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Recent Research: Measuring the Effectiveness of State R&D Tax Credits

April 30, 2008

Two weeks ago, Idaho Gov. C.L. “Butch” Otter vetoed legislation to repeal state R&D income tax credits for Idaho companies. Among his reasons for the veto, Gov. Otter claimed removing the credits would put Idaho at a competitive disadvantage because surrounding states over similar incentives. Was he right?

It is true most states offer R&D tax credits to their corporate residents at this point. Little has been known about the credits’ impacts or effectiveness on recruitment, however. Most of the academic research on the topic has focused on the federal R&D tax credits and competition among nations.
 
On the state level, in theory at least, a rationally acting, research-intensive firm can be expected to select a location within a state that has an R&D tax credit over another state without one – all other things being equal. Note: The italicized phrase is a critical but impossible one that is required for these kinds of conclusive statements. 
 
A recent research paper published in Economic Development Quarterly begins to shed some light on the effectiveness of state R&D tax credit programs for recruitment purposes. In State R&D Tax Credits and High-Technology Establishments, Yonghong Wu from the University of Illinois at Chicago concludes state R&D tax credits have “significant and positive effects” on the number of high tech establishments in a state.
 
Wu’s findings are based on increases in the number of high-tech companies within states, as measured by high-tech companies per capita and high-tech companies as a proportion of total businesses. Wu analyzed panel data for 49 states from 1994 to 2002, during which time 18 states initiated their own R&D tax credit programs. The author also provides an overview of the structure of state R&D tax credit programs, including their history, with Minnesota being the first to implement a program in 1982.
 
State R&D credits are primarily offered against a company’s state corporate income tax liability for R&D expenses performed within the state. Wu’s paper adds to the body of knowledge of tax credit research in that its main focus is state-level R&D tax credits and its central measure of effectiveness is high-tech firm growth, a bit different than gauging R&D spending levels as seen in other research on the topic. To better examine the effects of the state tax credits, the paper’s model accounts for the variation in state tax credit rates, academic and government R&D spending within the state, the percentage of a state’s population with a bachelor’s degree, and national economic factors that affect high-tech companies regardless of the state in which they are located.
 
Estimating the magnitude of impact for state R&D tax credits, Wu reports tax credit programs increase on average 0.07 percent of the total number of business establishments in a state per year and see an increase in the number of high-tech companies by 1.35 to 1.47 percent. On average, the tax credits help to create 101-106 high-tech firms and 2,306-2,422 high-tech jobs. Wu also steps though a sample exercise for the state of Washington for the year 1996, when it is estimated that state’s R&D tax credit program created one high-tech job at the cost of $9,000. If the job exists for 20 years, Wu estimates the present value of state tax revenues from the one position to be $112,000.
 
However, not all state R&D tax programs are created equal. For example, the percent of R&D expenditures eligible for credit varies from state to state. Additionally, some states offer “refundable” credits, set up such that the amount provided to a company utilizing the R&D tax credit may exceed that company’s actual state income tax liability. Some states allow credits to carry forward to future years, while others set percentage caps on the tax liability that can be applied to credits. 
 
Earlier this year, the Iowa Department of Revenue reviewed Iowa’s R&D tax credit program, which included a very detailed examination of the federal R&D tax credit and other state R&D tax credits across the country. The study found 38 states use R&D tax credits of various forms, with the most common credit rate percentage being 5 percent. The department reports the range extends from Michigan’s 1.9 percent rate to Rhode Island’s 22.5 percent. While the report offers no policy recommendations, it provides a structured analysis of Iowa’s R&D tax credit program.
 
Recent analysis by the Iowa Fiscal Partnership, based in part on the Iowa Revenue Department’s report, reveals potential problems with the refundable approach and highlights the fiscal impact of tax credits in general. The partnership is part of the State Fiscal Analysis Initiative, a network of state-level organizations, and the Center on Budget and Policy Priorities.
 
State R&D Tax Credits and High-Technology Establishments can be accessed from the most recent issue of Economic Development Quarterly (by subscription) at: http://edq.sagepub.com/cgi/content/abstract/22/2/136
 
Iowa’s Research Activities Tax Credit: Tax Credits Program Evaluation Study from January 2008 can be found through the Iowa Department of Revenue at: http://www.iowa.gov/tax/taxlaw/IDRTaxCreditEvalJan2008.pdf

Illinois, Iowa, Minnesota, Washingtonr&d, state revenue