Master Thesis in Economics “An analysis of the effectiveness of government R&D policies on business R&D expenditure” doc

The policy tool leaves decisions on the level and timing of R&D expenditure to the private sector, and meanwhile, it gives a government the option to pay for R&D that is otherwise not pr

The Royal Institute of Technology Master’s program in Economics of Innovation and Growth

(Professor Stefan Fölster)

Master Thesis in Economics

“An analysis of the effectiveness of government R&D policies on business

R&D expenditure”

Written by Kaifeng Li (kaifeng_baoding@yahoo.com.cn)

June 2010

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ABSTRACT

This thesis investigates the effectiveness of government R&D policies in 13 OECD countries from 1985 to 2007 R&D plays an important role in the world economy, and business-funded R&D accounts for the majority in total R&D spending Policy-makers design various R&D policies to stimulate business R&D expenditure Since the existence of R&D policies, researchers highly contributed their enthusiasm

on the analysis of the efficiency of those R&D policies, but the validity of government intervention still received considerable controversy Thereby, the purpose

of this thesis is tried to follow the historical arguments and investigates the effectiveness of government R&D policies on business-funded R&D Three questions are mainly addressed: Does the leverage effect of public funding on business R&D really exist? How those different policy instruments do influence firms’ R&D behavior? How do those policy instruments interact with each other? The thesis searched the answers for the three questions, and concluded that the optimal policy tool for government to stimulate private R&D is tax incentives, and government cannot affect much to firms’ R&D investment decisions

Key words: Business-funded R&D, government funding of R&D performed in

business, tax incentive, government research, university research, crowding-out effect, crowding-in effect

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ACKNOWLEDGEMENTS

I would like to express my gratitude to my supervisor Professor Stefan Fölster for the

valuable guidance, the precious help, and the constructive advices he provided to me during the entire process

Special thanks go to the Professor Hans Lööf for the data analysis guidance, without his generous support and unlimited patience, it is surely that I cannot go this far

I would also like to thank Professor Kristina Nyström for the grammar checking and constructive suggestions, I am sincerely appreciated to her kindness

At last, I would like to show my deepest gratitude to my mom, whom extremely eliminates my pressure with her love, and her tough support strongly encouraged my thesis working

In a word, I would like to extend my sincere gratitude to everyone for kind helps

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Table of Contents

ABSTRACT II ACKNOWLEDGEMENTS III

1 INTRODUCTION 1

2 THE THEORETICAL BACKGROUND 3

3 EMPIRICAL LITERATURE REVIEW 7

3.1 Empirical Literature Studies on Tax Incentives 7

3.2 Empirical Literature Studies on Government Direct Financial Support 9

3.3 Empirical Literature Studies on Public Research 12

4 ECONOMIC BACKGROUND 13

4.1 Trends of R&D Expenditure 14

4.2 Tax Concessions 15

4.3 Changes of Government R&D Budget 16

5 DATA AND METHODOLOGY 18

6 EMPIRICAL RESULTS 20

7 CONCLUDING REMARKS 27

8 REFERENCE 30

9 APPENDIX 32

A The B-Index 32

B Tax subsidy rate for USD 1 of R&D, large firms and SMEs, 2008 35

C Trends of B-index from 1985 to 2007 35

D The Effectiveness of R&D Policy Tools on Business-funded R&D in Country level analysis 36

E The Interaction between Various R&D Policy Tools in Country-level Analysis 37

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1 INTRODUCTION

In the past few decades, the importance of technical change has received increasing attention both from researchers and policymakers, because of the change stimulate a country’s long-run rate of economic growth A key factor dominating technical change is that the knowledge accumulation through expenditure on research and development (Becker and Pain, 2003) In 1994, R&D was defined by Frascati Manual as “Research and experimental development (R&D) comprise creative work undertaken on a systematic basis in order to increase the stock of knowledge, including knowledge of man, culture and society and the use of this stock of knowledge to devise new applications” Despite the recognition of the importance attached to R&D now for long-run economic growth and living standards, it is commonly argued that social optimal R&D level cannot be reached without government intervention Schumpeter (1942), Nelson (1959) and Arrow (1962) firstly argued the rationale of government R&D intervention They hold such a conceptual idea that knowledge is non-rival good Therefore, the private return on R&D investment will hardly be appropriated, which leads to an under-provision of R&D investment in the economy (Lööf and Hesmati, 2004) Guellec and van Pottelsberghe (2000) argued that imperfect appropriability and diffusion of knowledge uncontrolled caused innovators cannot fully appropriate the benefits of their innovations, which implied that the rate of private return to R&D is lower than its social return Becker and Pain (2003) emphasized that market failures can provide a rational for government intervention to support private R&D They mentioned that the expenditure on R&D should be lower than social optimal level if the private rate of return is lower than social rate of return, and if firms experience the significant external financial constrains, the R&D expenditure will also be lower than social optimal level Streicher, Schibany and Gretzmacher (2004) claimed that pure markets will not be efficient in stimulating innovation due to the inherent characteristics of

