Stock Options, R&D, and the R&D Tax Credit

Abstract

Two separate streams of research find evidence that firms decrease R&D spending to meet earnings benchmarks and that the R&D tax credit increases R&D spending. However, these studies do not consider stock option exercises by R&D employees which likely influence R&D spending decisions because they increase R&D tax credits without reducing reported earnings. This study extends both areas of research by incorporating R&D tax credits from stock option exercises into the R&D spending decision. We find evidence that firms reduce R&D spending by 0.46 percent of total assets to avoid earnings decreases, but R&D tax credits generated by stock option exercises offset this decrease by 16 percent on average and up to 42 percent for a fully taxable firm. The results of this study suggest that the tax benefits of R&D-related stock option exercises are important considerations in studies that investigate myopic R&D investment and in studies that investigate the effect of the R&D tax credit on R&D spending.

Keywords: Research and Development, Tax Credits, Stock Options, Earnings Management

JEL Classification: M41, M43, J33, H25, H32