On the Sensitivity of R&D to Delicate Tax Changes: The Behavior of U.S. Multinationals in the 1980s

James R. Hines Jr., University of Michigan Law School


The U.S. government has a long-standing interest in encouraging research and development (R&D) by American companies. Congress feels that the common-property nature of the know-how produced by R&D, and the competitive advantage that greater R&D affords U.S. firms in global markets, means that too little R&D is likely to be undertaken by private firms in the absence of strong government support. Concern over the sluggish rate of U.S. productivity growth in the 1970s, combined with alarm over rising foreign competition, led Congress to enact two tax changes in 1981 designed to stimulate R&D. The first, the research and experimentation tax credit, established a 25 percent credit for new research expenditures by U.S. firms. The second change, a suspension of Treasury regulation §1.861-8, offered very generous tax treatment of R&D performed in the United States by certain multinational corporations. In this paper, I examine the incentives introduced by this second change the suspension of §1.861-8—and the way that American multinationals responded to those incentives. The §1.861-8 rules were modified several times between 1986 and 1990 in a manner that affected only certain firms, so it is possible to infer the effect of the law by observing the responses of different companies to the changes. Based on these results, it appears that American multinationals significantly changed their R&D expenditures in response to tax policy in the 1980s. Nevertheless, the 1981 change may not have had the intended effect of greatly increasing R&D activity in the United States. In part, this may be due to some misunderstandings about the incentives that were embodied in the law prior to 1981 (and in its modifications after 1986).