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R&D “In most situations the market will fail to provide sufficient incentives to invest in R&D since firms face appropriability problems The reason is that R&D has some characteristics of a public good, so that the private returns on innovation will be lower than its social return”

Since the government R&D policy performed, lots of researchers have been contributed their effort to the evidence searching of the effectiveness of government intervention Although most of them observed positive effects in this field, but the validity of government intervention still received considerable controversy Some researchers argued that the existing econometric evidence of the substitutability or complementarity effects of public R&D funding is very inconclusive (Becker and Pain (2003), David, Hall and Toole (1999)) I wish this thesis will contribute about new implications and evidence to the current literature

The purpose of this thesis is try to follow the historical arguments and investigates the effectiveness of government R&D policies on business-funded R&D in OECD countries from 1985 to 2007 However, because of the limitation of data collection, only 13 OECD countries have been found that can qualified the thesis’ observation period requirement, which those OECD countries are United States, United Kingdom, France, Italy, German, Japan, Spain, Ireland, Belgium, Portugal, Denmark, Finland, and the Netherlands In the thesis, three questions are mainly addressed: Does the leverage effect of public funding on business R&D really exist? How do those different policy instruments affect firms’ R&D expenditure behavior? Do those policy instruments interact with each other? The analysis in this thesis implements a previous analytical model published by Gullec and van Pottelsberghe (2000) From my best knowledge, they are the only researchers whom organized all categories of government R&D policy tools within a single analytical model, which eliminate comparison issues by the heterogeneity of the empirical models used Besides, they also got reasonable results However, in

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contrast to their analysis, this thesis implemented more advanced regression technique and extended the analysis area to provide more details with country-level studies The observation period is also ten years longer than Gullec and van Pottelsberghe’s analysis

The remaining part of this thesis is structured as follows: The next section will provide the theoretical background, and section 3 reviews the empirical literature

of the effectiveness of R&D policies In section 4, the thesis will introduce the economic background of the 13 OECD countries Moreover, in the following two sections, this thesis will describe the data set and the analytical model, and state the empirical results The final conclusion will be provided in the section 7

2 THE THEORETICAL BACKGROUND

Historically, there are various policy tools available for government to stimulate business-funded R&D The empirical literature summarizes those policy tools into three main categories:

Firstly, government can encourage business R&D activities through favorable tax treatment The R&D tax may increase R&D that is marginally profitable for the firm, but only if the elasticity of R&D with respect to costs is high Government implements this policy tool to decrease firms’ R&D risk through tax breaks based

on the level of R&D expenditure Currently, there are many forms of tax treatment

of R&D, like accelerated depreciation of investment, tax credit In contrast to the other R&D policy tools, this one is more transparent, and this policy tool is a more market-oriented approach The policy tool leaves decisions on the level and timing

of R&D expenditure to the private sector, and meanwhile, it gives a government the option to pay for R&D that is otherwise not profitable at all for the firm, but may be socially worthwhile Guellec and van Pottelsberghe (2000) argued that tax concessions were not conditional on the type of recipient’s R&D performance

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Therefore, tax incentives will not affect the R&D composition

Secondly, government can directly fund business R&D through granting or/and procuring private R&D projects The previous mentioned Frascati Manual identified that the government direct funds to business R&D into two categories, one is specifically for procurements of R&D (the R&D result is government property) The other category is that government commits grants or subsidies to the R&D performer (the R&D results belong to the recipient) Yong (1998) argued that government procurements, grants, and fiscal incentives account for the bulk

of government support to business R&D In this category, the government funds will be purposed for the specific technical projects which seem to have higher rate

of social return Public investors wish that additional research projects will take place in contrast to the ones that would have been done without the public support through the performance of this policy tool Although the government funded R&D and performed by business primarily includes procurement and grants, it is worth to remind that some other forms of direct R&D support still exist, like loan guarantees, conditional loans, and convertible loans

