Microeconomic and Macroeconomic Effects of Restoring Full R&D Expense Deductibility in Section 174

[This post was updated on June 24 thanks to comments from Kyle Pomerleau and Jason DeBacker. We adjusted the effect of the reform on 2026 to only include a half-year effect from 2025.]

Summary

We find that restoring full R&D expense deductibility effective back to 2022 would:

• Reduce the marginal effective tax rate for the average U.S. business impacted by the change from 9.8 percent under current law to 6.2 percent in 2026 and to 7.4 percent in 2027 and beyond.

• Generate a $92 billion increase in GDP in 2026 (+0.29 percent) and an average increase of $58 billion per year over the 2027-2035 period (+0.17 percent).

• Generate an increase in the aggregate capital stock of 0.70 percent in 2026 as well as an average increase of 0.46 percent per year over the 2027-2035 period.

• Reduce federal tax revenue by $54.3 billion in 2026 and by an average of $28.0 billion per year for the 2027-2035 period.

1. Introduction

The Tax Cuts and Jobs Act of 2017 enacted a provision that became effective in tax year 2022 that replaced the ability of firms to fully expense research and development costs in the year they were incurred with a less generous 5-year amortization schedule for domestic R&D and a 15-year amortization schedule for international R&D. The part of the tax code where this law is specified is Section 174.¹ In this article, we estimate the effect on business investment incentives and on macroeconomic outcomes from restoring the Section 174 law to full deductibility of R&D expenses, beginning in 2026, with the ability to be effective back to 2022.²

In our microeconomic analysis of the effect on individual business investment incentives, we find that restoring full R&D expense deductibility backdated to 2022 would reduce the marginal effective tax rate for the average U.S. business impacted by the change from 9.8 percent under current law to 6.2 percent in 2026 and to 7.4 percent in 2027 and beyond. This reduction in the marginal effective tax rate on investment can be thought of as an increase in the incentives for businesses to invest in R&D. We estimate that this reform would reduce federal tax revenue by $54.3 billion in 2026 and by an average of $28.0 billion per year for the 2027-2035 period (see Table 1).

In line with our microsimulation results, our macroeconomic model predicts that the reform would generate an increase in the aggregate capital stock of 0.70 percent in 2026 as well as an average increase of 0.46 percent per year over the 2027-2035 period. The change would also generate a 0.29 percent increase in GDP in 2026 and an average increase of 0.17 percent per year over the 2027-2035 period. That is equivalent to a nearly $92 billion increase in GDP in 2026, followed by average annual increases in GDP of about $58 billion per year over the 2027-2035 period (see Table 2A and Figure 1). The larger increases in 2026 are due to the policy potentially increasing R&D investment in the last half of 2025. Table 2B and the dashed lines in Figure 1 show the effects of the policy without the backdating component (without the effect of 2025).

The macroeconomic effects of the reform, especially in 2026 are significant given the average annual growth in US GDP is 2.1 percent over the last 20 years. And our macroeconomic revenue results are consistent with the estimated annual cost of the policy from 2027 and beyond of decreased federal revenue of $28 billion per year.

2. Background on Section 174 and R&D deductibility

“Market economies are likely to underprovide innovation, primarily due to knowledge spillovers between firms…. In the short run, research and development tax credits and direct public funding seem the most effective.” (Bloom, et al, 2019)

Guenther (2022) provides a concise summary of the history of Section 174 and the R&D deduction. Congress created Section 174 of the tax code in 1954 to clarify arguments between businesses and the IRS regarding what research expenses could be immediately deducted and what expenses had to be amortized over 5 or more years. The creation of Section 174 gave businesses two options: (i) to immediately deduct R&D expenses, (ii) to amortize them over at least 5 years. After the creation of Section 174, most businesses chose to immediately deduct their R&D expenses.

Bloom, et al (2019) begin and end their survey of policies that promote innovation with the intuitive statement that “market economies are likely to underprovide innovation” because of the public good nature of knowledge. This market failure suggests a potential role for government to incentivize innovation. In their final ranking of policy reforms that incentivize innovation, R&D tax credits rank as the highest quality and conclusiveness of evidence, highest net benefit, and in the fastest effectiveness time frame.

Cowx, et al (2024) is a recent study that looks at the changes in US R&D investment since the 2022 repeal of immediate full deductibility resulting from the TCJA. They find that this policy change resulted in the effective tax rate faced by businesses increasing by 11.9 percentage points or 62% on average. This is a similar percentage change to our estimated changes in marginal effective tax rates in Table 1. They also found a significant decrease of $12.2 billion in domestic R&D investment in the first year of the policy among research-intensive and borrowing constrained firms. Because of their restricted sample of firms, they characterize their results as underestimating the economy-wide effects.

