that we either have to make these research and development tax credits refundable or find an equivalent mechanism that will allow them to be of value to our most troubled industries that are able to move ahead to find research and development opportunities and to become once again the high tech industries that they were at the end of World War II, or even in some cases through the 1960's. It seems to me if we don't do that, we indeed, Mr. Chairman, are doing something that I know you don't want to do, which is to pick winners and losers.

Current law, as it stands, picks winners among only those who are currently ahead in the race, and it consigns not just to the back of the pack but to falling at the wayside during the course of the race industries that are not now but could be in a healthy financial position in the future. So I hope, Mr. Chairman, as we continue our deliberations here that we will take a careful look at how we can make it possible for industries that can and do have a future, if they are allowed to participate in the kinds of incentives that are contemplated by you, myself and others in this committee, how, in fact, we can accomplish that goal. I thank you, Mr. Chair

man.

Senator DANFORTH. Well, maybe Secretary Chapoton can help us think creatively on this. [Laughter.]

Senator HEINZ. That is why I waited for him to arrive, Mr. Chairman.

STATEMENT OF HON. JOHN E. CHAPOTON, ASSISTANT SECRETARY FOR TAX POLICY, DEPARTMENT OF THE TREASURY, WASHINGTON, D.C.

Mr. CHAPOTON. Thank you, Mr. Chairman. I have a quite lengthy statement. I will summarize it. I think I would like to spend most of my time on the S. 738, the proposal for a permanent extension of the tax credit for incremental research and development.

We do appreciate the opportunity to present our views to the subcommittee this morning. The administration strongly supports the objectives of the R&D credit. We believe the credit should be extended to enable taxpayers to plan their research and experimental activities with a certainty that the credit will be available, and we are supporting an extension of the credit for 3 years through December 31, 1988.

The effectiveness and efficiency of the credit is currently under review within the administration by an interagency working group. Our review thus far indicates that some modifications of the credit may be called for when the credit is extended. We would like to come forward at a later time to the subcommittee with specific recommendations for improving the credit.

Congress enacted the credit for R&D expenditures in order to encourage industry to undertake the risky research and experimental activities that may lead to productivity enhancing innovation. The need for such activities cannot be disputed: innovation is essential if the United States is to retain and improve its competitive position in the world economy.

To provide the greatest incentive, the credit must flow to those industries, and to particular taxpayers, that devote increasing

amounts of resources to these risky activities. For that reason, the credit is an incremental credit. The level of qualified expenditures that increases over a base period is what is entitled to the 25 percent credit.

R&E is a term used to describe an organized activity undertaken by a firm to develop new products and services or to modify existing products and services. Commercial and industrial R&E leading to technological innovation is unquestionably beneficial to the economy. The more successful R&E effort in the economy, the higher the rate of productivity and growth.

Normally, we would expect that business will invest in R&E to the point that the expect return on investment is equal to returns from other investments, but the level of profit-motivated R&E frequently will be inadequate because businesses may not enjoy the full return realized from their innovation. For this reason, Government intervention through a mechanism such as the credit is definitely warranted.

Broad Government support of R&E is particularly essential in the basic research area. Substantial benefits from basic research are available to society generally, but the use of the results of the research by one does not impair another's ability to use it. Thus, basic research has all the characteristics of a public good which should be supported by Government. Similarly, commercial and industrial R&E also may add to the stock of knowledge that may be used by others, with the result that the innovator will not enjoy the full economic return from its efforts. Therefore, Government aid to the industrial and commercial R&E is also appropriate.

