jobs Act of 2017

The way governments can speed up innovation is through its treatment of research and development (R&D) expenditures. For example, most governments allow R&D spending to be expensed fully in the year it occurs. That means businesses can recoup the money and reinvest it for R&D immediately.

However, because of a provision of the 2017 Tax Cuts and Jobs Act, which took effect starting in 2022, Congress is discouraging research and development investments by requiring firms to amortize R&D expenditures over five years for domestic R&D rather than immediately deduct them from taxable income.

As an example of the impact of this change, consider a software startup with $20 million in revenue in 2022 and $1 million in profit. Its R&D expenditures over 2022 were $5 million.

In 2021, the business would have immediately expensed the annual R&D costs. In 2022, however, the domestic R&D costs would be amortized over five years and the mid-year convention would be used (i.e., in 2022, only 10% of the 2022 R&D costs can be claimed).

Instead of $1 million in profit, this startup is now looking at taxable income of $5.5 million and therefore a significantly higher tax liability. At a 21% corporate tax rate, this start-up would pay $1,155,000 in taxes —exceeding its total profit. Clearly, an unanticipated consequence for this small business.

A unique challenge for American small businesses

The United States is currently the only developed country requiring the amortization of R&D expenditures. This policy change has had an outsized impact on R&D-intensive industries including software and certain manufacturing industries.

A February 2, 2024 Wall Street Journal article reported that “Aerospace and defense technology company Northrop Grumman’s estimated tax liability for 2023 because of the law change was approximately $500 million, for instance, and aerospace and defense company Lockheed Martin said its 2023 cash tax liability increased by roughly $560 million because of the law, according to regulatory filings.”

It also puts America’s small and early-stage businesses, which often must manage their cash extremely carefully, in a particularly tough position.

From a macroeconomic perspective, an Ernst & Young report conducted for the R&D Coalition, concluded that the change requiring amortization will reduce R&D spending $4.1 billion annually in the first five years beginning with 2022 and $10.1 billion each year in the second five years and beyond. That will lead to a loss of 23,400 jobs in each of the first five years and 58,600 in each of the second five years.

A decline in R&D spending will make the United States less competitive, and some employers reluctant to hire additional workers or even choose to let go of current employees.

In February 2024, the House of Representatives passed the Tax Relief for American Families and Workers Act with a wide bipartisan margin that restores the ability to immediately deduct R&D expenses through 2025.

As recently as August 1, 2024, the Senate failed to advance that bill out of committee, thereby stalling the bill’s progress.

Labor Day is a celebration of the accomplishments of America’s workers. It reflects the many collaborations from a diverse mix of laborers that have benefited from the innovations of past generations.