Policy Studies Governance

The Effects of the Tax Reform on Energy and Environmental Research and Development

Philip Rossetti
Resident Senior Fellow, Energy

Key Points

For years, private sector energy and environmental research and development (R&D) has been stagnant. This could be normal, but it indicates that the government-driven view of innovation is at odds with the realities of private-sector responses.

Tax policy matters for energy and environmental innovation. For example, the private sector responded to the 2017 Tax Cuts and Jobs Act (more commonly known as the tax reform) in a big way, with an increase of $3.3 billion of investment in the energy and environmental space.

There is not enough data to determine how big of an impact specific pieces of the tax reform had on private-sector innovation. However, the fact that there was a notable response to the tax reform means that policymakers should be cautious when considering paying for energy or environmental priorities with corporate rate increases or other taxes on capital investment as those changes may be counter-productive to overall energy and environmental investment and innovation.

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Executive Summary

Changes in the 2017 tax reform to the tax treatment of research and development (R&D) may be an explanation for an observed increase in private sector R&D investment in energy and environmental R&D (E&E R&D). Prior to the tax reform, private sector E&E R&D was relatively stagnant, only increasing by 2 percent from 2012-2017. After the tax reform, E&E R&D jumped by $3.3 billion, or 11.8 percent. Private sector E&E R&D is roughly seven times as large as public sector R&D and fulfills a fundamentally different role in the innovation life cycle than public sector R&D, so the increase in private sector innovation may mark a win for investment in technologies that are key in the pursuit of global climate objectives.

Conversely, the jump in R&D could be temporary in nature. Since the most impactful changes to the tax code for R&D were temporary, it is possible that companies may simply be trying to move as much of their projected R&D to an earlier timeframe to capture a preferential tax treatment. Until further data is available, it will be difficult to pin down exactly what conditions of 2018 best explain the increase in both E&E R&D and economy-wide R&D.

Overall, the early data post-tax reform is promising, indicating that at least some of the policies included reforms achieved the hoped-for objectives of stimulating private sector investments in potential avenues for productivity. Importantly, though, this analysis is focused on R&D—specifically E&E R&D—and not the overall tax reform, which undoubtedly given its size has variability in which policies may have been effectual or not.

As policymakers move forward, they should keep in mind the significant impact that tax policy has on the incentives for the private sector to invest in innovation in the United States, including sectors that may be key for broader political priorities like climate change. They should also exercise discipline when seeking to raise taxes on capital, as they may inadvertently diminish investment opportunities in sectors that policymakers are otherwise seeking to amplify.

Key Findings

  • Immediately following the tax reform, economy-wide private sector R&D paid for and performed by companies increased by $38.8 billion, or 11.4 percent—nearly double the 6.4 percent increase of the year prior.
  • Private sector E&E R&D increased after the tax reform by $3.3 billion, or 11.8 percent, its largest increase in the observed data, and significantly higher than its 2012-2017 increase of only 2 percent.
  • The share of private sector E&E R&D relative to total economy-wide R&D following the tax reform also slightly increased, a change from its expected decline, indicating that there may be more appetite for E&E R&D investment in the private sector than previously expected.

Key Recommendations

  • Make permanent the tax reform’s authorization of R&D expensing in lieu of R&D amortization, which would preserve the incentive for the private sector to invest in innovation.
  • Avoid the temptation to implement or restore taxes on capital to pay for public spending, as the harm to future productivity from the tax may outweigh the benefit of public spending.
  • Understand that transferring too much of the costs of mature energy and environmental technology to the public sector may crowd out private sector investment, as competing technologies would have to compete with subsidized technology to enter into market.
  • Do not neglect the comparative advantages of both private- and public-sector innovation; the private sector is better at scaling and commercializing near-mature technology with profitable applications, and the public sector is better at advancing not-yet-profitable technologies that may yield long-term societal benefits.

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