The most recent OECD (2025) data on “R&D tax expenditure and direct government funding of BERD [business expenditure on R&D]” show that the US ranks 38th among OECD countries in its tax subsidy rates on R&D expenditure for large profitable firms. One reason for the US not ranking closer to the top is that the US private sector likely has more incentive to invest in R&D relative to other countries. However, this low ranking might also be an indicator that the US would benefit in its role as a global innovation leader by increasing its subsidization of R&D.

3. Modeling full R&D expensing deductibility

We use two open source models to simulate and estimate the effects of reforming Section 174 to return to full R&D expensing deductibility effective back to 2022. The first is Cost of Capital Calculator, a business tax microsimulation model of business investment incentives.³ The second is OG-USA, a macroeconomic model of US fiscal policy.⁴

Neither model has an explicit R&D expensing parameter, but both have investment tax credit rate parameters for businesses. To simulate the effects of returning to full R&D expense deductibility, we have to calculate what increase in the investment tax credit rate would be equivalent to moving back to full R&D expensing deductibility.

The Joint Committee on Taxation (JCT, 2017) estimated that replacing R&D expenditures deduction with expensing amortization in 2022 would result in an increase in federal revenue of $102.0 billion between 2022-2025, or about $25.5 billion per year.⁵ Thus, our goal is to determine how much of an increase in the investment tax credit (a parameter we have in our models) would reduce federal revenues by $25.5 billion per year (the amount of revenue lost from restoring R&D deductibility, which we don’t have in our model).

In 2014, the Joint Committee on Taxation (JCT, 2014) estimated that the American Research and Competitiveness Act of 2014 (H.R. 4438), which raised the investment tax credit rate 6 percentage points (from 14 to 20 percent), would reduce federal revenue by $19.9 billion in 2023 and $21.3 billion in 2024 (which averaged out to $20.6 billion per year). This was a 43 percent increase in the investment tax credit rate. We use these two estimates (JCT, 2014 and JCT, 2017) to assume that a 53 percent increase in the investment tax credit rate is equivalent to the implicit tax cut incentives from returning to full R&D expensing deductibility.⁶

The statutory federal and state investment tax credit rates vary by industry and asset types. Furthermore, a limited set of investment expenses qualify for the credit. In our baseline parameterization for both Cost of Capital Calculator and OG-USA we use the investment tax credit rate under current law of 1.5 percent for machines, 2.5 percent for buildings, and 1.0 percent for intangibles, representing an average overall rate of 1.5 percent. So our reform simulation is to model the change to full R&D expensing deductibility from 2027 and beyond as a 53 percent increase in the investment tax credit to 2.295 percent for machines, 3.825 percent for buildings, and 1.53 percent for intangibles, representing an average overall rate of 2.295 percent.

In our analysis, the year 2026 is different because it includes the increased investment tax credit on tax year 2025 R&D, which would affect business investment decisions for half the year if the legislation were passed in July 2025. We assume that 50 percent of tax-year 2025 business filers will either invest more in 2025 or push those investments forward to 2026. Either way, we are accounting for the effect of the policy on 2025 in the year 2026 in our analysis. As such, our calculation for the percent increase in the investment tax credit in 2026 is 79.5 percent, which equals the 53 percent increase in 2026 plus 50% of the 53% increase in 2025 (accounting for behavioral responses in the last half of 2025).

So our reform simulation is to model the change to full R&D expensing deductibility for 2026, which includes the behavioral response from 2025, as a 79.5 percent increase in the investment tax credit to 2.692 percent for machines, 4.488 percent for buildings, and 1.795 percent for intangibles, representing an average overall rate of 2.992 percent.

We estimate the cost of the policy in terms of revenue by using the inflation-adjusted average annual cost of reinstating full R&D deductibility of $28.0 billion per year from JCT (2017) (see the second row of Table 1). For a policy with backdating the deductibility for the years 2022-2025.

We assume the JCT (2017) cost estimate average for the years 2022-2025 of $25.5 billion per year. Then we inflate that amount from 2023/2024 dollars to 2027 dollars using the most recent CPI inflation forecast from the CBO (2025) March 2025 Long Term Budget Outlook to get a revenue loss estimate from the policy of -$28.0 billion per year. We then use the equation below that assumes a 50 percent decaying adherence rate to calculate the cumulative effect of the backdating effectiveness of the 2022-2025 years on the cost estimate for 2026 of -$54.3 billion.

