Lifting New Zealand’s productivity through R&D

By Shaun Hendy 24/05/2011

It gave me a warm glow to see innovation put at the heart of Labour’s new policy offerings this week.  As I said to the Herald last week, I held no optimism for R&D in the 2011 Budget:

“Both our government R&D spending and our business R&D spending is pretty tragic, both in terms of our percentage of GDP and in absolutes.  A lot of the work I’ve done shows that you get what you pay for.  If you want a high-tech, export-based economy then you actually need to put both public and private sector money into it and we haven’t had a Budget in my lifetime that’s actually addressed that.”

However, Phil Goff put R&D tax credits back on the table at the Labour Party conference over the weekend.  R&D tax credits were introduced by Labour deep into its last term as government, but were scrapped in late 2008 by the new government.  In this post, I will look at the case for and against R&D tax credits.

Innovation for the masses

It is well established that innovation drives economic growth in developed countries:

’In advanced industrial economies, innovation and exploitation of scientific discoveries and new technology have been the principal source of long-run economic growth….  In the future, the innovation performance of a country is likely to be even more crucial…’.

OECD (2005).  Innovation Policy and Performance:  A Cross-Country Comparison.

It is also well known that the benefits of innovation are shared across an economy.  When new ideas are patented or turned into products, it is not just the inventor that benefits.  Ideas can be copied, shared and improved upon, so the benefits accrue across the economy, not just to the original innovator.

Unfortunately, this means that individual firms will invest less in research and development than is optimal for economic growth:  why should businesses bear the full cost of R&D when the rest of us share in its benefits? Economists refer to this underinvestment as market failure; you may know it as the tragedy of the commons.

So this is the theory for why governments should invest in, or subsidise, research and development.  What’s the empirical evidence?  Take a look at the plots below of the distribution of patents among applicants in New Zealand, the USA, Australia and Finland:

Applicant distribution Applicant distribution by BERD

The plot on left shows the raw distributions, while that on the right shows those distributions once they are scaled by business R&D spending.  I have already discussed how these distributions follow something very close to Zipf’s law, but for our purposes here, it is sufficient to note how the the data collapse almost onto one curve when we scale by business R&D spending.  At least in terms of patents, you get what you pay for.

The case for a tax credit

So quite understandably, New Zealand firms under-invest in R&D.  Individual businesses will not be competitive if they are carrying the burden of innovation for the economy as a whole.  This means there is a strong case to be made for subsidising business R&D in New Zealand in some way.

However, not everyone agrees that R&D tax credits are the best way to deliver this.  For instance, David Farrar suggests that they are too blunt a tool; he worries that firms will reclassify existing work as research and development to gain tax credits, rather than actually innovate.

That is a minority viewpoint.  In early 2008, The Treasury wrote that the introduction of R&D tax credits was key for New Zealand’s long term productivity growth.  The OECD is even more unequivocal:

’Given New Zealand’s very low levels of business R&D investment, the provision of a tax incentive in this area seems urgently needed.’

OECD (2007).  OECD Reviews of Innovation Policy – New Zealand

Further, the OECD considers that R&D tax credits may be the best way to subsidise business R&D, noting that they can be both responsive:

’The overwhelming advantage of R&D tax incentives is their market friendly nature.  Another is that, if well-designed — keeping barriers to access and compliance costs at a low level — they are immediately available to any firm that sees an opportunity to develop an innovative new product or service.’

and cost effective:

’Another feature of well-designed R&D tax incentives is that administrative costs are low.  Overly complicated and targeted schemes tend to lead to high administrative and compliance costs and lose the specific advantages that characterise such tax incentives.’

Tax incentives are not enough

So while the case for R&D tax credits is very strong, I would argue that they are not sufficient for economic growth.  A few weeks ago, Sir Paul Callaghan noticed an even better way to scale my patent distribution data.  He suggested dividing the patent distributions by government R&D spending:

Applicants by Govt R&D

I didn’t believe it at first, as roughly 80% of patents are generated by the private sector, but public sector R&D spending would seem to be a better way of scaling the data than private sector R&D.

Why might this be?  Government R&D spending, whether at universities, government labs or at businesses themselves, is more likely to improve the long term capability and capacity of the private sector to undertake research.  In my case study of Finland, I found that it was government spending on R&D that produced the thousands of innovators needed to build Nokia.

Where to from here?

I think the case for R&D tax credits and for increased government spending on R&D is compelling.  In a recent analysis of how New Zealand can lift its productivity, MED’s Roger Procter argues:

’By themselves, size and distance can explain a substantial part of the gap between New Zealand’s GDP per capita and the OECD’s.  This means that all New Zealand’s policy settings must be close to world best practice if New Zealand is going to close the gap with the high income OECD countries.’