At last, through funding public research (public laboratories and universities) government may indirectly support private R&D Due to the main purpose of public institutions is generating basic knowledge to meet public needs But the knowledge may directly employ by private firms to improve their private return

on R&D investment Besides, basic research may also open new opportunities to business research, which in turn affects productivity Hence, this policy has a possibility to trigger higher business R&D expenditures through technology spillover effects

When government commits their funds with the purpose to encourage private R&D expenditures, they may aim directly to fund business R&D through granting or/and procuring private R&D projects to reduce the private R&D cost, or

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indirectly to support private R&D by providing technological opportunities available to firms If those policies works well, then public and private funding will be complementary, which means increase the intensity of one will enhance the other However, empirically, those policy tools have been challenged by four main grounds: full crowding-out effect, partial crowing-out effect, no influence, and allocative distortion Streicher, Schibany and Gretzmacher (2004) argued that R&D expenditure and the reaction of R&D subsidies were the result of firms’ internal decisions Therefore, government policy tools cannot (or only partially) influence private R&D directly The figure 1 is used to graphically describe part of the five main effects on public support to business-funded R&D

Figure 1 The effects of R&D subsidies on total R&D expenditures

(Source: Input Additionality Effects of R&D Subsidies in Austria 2004)

Firstly, for crowding-out effects, the full crowding-out effects implies firms may use government money as “windfall gains” They just use that money simply to substitute their own spending Moreover, government spending may increase the cost of R&D to crowd out private money Goolsbee (1998) and David and Hall

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(1999) both had been observed that government funding significantly raised the wage of researchers For instance, government funding may increase the salary of researchers, although the total amount of R&D costs looks higher, but nothing actually changes, and the real amount of R&D may be even lower than before The partial crowding-out effect means that firms may raise their R&D expenditure, but less than the amount of government support

Secondly, public support has no influences on private R&D occurs when firms maintain the level of their R&D expenditures, but by use of full amount of the subsidy extends total research Because of firms would like to do more R&D than they can afford to enhance their advantage in market, but banks are reluctant to provide financial support

Thirdly, the crowding-in effect reflects the stimulating effect of public support on private R&D expenditure, which means with one unit of public R&D spending will induce higher amount of business R&D expenditure than government support

In the empirical literatures, some authors use “substitutability” to imply crowding-out effect, and taken “complementarity” to imply crowding-in effect Like David, Hall and Toole (1999)

At last, the reasons of inducing allocative distortions is that government funds allocated to a project in the less efficient way than market force will do If government funding is directed towards those projects that firms will undertake anyway, thus this will leads to a misallocation of resources Furthermore, in the imperfect market, when government provides their financial assistance to a firm, government may help the recipient even it is initially inferior to alternatives

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3 EMPIRICAL LITERATURE REVIEW

In this section, the paper will review the empirical results for the effectiveness of government R&D policy instruments The serves at empirical literature shows that previous studies applied various dataset, observation period and testing methodology, but most of studies have demonstrated positive evidence of public intervention

3.1 Empirical Literature Studies on Tax Incentives

Hall (1992) used firm-level R&D spending data to evaluate the impacts of R&D tax policy on manufacturing firms’ R&D investment in the United States during 1980s She estimated average tax price elasticity for R&D spending which is in the neighborhood of unity in the short run, and concluded the existence of positive relationship between tax credits and private R&D spending The author also argued that the R&D tax credits had the intended effect, and although the high correlation over time of R&D spending at the firm level makes it difficult to estimate long run effects precisely, but the same high correlation makes it probable that these effects are large McCutcheon (1993) analyzed the response of the strategic groups

in the pharmaceutical industry to the credit He formed four strategic groups using different levels of research intensity and relative cash flow margin, and concluded that tax credits stimulated firms’ competitive R&D expenditures in the pharmaceutical industry The author contended that a 1.6% R&D increase was attributable to the credit Hall and Van Reenen (1999) argued that the effectiveness of fiscal incentives for R&D based on the tax system in OECD countries on the user cost of R&D, and they concluded that a dollar in tax credit for R&D stimulated a dollar of additional R&D Bloom, Griffith and Reenen (2000) examined the impact of fiscal incentives on the level of R&D investment with an econometric model of R&D investment They used a

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panel of data on tax changes and R&D spending in 9 OECD countries from