4. Business Investment Incentives: Cost of Capital Calculator

The open source Cost of Capital Calculator model simulates the effect of tax policy on the investment incentives of corporate and noncorporate businesses.⁷ Table 1 shows the effect of reinstating full R&D expensing in Section 174 with backdating to 2022 on business incentives to invest in equipment and machinery through a measure called the marginal effective tax rate (METR). The METR measures the total burden of the tax system on new, equity-financed investments by corporate businesses. Under current law, the METR on new investments is about 9.8 percent. This is much lower than the federal corporate income tax rate of 21 percent because corporations are able to utilize a number of provisions—such as bonus depreciation and state investment tax credits—that can reduce effective tax rates relative to the statutory rate.

When we change Section 174 to allow for full expensing of R&D in the current year effective back to 2022, the METR decreases to 6.2 percent in 2026 (due to the addition of a half-year of increased R&D investment in 2025) and to 7.4 percent in 2027 and beyond. We estimate that the decrease in federal tax revenue from this effective business tax cut would be $54.3 billion in 2026 and $28.0 billion in 2027 and each following year. This decrease in METR from 9.8 percent to 6.2 percent in 2026 then to 7.4 percent in 2027 and beyond shows the increase in pro-growth business investment incentives (a tax cut) from allowing full R&D expensing deductibility.

5. Macroeconomic Effects: OG-USA

OG-USA is an open source, large-scale, general equilibrium overlapping generations macroeconomic model with rich representations of fiscal policy including both individual and business taxation, as well as government spending, deficits, and debt. The model also has detailed population demographic dynamics and international capital flows.⁸ In each of these simulations, we are assuming that the reform is permanent rather than the 5-year expiration that is in the current version of the bill passed by the House.

Tables 2A and 2B show the percent change from the reform, with and without backdating to 2022, in GDP, aggregate capital stock, aggregate employment, and average wage over the 10-year budget window 2026-2035. Figure 1 plots those macroeconomic time series from 2026 to 2035. Our simulation results show that the policy change will result in an increase in the growth rate of GDP equal to 0.29 percent in 2026 followed by an average increase of 0.17 percent per year from 2027 onward. Our simulations also show that the annual increase in the aggregate capital stock would go up by 0.70 percent in 2026 followed by an average increase of 0.46 percent per year from 2027 onward. This is equivalent to a nearly $92 billion increase in GDP in 2026, followed by average annual increases in GDP of about $58 billion per year in the 2027-2035 period. Total employment would be mostly unaffected by the policy change. And average wages rise with percentages similar to that of GDP.

Figure 1. Percent change in macroeconomic variables from Section 174 reform allowing full R&D expensing deductibility, backdated to 2022 versus no backdating: 2025-2035

Figure 2 shows the percent change in government debt and total tax revenue from the reform. The decrease of 1.0 percent in 2026 followed by a decrease of just over 0.7 percent per year from 2027 and beyond is consistent with the JCT (2017) estimate of the increased revenue from removing the full and immediate expensing deductibility of R&D being $28 billion per year in federal revenue.

Figure 2. Percent change in fiscal variables from Section 174 reform allowing full R&D expensing deductibility, backdated to 2022 versus no backdating: 2025-2035

These relatively small macroeconomic changes are the reason for the small changes in government debt as a percent of GDP, shown in Figure 3. This plot shows the time series of debt-to-GDP in both the baseline and reform. The reform barely influences debt-to-GDP, with the reform values (with and without backdating) in 2035 being 130 percent compared to the baseline value in 2035 of 129 percent.

Figure 3. Change in government debt-to-GDP from Section 174 reform allowing full R&D expensing deductibility, backdated to 2022 versus no backdating: 2026-2035

As a final analysis of the macroeconomic output, Figure 4 shows the average percent change in household savings over the first 10 years of the simulation (2026-2035) by lifetime income group. This is a distributional analysis of the reform results. In Figure 1, we see that the biggest macroeconomic result from this reform is an increase in the aggregate capital stock of 1.10 percent in 2026 with an average increase of 0.46 percent per year from 2027 and beyond. Figure 4 shows that this increased aggregate capital stock is coming primarily from households in the top one percent of lifetime income earners. Everyone in the bottom 99 percent of income earners has roughly no change in savings behavior.

Figure 4. Average annual percent change in household savings by lifetime income group from Section 174 reform allowing full R&D expensing deductibility, backdated to 2022: 2026-2035

6. Conclusion

We find that reinstituting full deductibility of R&D expenses with backdated effectiveness to 2022 would have a significant positive effect on investment and GDP in 2026 with moderate increases in 2027 and beyond.

Although the reform does not significantly change the amount of labor supplied by US workers, the average wage does increase by percentages similar to those of GDP.