So while it is often argued that New Zealand cannot afford a first class innovation system,  I would argue that we cannot afford to not have a first class innovation system.

0 Responses to “Lifting New Zealand’s productivity through R&D”

  • Creating innovative changes to NZ economy via R&D investment, great.

    Creating said investment by crippling the current sectors spending a large quantity on R&D, not so great.

    Just using the ETS as a new tax revenue stream, pathetic.

    Labour will not be voted in with this as their main benefit.

    How about an editorial regarding Nationals investment in R&D, and perhaps the changes that occurred with FRST, and with it the change in investment?

  • Depressingly predictable. An interesting balanced article that weighed up the actual evidence for an R&D tax credit program and the first comment is partisan political tripe. There’s no mention of the ETS scheme in the article so why bring it up? This article isn’t about how you fund it, rather the benefits of having a credit scheme in place.

    The point here is that we’re not great on innovation and as crucial as agriculture is for the NZ economy there’s not a lot of room for growth outside of price, and that’s a pretty fickle metric to base an economy on.

    I think it’s something beyond a political issue, it really requires a societal change in attitude to recognise the value in a well educated and funded scientific community in NZ. Unfortunately what Goff’s speech has done most effectively is highlight how unsexy this type of thing currently is to voters.

  • Good stuff, Shaun.
    A couple of points.
    1. By international convention, the tax forgone via an R&D credit is not counted as government expenditure on R&D. Hence NZ’s position vis a vis the many countries that do have R&D tax credits is even worse than it looks.
    2. It is true that the evidence for the cost/benefit of tax credits is a bit murky; there a lot of other variables. If it is important for us to have a lot more startups, for example, tax credits may not be a strong tool (depending on the design).
    3. I have reservations about overuse of patent data. Patents are not that important in certain industries where NZ is active eg software, communications.
    4. Major blunder by Labour in linking tax credits to farming ETS; it has become a serious distraction.
    5. Estimates as to the eventual cost of Labour’s previous tax credit were very unreliable. They were based on the effect of introducing the Australian tax credit on R&D spending in Australian firms; probably not a good analogy.

  • It seems to me that some of the key challenges with tax credits are mainly due to uncertainty during start-up.

    First, the government will be uncertain in the first few years how much companies will claim as tax credits. After the first few years, the trend data will help with budgeting, but initially this will be a big problem.

    Second, until some precedents are in place, companies will be uncertain what IRD will allow as legitimate R&D expenditure on which they can claim. Consider a moderate sized company that hiked up its R&D expenditure to take advantage of the tax credit. At the end of the year, it might find that IRD disagreed with the company’s interpretation of what was legitimate R&D expenditure and the company then would not receive the tax credit, which would put an unexpected and large (for companies that do a lot of R&D) additional cost in the year’s accounts.

    The schemes with which the current government replaced the tax credit (mainly the R&D grant scheme, but also vouchers) solve this uncertainty problem for both parties. The government knows exactly how much it is going to spend and companies know from day 1 how much money they’re going to get from the government.

  • kerravon
    You’re a too pessimistic. Last time round the IRD really got its act together on this. They consulted widely, their documentation was clear, and they were in the process of hiring specialist advisors to help firms lodge their claims. Your scenario is pretty unlikely to have happened.
    Then the government changed and it was all for nothing.
    From the government’s point of view, it creates an incentive aimed at getting firms to change their behaviour, but it’s not clear what this behaviour change will be. A lot of firms might just say, ‘Well, we are spending the right amount on R&D already, so we’ll just pocket the tax credit’. Who’s to say they are wrong?
    You could have a scheme which gave a credit only for additional R&D expenditure, but this just creates new anomalies.
    The big advantage of tax credits over grants and vouchers is their low administration costs, and not having to go cap in hand to bureaucrats who don’t understand your business anyway. But yes, the gov’t knows exactly what grants and vouchers will cost.

  • One reason why the government R&D spend is so important is that it is usually under government funding that innovators are trained, not always but usually. So as government R&D funding decreases there are fewer innovators available for business.

    The other big value of the government R&D spend is that it is the only place you get undirected funding. While directed funding to develop products for a specific goal is important you also really need research in areas where you don’t know that there will be a product. It is those new areas where no product exists that have the greatest potential to create new industries where there is little or no competition.

    One last point is that R&D spending has a lag of decades. You spend now for changes in decades not for a change before the next election.

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