Rethinking the Research Tax Credit


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A recent report from the Office of the Legislative Auditor (OLA) sheds new light on Minnesota’s research tax credit, also known as the research and development, or R&D, credit. This credit allows businesses that conduct qualifying research in Minnesota to reduce their state tax liability. The OLA report examines the question of whether the credit is providing benefits commensurate with the costs to the state in foregone revenue. The short answer appears to be “no.”

In 1981, Minnesota became the first state in the nation to enact a research credit. The credit was patterned after an existing federal credit and was designed to help remedy a sizable state budget deficit. Since 2010, Minnesota’s research tax credit has been available to C corporations, S corporations, and partners in a partnership.* The credit may be applied to qualified research expenses related to research conducted in Minnesota; a qualified expense includes wages paid to employee researchers, research supplies, payments for use of time-sharing computers, and other items. The credit equals 10 percent of the first $2 million in qualifying expenses and 2.5 percent of qualifying expenses in excess of $2 million. While C corps make up the smallest category of credit claimants, most credit payments (67 percent in 2014) went to C corps.

The OLA report describes how the research tax credit is supposed to work in theory:

Companies that receive Minnesota’s research tax credit experience the tax credit’s direct effects—lower business costs due to lower tax burdens. Lower business costs can help a business to expand its economic activity, such as by investing in new machinery and hiring more workers to operate it. In turn, the business has a greater opportunity to produce and sell more goods or services.

The report goes on to describe other indirect benefits that could potentially result from the research credit:

Indirect effects of the tax credit occur when incentivized companies purchase more from in-state suppliers, which may increase employment and business output at the suppliers (commonly referred to as “spillover” effects). Induced effects may also occur when incentivized firms pay higher wages to employees. As these individuals spend their earnings on goods and services in the local economy, they create new income for the businesses supplying those purchases (also known as “multiplier” or “ripple” effects).

The OLA used an economic model that examined not only the direct effects of the research tax credit, but also indirect effects, induced effects, and the opportunity costs of the credit defined as “the loss of potential gain from alternatives”—such as increased spending or other tax reductions—that are foregone as a result of the decision to invest in the research credit. The information in the following charts are from this model, as applied to data for C corporations in four industries† that claimed 95 percent of the total C corp research credit amount from 2010 to 2014. Based on this data, Minnesota’s research credit did indeed produce increased statewide employment and earnings.

While the research tax credit did result in increased employment and earnings in Minnesota—and appears to have drawn employment into Minnesota from other states—these benefits were significantly less than the cost of the credit in terms of foregone state tax revenue.

Among the C corps examined as part of the OLA analysis, the net fiscal benefit of the research tax credit as a percent of the credit claimed ranged from a low of five percent in 2010 to a high of 22 percent in 2014. Net fiscal benefits as a percentage of credit claimed were lowest during the three year period from 2010 to 2012, when the credit was refundable (i.e., the amount of the credit could exceed the tax due, essentially allowing business to receive a net payment from the state) and the total amount of the credit claimed was greatest.

The OLA acknowledges the limitations of their analysis of the research credit’s economic effects, which is sensitive to the assumptions used and the inability to factor in all possible costs and benefits of the credit. The OLA report recommends that the Minnesota Department of Revenue (MDOR) be authorized to collect data sufficient to allow for a more comprehensive examination of the credit. However, based on the weight of the evidence currently available, the OLA concludes that:

Minnesota’s research tax credit increased jobs and earnings statewide from 2008 to 2014, according to our estimates. However, the growth was relatively small, and the credit did not pay for itself, as its statewide net fiscal benefits offset only a small share of the amount of credit claimed.

In addition to their analysis of Minnesota data, the OLA examined academic research that focused on Connecticut, New Hampshire, and Washington state, as well as surveying and interviewing Minnesota research tax credit claimants. The review of academic research indicated that, while the credit did “cause marginal increases in the number of jobs in the state,” those increases generally came at a high price and were not commensurate with the cost of the credit. Survey respondents and interviewees indicated that “the research tax credit has helped their company create or maintain jobs.” However, fewer than one in six of survey respondents indicated that the credit was important when considering whether to relocate business activity to Minnesota.‡

In addition to calling for increased collection of data “to allow periodic evaluations of the research tax credit” on the part of MDOR, the OLA also recommends that state policymakers establish “explicit and measurable objectives” for the credit in state law, require and review analyses of how well proposed changes to the credit facilitate the achievement of these objectives, and require MDOR to “provide additional and more specific information to taxpayers about the documentation needed to substantiate claims for the research tax credit.”

The OLA further suggests that direct state expenditures—because they are more frequently and thoroughly scrutinized by state policymakers—be considered as an alternative to the research tax credit as a way of promoting economically beneficial research. In comparing direct expenditures to tax expenditures (such as the research tax credit), the OLA notes that:

A 2011 analysis, contracted for by the Department of Revenue, concluded that tax expenditures receive less scrutiny than direct expenditures because they are outside the Legislature’s normal budget process. A 2013 House Research study determined that there is a bias for retaining tax expenditure laws. The study says this is because legislatures commonly make tax expenditures “permanent features of the tax law that remain in place until modified or repealed by a future legislature.” By contrast, direct spending programs receive appropriations that a legislature typically reviews biennially.

The exhaustive Office of the Legislative Auditor’s report on Minnesota’s research tax credit is likely to have significant implications for the program and upon proposed enhancements to the credit currently before the legislature.

 

*Legislation introduced during the current legislative session would extend the credit to sole proprietorships.

These four industries are (1) manufacturing, (2) professional, scientific, and technical services, (3) management of companies and enterprises, and (4) wholesale trade.

In discussing their survey results, the OLA notes that:

Due to our uncertainty regarding the survey mailing list provided by the Department of Revenue, we do not believe the survey results are generalizable to all Minnesota research tax credit claimants. We weighted survey results to reflect the probability of responding to the survey, based on company type and year a company claimed the credit.