1979 to 1996 They concluded that tax incentives were effective in increasing R&D intensity This is true even after allowing for permanent country specific characteristics, world macro shocks and other policy influences They concluded that a 10% fall in the cost of R&D stimulates just over a 1% rise in the level of R&D in the short-run, and just under a 10% rise in R&D

in the long-run Guellec and van Pottelsberghe (2000) used a first-difference auto-regressive model to analyze a panel data which collected from 17 OECD countries over 1983-1996 They concluded that tax incentives have positive effect on business-financed R&D, The short-term (long-term) private R&D elasticities is -0.29 (-0.33) for tax incentives Mulkay and Mairesse (2003) analyzed the effectiveness of tax credits in France, which the credits have been in place since 1983 The data in French companies from 1980 to

1997 is used to test an error correction model for R&D expenditure with a user cost of R&D capital including this incremental tax credit They concluded that the R&D tax credit had a large significant and positive effect

on the optimal R&D capital If the rate of the current tax credits is raised by 10% the optimal stock of R&D capital will increase by 4.6% to 6%, which is far from being negligible The summary of the empirical literature of the effectiveness of fiscal incentives on private financed R&D displays in the table 1

Table 1: Recent studies on the impact of fiscal incentives

1992 U.S

manufacturing firms data Firm level

spending induced was greater than the cost in foregone tax revenue, although the effective credit rate is less than five percent until 1990

1993 U.S

pharmaceutical industry data Firm level

competitive R&D expenditures, and

attributable to the credit

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countries’ data Country level

Hall and Van Reenen

A dollar in tax credit for R&D stimulated a dollar of additional R&D

countries data Country level

countries’ data Country level

Van Pottelsberghe

Tax breaks has a positive impact on business spending in R&D The short-term (long-term) private R&D elasticities is -0.29 (-0.33) for tax incentives

3.2 Empirical Literature Studies on Government Direct Financial Support

For the government direct financial support, Guellec and van Pottelsberghe (2000) had also estimated it in their paper They argued that Direct government funding of business R&D has a positive impact on business financed R&D One dollar give to firms results in 1.70 dollars of private research However, the stimulating effect will increases up to a certain threshold and then decreases beyond, which the threshold is about 13% of business R&D Becker and Pain (2003) estimated an econometric model of R&D expenditure to analyze a panel of UK manufacturing industries Their results highlighted the importance of industry characteristics, and they found that government funding appeared to play an important role on the total industry R&D expenditures 1 percentage point in the share of business R&D expenditure funded by the government is estimated to raise the level of R&D

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expenditure by 1.8% Streicher, Schibany and Gretzmacher (2004) argued that leverage effect of public subsidies to private R&D based on firm-level data from the Austrian Industrial Research Promotion Fund They concluded that the public subsidies to private R&D have a crowding-in effect With 1 additional euro of funding will induce firms to contribute an additional 40 cents of their own money They also mentioned that very small and large firms seem to exhibit higher leverage effect, but small and medium-sized firms appeared to have smaller leverage effect Lööf and Hesmati (2004) investigated the effectiveness of a public innovation policy aimed at stimulating private R&D investment at firm level However, their result is somewhat difference They used the data from the Community Innovation Survey (CIS) III for Sweden, and evaluated whether firms receiving public funds have a higher R&D intensity on average compared to those not receiving any such support They concluded that there were additive effects

of public R&D financing on private research expenditure, but only for small firms Benavente (2003) compared and analyzed the Chilean manufacturing firms under a situation that whether firms received or did not receive R&D subsidies from 1995 to 1998 The author found a positive relationship between public funding and private R&D There was a 0.3 dollars crowding-in effect in R&D spending in firms that received public funding The firms that received public R&D funding had higher R&D spending than those corresponding firms without public R&D support Besides, Einiö (2009) identified of the causal effect of government support on private R&D effort from a very different viewpoint compared with previous literature The author’s analysis is based on regional differences in eligibility for European Union Regional Development Funds (ERDF) which determined by the population-density rule, and the data is constructed by linking a broad R&D survey to administrative data on all R&D support applications in Finland from 2000 to 2006 He concluded that the support program had induced additional private R&D expenditures among the participants who entered it

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as a result of higher funding in their region, and among this group one subsidy euro induced additional R&D worth at least 1.5 euro However, Wallsten (2000) found counterfactual evidence in his studies The author used a dataset of firms involved in the Small Business Innovation Research (SBIR) program to exam whether government-industry commercial R&D grants stimulated private R&D expenditure He estimated a multi-equation model to make the analysis, and concluded that grants crowded out firm-financed spending R&D dollar for dollar Table 2 summarized the recent studies on the impact of government direct financial support

