Productivity and Government Policy Towards R&D

1. Productivity and Government Policy Towards R&D Rupert Harrison Institute for Fiscal Studies

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 and total factor productivity Source: HM Treasury (2000)

4. An aside: why productivity? • Governments should be interested in ‘welfare’, broadly defined • In practice economists measure GDP per capita • This is the product of value added per worker (labour productivity) and the employment rate • Focusing only on productivity leads to perverse conclusions • For example, making low productivity people unemployed increases average labour productivity • Average labour productivity is not just a measure of technology, it also depends on the factor mix, industrial structure etc.

5. An aside: why productivity? • Does a higher level of employment explain the UK productivity gap? • Employment rates in the UK are similar to those in the USA (73% and 72% respectively in 2001) • They are substantially lower in both France (62%) and Germany (66%) • If the extra people drawn into the labour force have below average productivity, this may partly explain the productivity gap with France and Germany, but not the USA • HMT hybrid measure: “Value added per person of working age” makes the UK the same as France and Germany but well below the USA

6. Source: HM Treasury (2003)

7. N.B. Service sectors account for an increasingly large part of the gap Source: Griffith, Harrison, Haskel and Sako (2003)

8. Determinants of productivity • R&D and technological 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

9. UK R&D performance, 1981-2000

10. Who performs R&D in UK? (2000)

11. Decline in BERD, 1981-2000

12. Increase in overseas R&D

13. 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 incentives for individuals and firms to engage in the socially optimal amount of innovation and technology transfer? • If not, can government intervention efficiently and effectively provide the appropriate incentives?

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

15. 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)

16. Augmented production function approach (see Griliches, 1998) is the elasticity of output w.r.t. R&D stock is the (private) rate of return to R&D stock

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

18. 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%

19. R&D – imitation as well as innovation? • R&D does not just generate new knowledge, ie push out the technology ‘frontier’ • It may also allow firms behind the frontier to imitate those at the frontier by increasing their ‘absorptive capacity’ (Cohen and Levinthal, 1989) • The “two faces” of R&D • Implications: 1. Imitation may be costly 2. Doing R&D may allow a firm/ economy to catch up with high productivity firms/ economies, raising its growth rate in the short run until it catches up

20. Estimates of social rate of returnGriffith 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 • But 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 effect (innovation + imitation)  90%

21. Implications for policy on R&D • 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 • Direct subsidy vs R&D tax credit • Move away from discretionary support schemes • Tax-based schemes allow firms to choose R&D projects • Tax-credits directly address the externality by bringing the marginal private return closer to the social return

22. 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 (eg 50% of level in base year)

23. An example: volume based credit • £1m of current expenditure on R&D • Taxable profits of £10m • Tax bill = 30% of £10m = £3m • Now, R&D tax relief at a 50% rate • Can deduct 150% (instead of 100%) of £1m from taxable profits • Taxable profits now £9.5m • Tax bill = 30% of £9.5m = £2,850,000

24. An example: incremental credit • £0.9m of current expenditure on R&D last year • £1m current expenditure on R&D this year • Taxable profits of £10m • Tax bill = 30% of £10m = £3m • Now, incremental R&D tax relief at a 50% rate • Can deduct 150% (instead of 100%) of £100,000 from taxable profits • Taxable profits now £9,950,000 • Tax bill = 30% of £9,950,000 = £2,985,000

25. 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?

26. 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?

27. 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%)

28. 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) • Complex rules necessary for incremental credit

29. R&D tax credits in the UK

30. How much new R&D might this generate? • Additional R&D will be equal to: • Eligible R&D * %Δprice * price-elasticity of demand for R&D

31. Change in price of R&D(see Griffith et al, 2001b) User cost of R&D after credit = Where Ad is NPV of capital allowances before credit Ac is METC for R&D t is rate of corporation tax  is the firm’s real discount rate  is the rate of economic depreciation of R&D Change in price =

32. Effect on R&D expenditure • Bloom et al (2002) use data on tax treatment of R&D in a panel of OECD countries to estimate the price-elasticity of demand for R&D as: • 0.12 in the short run • 0.86 in the long run • Implies a change in R/Y (R&D intensity) of around • 0.11 * 0.12 = 1.3% in the short run • 0.11 * 0.86 = 9.5% in the long run

33. What might this do to productivity growth in manufacturing? (Griffith et al 2001b) • Given eligible R&D in manufacturing  £8bn • Manufacturing value added  £150bn • Hence R/Y  5.3% • Effect on growth of TFP = (R/Y) * %(R/Y) * elasticity of TFP wrt (R/Y) = 0.04% in short run or 0.30% in long run (assuming Ai/AF = 85% of frontier productivity)

34. Tentative 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 • R&D tax credits are likely to cost effective, at least in the long run • Too early to evaluate the impact of the UK R&D tax credits – early results possible in maybe 2/3 years • Not going to narrow the ‘productivity gap’ on their own

35. Caveats • If supply of scientists and engineers is inelastic in the short run then initial impact of R&D tax credits may be mainly to raise their wages • UK firms are doing more R&D overseas, especially in the USA • 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 in the UK or are they better off doing it in the US (frontier)?

36. Forthcoming IFS lectures