Productivity and Government Policy Towards R&D

1. Productivity and Government Policy Towards R&D Laura Abramovsky Institute for Fiscal Studies Public Economics Lectures London 19th March 2007

2. Plan of the lecture • Motivation • The UK ‘Productivity Gap’ • UK R&D performance • Private and social returns to R&D • Theory • Evidence • R&D tax credits • The basic idea • Do R&D tax credits work? • The UK R&D tax credits • Conclusions

3. The productivity gap Labour productivity Source: Office for National Statistics, International Comparisons of Productivity, year 2005

4. Determinants of productivity • R&D and innovation • creation of new knowledge and technologies • diffusion and adoption of existing technologies • Human capital • direct effect on labour productivity • indirect effect as skills and technological progress may be complementary • Investment climate • Competition, regulatory regime • Infrastructure

5. UK R&D performance, 1981-2004Gross expenditure on R&D as a % of GDP Source: Main Science and Technology Indicators, OECD 2006

6. Who performs R&D in UK? (2004) Source: Main Science and Technology Indicators, OECD 2006

7. Decline in BERD intensityBusiness Enterprise Expenditure on R&D (BERD) as a % of GDP Source: Main Science and Technology Indicators, OECD 2006

8. International comparisons • What is the optimal level of innovative activity for the UK? • International comparisons can point to areas in which the UK may be under-performing • But differences between countries also arise for structural reasons that do not necessarily merit policy attention (e.g. preferences or industrial composition)

9. Why should government support R&D? • The ‘policy-makers argument’ • “support innovation…” • “improve competitiveness…” • The economist’s response • Where’s the market failure? • Does the market create sufficient incentives for individuals and firms to engage in the socially optimal amount of innovation and technology transfer? • If not, can government intervention effectively provide the appropriate incentives at sufficiently low administrative and compliance cost, and without creating further distortions?

10. Economic rationales for government support of R&D • ‘Spillovers’ justification • In the absence of perfect intellectual property rights, knowledge is partially non-excludable • Total benefits of new knowledge may not be captured by the innovator • Private returns to innovation are lower than social returns • The market will not provide the socially optimal level of innovation • Coordination / information failures • Role of R&D and spillovers in models of endogenous growth (e.g. Romer 1990, Aghion and Howitt 1992) • Non-rival nature of knowledge

11. Private and social returns to innovation • What evidence is there that SROR > PROR ? • Intuition, case-studies • Econometric evidence • 3 broad types of econometric evidence: • Cross-country studies at economy level • Cross-industry studies (often across countries as well) • Plant- and firm-level studies (usually for 1 country)

12. Augmented production function approach (see Griliches, 1998) is the elasticity of output w.r.t. the firm’s R&D stock is the (private) rate of return (r.o.r) to the firm’s R&D stock

13. Estimate external r.o.r. from production function is the elasticity of output w.r.t. others’ R&D stock

14. Empirical evidence: firm and industry-level studies • Griliches (1998) concludes from the literature that • “R&D spillovers are present, their magnitude may be quite large, and social rates of return remain significantly above private rates” • Estimates at firm level • Private rate of return: 15% to 30% • Social rate of return: 30% to 50% • Estimates at industry level • Social rate of return (only within-industry spillovers): 20% to 40% • Social rate of return (incl inter-industry spillovers): 50% to 100%

15. R&D – imitation as well as innovation? • Knowledge is ‘tacit’ in nature: imitation may be costly • Doing R&D may allow a firm to better understand the discoveries of others, i.e. it may also allow firms behind the frontier to imitate those at the frontier by increasing their ‘absorptive capacity’ • Implications: two effects of R&D • ‘innovation effect’: R&D push out the technology ‘frontier’ • ‘R&D-based technology transfer’: R&D also increases firms’ ‘absorptive capacity’ and may allow a firm/economy behind the frontier to catch up with high productivity firms/ economies, raising its growth rate in the short run until it catches up

16. Estimates of the social rate of return Griffith et al (2001a) • Innovation effect  40% • this is the rate of return to R&D for the country at the frontier in a given industry (e.g. US) • Total R&D effect for country behind the frontier • innovation • imitation/technology transfer (varies with a country’s distance from the technological frontier) • Example • UK behind the US: UK TFP was only 63% of US TFP (1974-90) • So R&D may also enable us to catch up with the frontier, boosting the social return to R&D • Total R&D effect for UK  90%

17. Implications for government policy • Evidence supports some kind of subsidy to R&D as externalities appear to be substantial • Gap between private and social rate of return implies that subsidy should be quite large • In practice no government offers this much subsidy

18. R&D tax credits operate within a broader context of interventions • The education system, especially higher education • Direct government support for research in universities • The patent system (appropriability) • Competition policy • Government direct funding • Other schemes aimed at technology transfer and development • And many others…

19. R&D tax credits • Direct subsidy vs R&D tax credit • Gradual move away from discretionary support schemes • Tax-based schemes allow firms to choose R&D projects • Tax-credits directly address the ‘spillovers’ externality by bringing the marginal private return closer to the social return, through lowering the private cost of doing R&D

20. Alternative credit designs • Volume-based credit • Payable on all R&D • Incremental credit • Payable on all R&D above a rolling base • Fixed base credit • Payable on all R&D above a fixed base (e.g. 50% of level in base year)

21. Key criteria for R&D credit design • Cost-effectiveness • additional R&D (value added) generated per pound of exchequer cost • Simplicity • low compliance and administrative costs • Certainty for companies • how much credit will they receive and when?

