Plenty is up in the air in Washington, D.C., these days, but there is one thing that seems a safe bet: major U.S. tax reform is more likely than at any time since Ronald Reagan accomplished the task in 1986. While the changes being discussed are undoubtedly pro-business—both the Republican-controlled Congress and the White House want to see corporate taxes cut roughly in half—they are not particularly pro-innovation.
“We need tax reform, but it remains to be seen if the proposals being discussed will actually boost innovation,” says Lisa De Simone, an assistant professor of accounting at the Stanford Graduate School of Business, who has spoken with numerous tech firms in recent days about the potential reforms. “Silicon Valley will be watching carefully.”
President Trump, who says he will introduce a “phenomenal” tax plan in the next few weeks, has made supportive comments about a proposed overhaul called “A Better Way” that Republicans in the House of Representatives introduced last summer. That plan calls for a cut in the U.S. corporate tax from 35 percent to 20 percent, a controversial “border adjustment tax” to penalize importers and reward exporters, and a more advantageous way for companies to account for capital investment. In speeches, Trump has suggested an even lower corporate tax rate of 15 percent.
While cash-rich tech giants will benefit from the changes, many executives worry the plan doesn’t do enough to encourage innovation by the smaller companies that are the primary engine of growth for the tech sector. Overall, corporate R&D spending in the U.S. has been strong—growing 3.1 percent per year from 2008 to 2015, almost three times faster than the overall U.S. economy, according to the National Science Foundation. But it’s not fast enough to keep up with increased spending by other countries, particularly China. As of 1960, American companies were responsible for 69 percent of global R&D spending, but that has now dropped to 26 percent, according to the Information Technology & Innovation Foundation, a nonprofit think tank funded partially by tech companies.
The reform with the most bipartisan political support is called repatriation. In recent years, U.S.-based multinational tech companies have accumulated more than $700 billion in cash in their overseas operations in order to avoid paying the U.S. tax, which at 35 percent is the highest imposed by any developed nation. (Add in state taxes and the average hit is 39 percent.) To get companies to “repatriate” all that cash, Congress and the Trump administration want to lower the tax rate on it to between 8 and 10 percent, and require annual payment rather than let companies defer payment indefinitely. They are also likely to require companies to pay whether or not they actually bring the cash back.
A multibillion-dollar cash injection would seem to be a terrific catalyst for an R&D boom, except for one thing: nearly 70 percent of the money is held by just six super-rich companies (Google, Microsoft, Apple, Oracle and Qualcomm), which already have more than enough cash in the U.S. to invest in whatever moonshot projects they like, says Richard Lane, an analyst with Moody’s Investor Services. These giants have made massive capital investments in the data centers and network infrastructure essential to innovation. Capital spending by tech companies grew by 5.4 percent in 2016, to $30.8 billion, says Michael Mandel, chief economic strategist at the Progressive Policy Institute.
Smaller companies that could use a cash infusion to fund R&D typically don’t have big offshore reserves, either because they aren’t old enough to have amassed them or they don’t have departments of sophisticated tax experts to exploit the regulations. As for the big boys, they will most likely use their repatriated billions to boost their stock prices by issuing dividends or paying down debt. In 2004, when Congress created a temporary repatriation holiday with a tax rate of only 5.25, tech firms used more than 90 percent of the $58 billion they brought back to issue dividends and buy back company shares.
Apple, Cisco, Facebook, Google, and Microsoft, all of which would benefit significantly from a repatriation tax cut, declined to comment for this article.
In the long run, a more competitive U.S. tax code will have a big impact as companies stop worrying about where to innovate, says Michael Marks, a partner at the private equity firm Riverwood Capital and CEO of a cloud software company called Katerra. “When your money is offshore, you spend it offshore,” says Marks who used to be CEO of the contract manufacturer Flextronics. “I don’t know what we would have done differently if we could have repatriated our offshore cash, but I do know this: we wouldn’t have sat around thinking about how to spend it overseas.”
While Marks welcomes the lower rates, he and many others in Silicon Valley fear the benefits will be diluted by the House plan’s provision for a border adjustment tax. Companies would not have to pay any tax on goods they export, but they would have to pay for parts or services they import. For hardware makers in particular, that’s almost everything. From iPhones to million-dollar routers, most electronic products are built overseas and made up largely of displays, motherboards, and other components that were built elsewhere as well.
“The border adjustment tax scares me to death,” says Tom Fallon, chief executive officer of Infinera, which makes networking equipment. Unlike most of its Silicon Valley brethren, the company makes some of its own chips in the U.S. and imports fewer than half of its components. Still, he fears that the border adjustment tax would crimp his ability to maintain his spending on R&D, currently more than 40 percent of annual revenue. By driving up Infinera’s costs, this new tax would force him to raise prices on his products and impede the company’s ability to compete with larger rivals, including China-based Huawei Technologies, says Fallon.
Large importers from other industries, including Wal-Mart and energy firms, are lobbying hard against the new tax.
Tax reformers should include some other sweeteners to encourage innovation, says Joe Kennedy, a senior fellow at ITIF who issued a report on the subject on February 21. For starters, Congress should enhance the 36-year-old R&D tax credit so it covers a higher percentage of companies’ R&D spending.
He and others are also calling for a lower tax rate on revenues derived from patents, copyrights, and other inventions created in the U.S. Rather than just offer incentives for trying to innovate, this approach would reward commercial success. “This way, if you create the iPhone, you get rewarded with a lower tax rate,” says Kennedy.
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