References

Bloom, Nicholas, John Van Reenen, and Heidi Williams, “A Toolkit of Policies to Promote Innovation”, Journal of Economic Perspectives, 33 (3): 163–84 (Summer 2019).

CBO, “The Long-Term Budget Outlook: 2025 to 2055”, Congressional Budget Office (March 27, 2025).

Cowx, Mary, Rebecca Lester, and Michelle Nessa, “The Consequences of Limiting the Tax Deductibility of R&D”, Working Paper No. 4192, Stanford Business (July 2024).

Guenther, Gary, “Tax Treatment of Research Expenses: Current Law and Policy Issues”, CRS Insight, Congressional Research Service (Dec. 19, 2022).

JCT, “Description of H.R. 4438, the ‘American Research and Competitiveness Act of 2014’”, JCX-38-14, Joint Committee on Taxation (April 29, 2014).

JCT, “Estimated Budget Effects of the Conference Agreement for H.R. 1, The ‘Tax Cuts and Jobs Act’: Fiscal Years 2018-2027”, JCX-67-17, Joint Committee on Taxation (December 18, 2017).

JCT, “Estimated Revenue Effects of Provisions to Provide for Reconciliation of the Fiscal Year 2025 Budget: Fiscal Years 2025-2034”, JCX-22-2 R, Joint Committee on Taxation (May 13, 2025).

OECD, “R&D tax expenditure and direct government funding of BERD”, Organization for Economic Cooperation and Development, (last updated May 19, 2025, accessed May 31, 2025).

1. The Tax Cuts and Jobs Act is officially titled, “H.R.1 - An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018”. Its text is available at https://www.congress.gov/bill/115th-congress/house-bill/1/text. The changes to Section 174 of the tax code are in Section 3315 of the bill, which can be found by going to the XML/HTML version of the bill at this link and searching Section 174.

2. The current version of the bill that came out of the House has the policy being in effect from January 1, 2025 through December 31, 2029. It thus both includes parts of the current year 2025 in which households and businesses have already made many of their savings and investment decisions. The reform is also set to expire in this version of the bill after 5 years. In our macroeconomic analysis in Section “5. Macroeconomic Effects: OG-USA”, we assume that the policy begins on January 1, 2026 and is permanent thereafter.

3. The documentation for the Cost of Capital Calculator model is available online at https://ccc.pslmodels.org, and the source code is available in the GitHub repository https://github.com/PSLmodels/Cost-of-Capital-Calculator.

4. The documentation for the OG-USA model is available online at https://pslmodels.github.io/OG-USA, and the source code is available in the GitHub repository https://github.com/PSLmodels/OG-USA.

5. The CBO forecast of inflation between 2023 and 2026 is +10.7% and the forecast inflation between 2024 and 2026 is +7.2% (See the Long Term Economic Projections from the March 2025 Long Term Budget Outlook [CBO, 2025]). If we adjust our 2023-2024 cost estimate of $25.5 billion per year to 2026 dollars using these CBO forecasts, we get an annual cost estimate of about $28 billion per year. This value is in the range of the JCT (2025) estimate of the cost of reinstating full R&D expensing for the years 2025-2028.

6. Our 53% investment tax rate increase comes from the 6 percentage point increase (14% to 20%) in the investment tax credit from JCT (2014) which generated an annual $20.6 billion revenue cost. This was a 43% increase in the investment tax rate (+6pp/14%). This implies that a 7.4 percentage point increase in the investment tax credit rate would have generated a revenue cost of $25.5 billion per year. A 7.4 percentage point increase would have been a 53% increase in the investment tax credit rate.

7. The documentation for the Cost of Capital Calculator model is available online at https://ccc.pslmodels.org, and the source code is available in the GitHub repository https://github.com/PSLmodels/Cost-of-Capital-Calculator. All analyses in this section using the Cost of Capital Calculator model can be replicated using this Google Colab online notebook, entitled, “RDcredit2025.ipynb”. This notebook is also available in the RDcredit2025 GitHub repository for this article (https://github.com/OpenSourceEcon/RDcredit2025/code/rdcredit_ccc.ipynb).

8. The documentation for the OG-USA model is available online at https://pslmodels.github.io/OG-USA, and the source code is available in the GitHub repository https://github.com/PSLmodels/OG-USA. All analyses in this section using the OG-USA model can be replicated by running the “rdcredit_ogusa.py” Python script on your local machine after following the instructions for installing the “ogusa-dev” Conda environment. This file is in the RDcredit2025 GitHub repository for this article (https://github.com/OpenSourceEcon/RDcredit2025/code/rdcredit_ogusa.py).