Our experience in administering the credit so far has been limited, but we believe that you can draw some preliminary indication as to how the credit is being used. And we think this information needs to be analyzed further to see how the credit can be improved. We have made a preliminary review and analysis of 1981 tax returns the first year that the credit was in effect. Our sample represents some 11,700 corporations that reported $1.9 billion of qualified incremental R&E expenditures. These corporations claimed half a billion dollars of R&E credits. Some of the companies must carry over all or a portion of the 1981 credit, since the credit can, as Senator Heinz has pointed out, offset only actual tax liabilities. And also I want to mention that the tax returns for a number of very large companies, many of which will have large R&E budgets, are not yet available and are not included in the numbers I am giving you. Of the total credit claimed by the companies for which we have data, half went to 65 companies, each of which reported $1 million or more of credit. These 65 companies may be divided into two broad groups. The first consisting of companies whose main business are in the high tech fields of pharmaceuticals, computers, electronics, aerospace, scientific instruments, and photographic equipment. Those 28 companies account for $107 million of the credit claimed.

The second group consists of 35 companies in the oil industry and in the more traditional heavy manufacturing fields such as chemicals, rubber, steel, motor vehicles, farm and construction equipment, industrial machinery, and electrical equipment. These heavy industry companies earned $129 million of credit. Virtually

all of the companies in both groups are large and have large R&E budgets.

The credit was not used exclusively by manufacturing companies, however. Of the total number of companies in our sample that claimed credits, almost half have their principal line of business outside of manufacturing. These companies were mainly in the trade, service, public utility, and financial sectors. They claimed growth in qualified R&E from 1980 to 1981 of 91 percent. While these companies account for only 17 percent of the total credits claimed, the large number of companies in this category and their extraordinarily high growth rate in R&E indicates that their share of the credit is likely to increase in the future.

Among taxpayers who claimed the R&E credit were taxpayers in such lines of business as fast food restaurants, baked goods, home building, publishing, banking, stock brokerage and movie production. Although we do not have data indicating the particular activities for which the credit was claimed by these taxpayers, we would anticipate that they do not involve the high technology or high risk research that is involved in the other companies.

In addition, it appears that the credit provided significant benefits to certain foreign manufacturers. Several domestic sales subsidiaries of foreign automobile and electronic manufacturers have claimed the credit. Again, the data is lacking concerning the particular activities that gave rise to the credit in these instances, but we would surmise that these activities may be related to research applicable to product design which will be incorporated in foreign manufacturing rather than the companies' U.S. sales operations

The credit can only be used to offset a taxpayer's tax liability. As Senator Heinz has pointed out, companies with tax losses are not able to use any credit currently. Overall, the companies in our sample were able to use in the current year only about 59 percent of the credits claimed for 1981. The balance had to be carried forward to be claimed against future tax liability. In general, the largest companies, those with $250 million or more in assets, were able to use about 60 percent of their R&E credits earned, and the smaller companies less than $1 million of assets were able to use only about 45 percent of the credits earned in 1981.

As I mentioned, we are supporting extension of the credit. We would like to consider some improvements in the credit. We want to suggest three specific areas in which improvement might be considered. First, we think it is going to be necessary to define "research" or "experimental activities" with more precision. Second, to encourage taxpayers to increase the amount of real resources dedicated to R&E, it may be desirable to index the "base" expenditure to take into account inflationary increase in the cost in the incremental feature of the credit. Third, we should attempt to make the credit a more effective incentive for startup companies and the loss companies that Senator Heinz has mentioned. We are studying these matters and plan to come forward, as I mentioned, to the committee with specific recommendations in the future.

Turning now, Mr. Chairman, to S. 1194 and 1195, both of these bills are designed to encourage research training and research endeavors at all levels of education. The bills are similar but not identical. Section 2 of each of the bills would provide increased

charitable deductions for contributions by corporations of computers and research equipment. Section 3 would modify the tax credit-the R&D tax credit-as it relates to contributions by corporate taxpayers for basic research performed by colleges and universities. And section 4 provides a special exclusion from gross income for amounts that graduate students receive in the form of scholarship, grants, loans or foregiveness of loans. The most important aspect of these bills, the one I will spend the most time on, is section 2, which relates to the contributions of computers and science equipment.

Under current law, with certain limitations, the amount of cash or fair market value of property contributed to a charitable organization qualifies for the charitable deduction. Limitations are imposed with respect to contributions of ordinary income property, that is, to the extent, if sold, the proceeds would be taxed as ordinary income rather than capital gain. In general, in the case of such property, the taxpayer's deduction is limited to his basis in the property. And under current law, there is no deduction for services contributed to charity in excess of the taxpayer's out-ofpocket cost in performing the services.

