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:
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:
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.