The Looming R&D Cliff…

Editor’s Note: As always, our political commentary is non-ideological by design and aims to analyze events solely for market impact. We prefer neither party—political bias blinds.

What’s a sign midterm elections are coming up? If you’re thinking stump speeches, mudslinging and awkward TV ads, you’re right. But we’ll add a fourth: Congress turning what would ordinarily be procedural votes into divisive hot-button issues. One surfaced in a big way last week: the R&D tax credit for businesses. Renewal is usually a no brainer, but this time around, progress is stalling amid a noisy debate: The House passed a perma-extension, the president threatened a veto, and the Senate favors a two-year patch. Ah, politics. It won’t shock if the bickering goes to 11 (one louder than 10) over the next six months, along with hyperbolic theories on the credit’s expiration killing business and others suggesting extending it will bore a hole in the Federal budget. But it’s all noise—in our view, the tax is incremental and investors needn’t fear the credit’s expiration biting business investment (and this expansion). There are three virtual certainties in life: death, taxes, and Congress’s ability to kick the can at 11:59:59.

The R&D tax break, enacted in 1981, gives businesses the opportunity to receive a 14-20% credit on their qualified research spending, depending on which formula they use. It’s one of 50 or so “temporary” tax breaks up for renewal. Like the other 49 (ish), most in Congress believe it has merit and benefits constituents. Hence, they have a huge incentive never to make it permanent. Why pass something with no-brainer benefits and then lose the power to campaign on (and brag about) it year after year? Yes, shockingly, politicians put their own interests ahead of the rest of us. Congress renews the R&D credit and its ilk regularly and usually makes the extensions retroactive if there is a gap, so such temporary breaks lapsing carries little real cost. For instance, the measure last expired in 2011—Congress renewed it in January 2013, retroactively covering 2012 and extending it through 2013. This time around, both parties favor an extension, but this is an election year—that bi-annual spectacle where policy moves everyone agrees on to an extent become big, raging campaign issues for little reason than to rile up voters (oh, and campaign contributors). Ladies and gentlemen, your tax dollars at work.

With the 2014 contest less than six months away, the R&D tax credit rhetoric is heating up right on schedule. Last week, the House voted 274 to 131 to make it permanent. All but one House Republican voted in favor of the measure along with one-third of House Democrats—all largely agreeing a permanent tax break will make it easier for businesses to plan R&D initiatives, in turn, fueling more jobs and innovation.

It seems both sides want to renew the credit. The debate isn’t even about the merits of the tax credits—it’s more about posturing. For House Republicans, passing a clean perma-extension is a chance to tell voters, “We support innovation!” For Senate Democrats, pointing at the estimated $156 billion (over 10 years) cost of a permanent increase and arguing any long-term extensions should come with offsetting loophole closures is a chance to shout, “We’re fiscally responsible!” That’s a message that no doubt plays well in the Republican strongholds the Democrats must win to keep their majority. So the Senate Finance Committee proposes a two-year credit extension, by which time they claim they’ll pass a more comprehensive tax overhaul (the mythical grand bargain, no doubt). It’s all just politics as usual.

Most expect the Senate bill to pass, then go to the House as a substitute for last week’s bill. Maybe the House rubber stamps it, but we have our doubts—no one has any incentive to pass the R&D tax credit until after November 4^th, otherwise they lose campaigning power. On the bright side, this political posturing should mean little for markets—it’s just noise. Just as Congress hyped and bickered over the fiscal cliff, 2010 tax cut extensions or even the farm bill debate in 2002, 2008 and 2012 way longer than pundits thought prudent, then ultimately compromised, they’ll probably do that with the R&D tax credit, leaving everyone to wonder what all the fuss was about. In the meantime, expect hype and debate. The same media that gave you a fiscal cliff, dairy cliff and transportation cliff will probably try to give you an R&D cliff. Politicians might try to convince you this is the be-all, end-all issue for our nation’s innovation and competitiveness, or that the cost will make or break the country’s budget. But it’s ultimately just a bunch of political rhetoric. We’ve all seen this movie before.

The market impact here is basically nil. Despite pols’ and pundits’ claims otherwise, businesses are pretty good at tuning out noise and gaming rational outcomes. Take 2012—even though the tax credit hadn’t yet been renewed, R&D spending rose as the year progressed and finished at an all-time high, adjusted for inflation.^[i]Which really highlights the point: Businesses don’t invest in R&D because of a tax benefit. They do so in search of profits. Profits often come from new products and business lines—R&D is usually compulsory. Losing the tax credit would be a headwind, but a small one. So even in the extremely unlikely event politicians don’t extend the credit, R&D likely doesn’t plunge off a cliff. Businesses care more about profits than they do rhetoric.

Ultimately, though, the chances we all have to learn this the hard way seem slim to none—lawmakers just about always find a way to kick the can or compromise.