Reforming R&D Tax Incentives: Do Video Games Deserve Special Treatment?

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In September, the New York Times reported that video game designers have been taking advantage of tax breaks meant for other industries, often under terms more favorable than those received by many of the originally intended recipients. Electronic Arts (EA), for example, paid $98 million on $1.2 billion of operating profits over the last five years—an effective corporate tax rate of just under 8.2%. In addition, EA has set up off shore subsidiaries in tax havens and successfully lobbied Congress for new tax breaks.

Firms claiming the federal R&D tax credit elect to receive either a credit for 20% of their research costs above a base amount, or 14% of the excess above the average of the last three years’ R&D spending. I.R.C. §41. Inventive procurement of R&D tax credits has become a lucrative business for the accountants and attorneys who assist firms in obtaining these tax breaks. AlliantGroup, for example, specializes in helping clients obtain tax incentives, and claims credit for helping its clients secure over $1 billion in R&D tax incentives to date.

Claiming the R&D tax credit has become more difficult since its heyday in the 1980s, the NY Times writes, “the credit was being claimed by businesses with little technological background — fast-food restaurants, hair stylists and fashion designers.” Marketing and social science research are no longer eligible for the R&D tax credit. But previous plans to further restrict the credit to basic research have been as poorly designed as the original credit. The Clinton administration proposed restricting the credit to research producing an “actual innovation,” but the Bush administration dropped the proposal as unenforceable.

This difficulty of the enforcement rationale, however, is specious. According to Alliantgroup, more than $5 billion in R&D tax credits are given out annually. Given the amount of money at stake, significant enforcement efforts are warranted. The entire budget of the US Patent and Trademark Office is only about half the amount spent on R&D tax credits. The cost of determining the novelty for products supposedly qualifying for R&D tax credits would be worthwhile if it brought in more revenue by ending frivolous tax credits.

The actual cost, however, would be much lower than the cost of de novo assessments of novelty, as the IRS could treat R&D tax credits as it does the rest of the tax code: grant the credit, only questioning it if the application raises red flags or is part of a routine audit. The threat of being one of those randomly chosen for an audit would ensure substantial honesty from most taxpayers. In the event of an audit, a patent could be accepted as incontrovertible evidence of an “actual innovation.” An innovation subject to trade secret protection would still be eligible for the tax credit as long as the company could prove to auditors that such an innovation existed.

The real problem with the “actual innovation” requirement is that it would increase the tax burden on companies which engage in significant, valuable, but unsuccessful research. Ninety percent of new drugs, for example, fail in clinical trials. Successful research is already incentivized through market forces. There is no need to convince companies to engage in research they know will be successful. The real benefit derived from R&D tax credits is the mitigation of risks involved in R&D expenditures, by reducing total losses, so research failures must be subsidized along with successes.

Alternatively, Congress could simply make a political judgment about which industries or types of research create enough public benefit to deserve R&D tax credits. When video game developers change a few lines of code to create version 10 of their game are the really conducting “research” on something that provides public benefits beyond what the market can reward adequately? Alliantgroup argues that video games do produce public benefits, such as the use of some video games in training military personnel. But this benefit is rewarded by lucrative defense contracts. The best rationale Electronic Arts can come up with is that it donates some games to charity. This, of courses, is already rewarded by a separate tax write-off.

Making video games does create jobs, just like every industry. But making video games is profitable. There is no evidence that game producers would choose to stop making potentially profitable investments if they stopped receiving favorable tax treatment. And even if deprived of the R&D credit, they would still be eligible for the economic development credits given to every industry. R&D tax credits will continue to be just one more government handout for the already well off, unless they are restricted to research which has public value beyond what the market will reward. Those who advocate preserving or expanding the R&D tax credit for video game producers have failed to make a convincing case that there is a public benefit.