22. Cost-effectiveness 1: additional R&D • Additional R&D generated depends on: • amount of R&D eligible for the credit • effect of tax credit on the ‘price’ of the last pound of R&D (marginal effective tax credit) • responsiveness of R&D to the lower ‘price’ of R&D • Is additional R&D of the same quality as existing R&D? • Marginal projects • Re-labelling of other activities as R&D?

23. Cost-effectiveness 2: exchequer cost • Exchequer cost of tax credit depends on: • credit rate (and statutory rate of corporation tax) • amount of ‘existing’ R&D that receives the credit (‘deadweight’) • amount of new R&D generated • ‘Deadweight’ cost is by far the largest component of cost in most designs (often >95%)

24. Pros and cons of each design • Volume–based credit • simple to understand and predict but high ‘deadweight’ • Incremental credit • lowest ‘deadweight’ but frequent uprating of base reduces effectiveness (METC < credit rate) • Fixed base credit • intermediate deadweight but uncertainty over future uprating of base may reduce effectiveness • Complex rules necessary for incremental and fixed base designs

25. R&D tax credits in the UK: volume-based

26. Conclusions • Theory and empirical evidence suggests that social return > private return to R&D due to spillovers • R&D tax credits go some way to internalise externality at sufficiently low admin and compliance cost; likely to be cost effective, at least in the long run • UK government starting to consider econometric evaluation of the impact of the UK R&D tax credits • Not going to narrow the ‘productivity gap’ on their own • Griffith et al (2001b) estimate effect of increase in R/Y on TFP for manufacturing (consider both innovation and imitation effects): 0.04% in short run ; 0.30% in long run

27. Caveats • UK firms are doing more R&D overseas, especially in the US • Some evidence that this R&D is more productive and provides access to cutting edge technologies • Should we encourage them to do more R&D here or are they better off doing it in the US (frontier)?

28. References The UK productivity gap Crafts, N. and O’Mahony, M. (2001), “A perspective on UK productivity performance”, Fiscal Studies, 22 (3), pp 271-306 R. Griffith, R. Harrison, J. Haskel and M. Sako, The UK Productivity Gap and the Importance of the Service Sectors, IFS Briefing Note no. 42, 2003 (http://www.ifs.org.uk/publications.php?publication_id=1790) The UK R&D performance R. Griffith and R. Harrison, Understanding the UK’s Poor Technological Performance, IFS Briefing Note no. 37, June 2003 (www.ifs.org.uk/corpact/bn37.pdf) Private and social returns to R&D Griliches (1998), “The Search for R&D spillovers”, Chapter 11 in R&D and productivity: the econometric evidence, Zvi Griliches, University of Chicago Press, 1998 Griffith, R., S. Redding and J. Van Reenen (2001a), “Mapping the two faces of R&D: Productivity growth in a panel of OECD industries”, Institute for Fiscal Studies Working Paper W00/02 (http://www.ifs.org.uk/publications.php?publication_id=2051) R&D tax credits Bloom, N, R. Griffith and J. Van Reenen (2002), “Do R&D tax credits work: evidence from a panel of coutries 1979-97”, Journal of Public Economics 85, pp 1-31 Griffith, R., S. Redding and J. Van Reenen (2001b), “Measuring the cost-effectivenes of an R&D tax credit for the UK”, Fiscal Studies, 22(3), pp 375-399

29. The two faces of R&D (Griffith et al, 2001a) ‘non R&D-based technology transfer’ ‘R&D innovation effect’ ‘R&D-based technology transfer’ A: Technical efficiency or TFP

30. Change in price of R&D (see Griffith et al, 2001b) User cost of R&D after credit = Ad: NPV of capital allowances before credit Ac: Marginal Effective Tax Credit for R&D : firm’s real discount rate : rate of economic depreciation of R&D t : is rate of corporation tax Proportional change in R&D user price (large firms) 

31. UK R&D tax credits: additional R&D and its impact on TFP • Additional R&D will be equal to: Eligible R&D * %Δprice * price-elasticity of demand for R&D • Implies a change in R/Y of around • 0.11 * 0.12 = 1.3% in the short run • 0.11 * 0.86 = 9.5% in the long run • Griffith et al (2001b) estimate effect of increase in R/Y on TFP for manufacturing (consider both innovation and imitation effects) • 0.04% in short run ; 0.30% in long run • 0.12 in the short run • 0.86 in the long run • (see Bloom et al, 2002) • 0.11 (see Griffith et al, 2001b)

32. Increase in overseas R&D…?