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What the tax plan means for innovation

December 20, 2017
By: Jason Rittenberg

The Republican tax plan passed Congress this week. The legislation, which is part tax cut — $1.5 trillion over 10 years — and part reform — replacing multiple deductions and credits with overall lower rates — will affect the U.S. economy for years to come. Education, employment, capital access and business investment are likely to be directly affected as soon as next year, and, if state budgets hold any value as predictors, regional innovation economies will be particularly affected through future reductions in federal spending.

What the bill does for innovation

The bill’s final, direct impacts on education, science, tech and innovation are more limited than those presented in earlier drafts. Deductions related to higher education affordability remain intact, as do the R&D tax credit, along with most economic development credits, and the ability of startup employees to defer taxes on equity grants. There are several changes likely to affect universities and new businesses:[*]

  • Private universities with at least 500 students and an endowment of more than $500,000 per student will pay a 1.4 percent excise tax;[#]
  • Deductions for charitable giving remain and individuals will be able to claim contributions up to 60 percent of their income — but contributions made in relation to ticket purchases will no longer be eligible (beyond other implications, many NCAA Division I institutions raise millions of dollars through these arrangements);
  • Some fringe benefits, particularly transportation, parking and achievement awards will be subject to tax for both nonprofits (as unrelated business income) and corporations (through the removal of deductions);
  • Net operating loss deductions will be limited to 80 percent of income and are no longer eligible for carryback;
  • Bonus depreciation is increased to 100 percent through 2022, extends 50 percent through 2026 and makes used property eligible for the deduction;
  • Investors will be able to defer capital gains taxes as long as they invest in businesses in distressed communities designated by each state as “opportunity zones;” and,
  • Fund managers will be able to avoid short term capital gains taxes so long as investments are held for three years.

How the bill may shift innovation priorities

The most significant changes for innovation are likely to come from shifting priorities as individuals, investors and businesses learn and react to how more fundamental changes affect the marginal benefits of different types of activities. These changes will result from the transition of higher taxes with more itemized deductions to lower rates with fewer experienced deductions.

Here are a few examples of areas to watch in the coming months and years:

  • Decisions to attend universities – while college affordability deductions remain in place, lower tax rates and a higher standard deduction mean that fewer people are expected to use these benefits. Whether this will translate to lower enrollment is less clear.
  • Charitable giving – while the deduction for charitable contributions are in the bill, low-moderate income households will be less likely to itemize their taxes while high income households will see lower rates and larger estate thresholds limit their incentives to give. With a weakened financial motivation to call upon, nonprofits may need to do more work to attract funds.
  • Employee decisions – the limit to state and local tax deductibility will increase the costs of living and working in many coastal cities, which may further exacerbate the affordability of notable tech hubs like San Francisco and Boston. At the same time, established firms may limit some of their employment perks once fewer benefits are deductible. These factors could make positions with startups in “flyover” regions comparatively more attractive than they have been in the past.
  • Business investments – the corporate tax rate will be reduced from 35 percent to 21 percent, but the effective change in rates will be much smaller for most industries because few companies paid the maximum corporate tax rate. The optimistic assumption is that businesses will have more money to invest, but many firms are sitting on billions in cash already that is not invested. Then again, many tech firms hold this cash overseas and will be able to bring it to the U.S. at lower rates… but firms making payments to overseas affiliates will pay a new tax and see the benefit of many tax credits reduced. Compelling predictions include decreasing valuations for sellable tax credits and an increase in M&A activity by international corporations in 2018.

Will the bill affect innovation spending?

The greatest impact of the tax plan is likely to be felt once Congress sees the reports on federal revenues in FY 2021 and beyond. Even with factoring a modest boost to GDP, most scores of the tax plan see a cost of about $1 trillion over 10 years. This is nearly 10 percent of the federal discretionary budget. The FY 2019 budget will be prepared early next year and even the 2020 budget may be underway before reporting on a full year of receipts under the new tax regime are understood.

Several states, most notably Kansas, have significantly reduced state taxes and then felt compelled to trim spending when growth rates did not increase enough (or at all) to cover the lost revenues. If the hoped for growth does not materialize and Congress experiences a similar drive to control spending, the results for innovation could be catastrophic.

As an illustration, consider the dynamically-scored cost of $1 trillion, approximately $100 billion per year, and assume that Congress would not make cuts to mandatory programs (which may be on the table) and would honor its traditional approach of cutting defense and non-defense discretionary spending evenly (something defense hawks strongly oppose). If these factors all held, a $50 billion reduction in non-defense spending is almost exactly what the White House requested in its FY 2018 budget, which eliminated EDA and cut $12 billion from federal science agencies, among many other harmful provisions. Even if Congress decides only to make up half of the bill’s costs in future years, the impact on innovation could be substantial.

Regardless, then, of whether the tax bill is good or bad for innovation in a vacuum, the community of science, tech, innovation and entrepreneurship policymakers and practitioners should be very concerned about its implications for innovation economies.




[*] Unless otherwise noted, the information for this section was primarily developed with reliance on: the bill’s conference report; “Conference committee tax bill released” by Steptoe & Johnson LLP; and, “House-Senate Conferees Approve Tax Cuts and Jobs Act” by Michael Novogradac.

[#] Added December 22. An exemption for universities that use their endowments to provide free tuition was removed to satisfy the Byrd Rule, but the overall excise tax remains.

 

tax rules, tax credits