Renew California’s commitment to its innovation economy

As California contemplates how to create more and better high-paying jobs, our dominance in high-technology industries provides a unique set of tools to provide residents with economic opportunity. But the Golden State risks squandering its advantages without new approaches to developing and retaining innovative talent, particularly as high-tech industries are drawn to incentives in other locations. 

The foundation of knowledge-based economic development in California has long been bolstered by its research and development credit. First created in 1987, it provides firms conducting qualified research activities with a 15% tax credit on overall expenses and a 24% tax credit on basic research, including wages paid to employees engaging in or supervising R&D.

While the specific effects of the credit on investment are difficult to quantify, various studies have demonstrated the effectiveness of similar research credits, and local firms have cited its influence on their planning.

In 2015, the Milken Institute analyzed the effectiveness of the R&D credit in our report on “California’s Innovation-Based Economy.” Our report suggested benefits surrounding expanding the credit, particularly to help offset high local operating costs. As many of those costs have continued to rise, however, state leaders have prioritized short-term concerns at the expense of sustaining the state’s long-term comparative innovation advantage.

When the state confronted a projected $54 billion deficit during the early stages of the pandemic, leaders placed a three-year cap on business tax incentives, including the R&D credit. Despite protecting the state’s fiscal outlook by increasing general fund revenues, this move increased cost uncertainty for businesses at a time when economic volatility was already high. 

For three decades, this incentive had helped businesses lower the risks inherent to investing in product and process improvements, but the policy change signaled a diminished commitment to innovation-led growth.

There were already signs that California’s edge in high-tech employment was starting to diminish. In industries where R&D is a cornerstone of firms’ ability to compete for market share – such as information and computer science; architecture and engineering; life and physical sciences; and arts, entertainment, and media – the proportion of state residents employed in 2015 was 26% higher than it was nationwide (8.7% to 6.9%, respectively) according to the U.S. Bureau of Labor Statistics. By May 2020, California’s edge had dropped to 20% over the national average (8.9% to 7.4%). And since last year, several high-profile high-tech companies have announced their departures from the state. 

California is now at an inflection point, with a projected surplus of $31 billion but no clear commitment to restore the R&D credit. The analysis in the Milken Institute’s new report: “Sustaining California’s Innovation Economy Through Investments in R&D” illustrates the continued value of R&D in terms of supporting high-wage jobs growth in California as well as providing the investment necessary to capture a broader range of innovation hubs. 

By comparing the state’s R&D credit with similar incentives in other states, we also seek to promote a conversation about ensuring that innovation-oriented firms choose to pursue growth opportunities in the Golden State. 

Our new report provides three main suggestions for consideration by state leaders:

•  Reintroduce the net operating loss provision. Relatively newer firms – including startups at the pre-revenue stage and companies that have not yet turned a profit – don’t generate enough income for the credit to provide a clear incentive for investment in R&D.

• Offer refundable and tradeable R&D credits for small businesses. Small businesses create a disproportionate share of new jobs and can be major sources of innovation and entrepreneurship.

• Provide additional incentives to invest in basic research. Providing incentives for the private sector to invest in basic research – including sponsorship of academic research that can take longer to bear fruit commercially – helps reduce marginal research costs and provides job pathways for graduates.

As firms and businesses reorient to the realities of booming remote work and employees leaving the workforce, California cannot rest if it wants to maintain its competitive innovation advantage while minimizing the number of businesses expanding R&D operations elsewhere.

Through bold actions, state leaders can also send a clear signal of their commitment to support for the state’s most innovative firms. Not only will this restore competitiveness by providing incentives for in-state R&D, but these investments can also generate new assets – from jobs to patents and licensing income – that support more inclusive economic opportunities around the state.

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Matt Horton has also written about California needing a redistribution of innovation and steps California can take for an equitable recovery.