There are two exceptions to the general rule with respect to ordinary income property. One relates to gifts of inventory for the ill, the needy, or infants, which is not related here. The second exception, which these bills would expand, involves corporate gifts of scientific equipment and apparatus to colleges and universities for research and experimentation. Section 2 of the bill would expand this provision in two ways. First, the current law exception would be made available for gifts of computer equipment and related services to primary and secondary schools, and, second, the current exception for gifts of scientific property to colleges and universities would be broadened.

In the case of the computer, the gift of computers, the bills provide that the taxpayer must provide training in the use of the contributed equipment, and there are limits on certain technical specifications that the computer equipment must meet to qualify for the deduction.

If the conditions are met, the deduction is the same as the present law exception for gifts of scientific property to colleges, that is, the cost of the property plus one-half of the unrealized depreciation, not to exceed twice the taxpayer's basis in the property. In addition, in these bills, the present rule would be expanded with respect to the cost of providing training. The taxpayer's basis in the property would include the cost of providing the training to the employees of the recipient organization.

The bill also provides a special deduction for the value of services contributed with respect to contributed equipment. In the case of scientific property, the broadening is to expand the type of property, to include software and to include not only inventory but to include property that the taxpayer has used in his own trade or business, a piece of equipment, for example, that has been used and appreciated by the taxpayer. And the uses of the property which the property may be put is expanded to cover the physical and biological sciences, as well as computer science education and vocational education.

The Treasury Department opposes section 2 of these two bills. In our view, these changes would create an open-ended expenditure program funded by the Treasury but administered by private taxpayers to place computers and scientific equipment in schools throughout the country. We, of course, recognize that the end result of having computers in every school is highly desirable, but the taxpayers in this case would bear ultimately the entire cost of funding the program. And I think you then have to judge the program in the same manner as a direct appropriation. We have to question whether gifts of computers should be favored over other types of gifts, of books, for example, and whether gifts of repair services for computers should be preferred over gifts of doctors 'services to hospitals, for example.

The direct cost of the benefits available under these bills would, as I mentioned, shift most or all of the cost of the gift to the Government. And we would point out that the donors can and would anticipate receiving substantial commercial rewards in the form of future sales to schools and students' families. We do not think the commercial motivation, such as this, should be preferentially awarded through a charitable deduction.

We have some more in the nature of technical concerns about the bill. For example, with respect to gifts of property used in a taxpayer's trade or business, the deduction is granted without regard to the value of the property, so that a taxpayer could take 3-year ACRS property, depreciate it to zero, and then claim a charitable deduction for one-half of its cost at the end of the 3-year period. And we also raise concerns about allowing the cost of training services as a part of the cost of the equipment in computing the value of the deduction. That would result in a double or even triple deduction for the cost of the training since the cost could be counted twice in determining the taxpayer's contribution deduction and could also be deducted as an ordinary business expense under section 162 of the Code.

There are three provisions which would modify current law, which we would not oppose. We understand that gifts of computer equipment, of course, is virtually worthless without a gift of the relevant software, and that the cost of purchasing the software could be prohibitive. Assuming that Congress intended the schools benefit fully from the receipt of computer equipment, and from research and training under the present law exception, then we think the gift of software should qualify for the enhanced deduction as well. Also the current law requirement that inventory must be manufactured by the taxpayer, we are informed, disqualifies many potential donors from the gift. We question whether Congress intended to disqualify all of these taxpayers, and believe that that requirement that the taxpayer manufacture the propertv should be reexamined. And, third, the requirement that qualifying property be manufactured within 6 months of the date of the contribution of the property, as opposed to the 2-year rule under existing law, we think would be a helpful change, and that it will assure that schools are not receiving technologically outdated equipment.

Section 3 and 4 of the bill, Mr. Chairman, let me just go over very hurriedly. Section 3 would allow the present law rule which