Table 2: Recent studies on the impact of government direct financial support

countries’ data Country level

Van Pottelsberghe

business R&D has a positive impact

on business financed R&D One dollar give to firms results in 1.70

However, the stimulating effect will increases up to a certain threshold and then decreases beyond, which the threshold is about 13% of business R&D

Firm level

firm-financed spending R&D dollar for dollar

manufacturing industries’ data Industry level

Pain

Government funding played an important role on the total industry R&D expenditures 1 percentage point in the share of business R&D

government is estimated to raise the level of R&D expenditure by 1.8%

manufacturing firms’ data Firm level

between public funding and private R&D There was a 0.3 dollars

spending in firms that received public funding

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Industrial Research Promotion Fund data

Firm level

Schibany and Gretzmacher

will induce firms to contribute an additional 40 cents of their own money Very small and large firms seem to exhibit higher leverage effect, but small and medium-sized firms appeared to have smaller leverage effect

2004 CIS III data for

Sweden Firm level

Hesmati

There were additive effects of public R&D financing on private research expenditure, but only for small firms

Firm level

expenditures One subsidy euro induced additional R&D worth at least 1.5 euro

3.3 Empirical Literature Studies on Public Research

In 1996, Kealey argued that public research activities are irrelevant on business R&D expenditure in his book which with a tile of “The Economic Laws of Scientific Research” Free commerce will virtually and automatically generate technological innovation and economic growth even without government intervention The author argued that if the knowledge is useful, then business enterprises will undertake it anyway So government intervention will reduce the efficacy of private R&D effort, which will leads

to the negative effect for public spending on private R&D Guellec and van Pottelsberghe (2000) argued that defense research performed in public labs and universities crowds out private financed R&D The short-term (long-term) private R&D elasticities are -0.07(-0.08) for government research and -0.04(-0.05) for university search The negative effect of university research

is mitigated when government funding of business R&D increases However,

in contrast to the fact from Kealey and Guellec and Van Pottelsberghe, Benavente (2003) mentioned that firms that have cooperated with universities and/or public R&D institutes had contributed higher level of

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R&D expenditure than the firms have not made contracts with those types of institutions The summaries of recent studies on the impact of public research are presented in table 3

Table 3: Recent studies on the impact of public reserch

Country level

expenditure, and free commerce will virtually and automatically generate technological innovation and economic growth even without government intervention

countries’ data Country level

Van Pottelsberghe

Defence research performed in public labs and universities crowds out private financed R&D The short-term (long-term) private R&D elasticities are -0.07(-0.08) for

-0.04(-0.05) for university search The negative effect of university

government funding of business R&D increases

manufacturing firms’ data Firm-level

universities and/or public R&D institutes had contributed higher level of R&D expenditure than the firms have not made contracts with those types of institutions

4 ECONOMIC BACKGROUND

In this section, the paper will provide the economic background related to R&D investment based on the 13 observed OECD countries, and as mentioned before, those OECD countries are United States, United Kingdom, France, Italy, German, Japan, Spain, Ireland, Belgium, Portugal, Denmark, the Netherlands, and Finland

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4.1 Trends of R&D Expenditure

In 2007, the total R&D expenditure in OECD countries has been reached USD 886.3 billion (in current purchasing power parity, PPP), which accounts for about 2.29% of overall GDP Gross domestic expenditure on R&D has been growing steadily since the 1980s despite a slowdown in the early 1990s and 2000s Business enterprise R&D accounts for the majority R&D activity

in OECD countries in terms of both performance and funding In 2007, business enterprise sector accounting for around two-thirds of the R&D funding in OECD countries, which is the component most affected by the business cycle over 1982-2006, and business sector R&D performed reach USD 616.8 billion (in current PPP), which was close to 70% of total R&D expenditure United States accounted for around 43% of business enterprise R&D expenditure, EU and Japan accounted for 27% and 19%, respectively Figure 2 depicts the trends of business R&D over 1993-2007

Figure 2 Business R&D trends by area, 1993-2007

Japan United States Total OECD

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(Source: OECD Science, Technology and Industry Scoreboard 2009)

From the figure 2 we can see that the business R&D expenditure has been roughly keeping grow over 1997-2007 In this period, business R&D in OECD-area grew by USD 160 billion (in PPP of 2000), in which United States accounted for almost 40% of the growth, and Japan accounted for around 20% Among the EU27 countries, Portugal experienced strong growth which the growth rate excess 10% a year during the last decade

4.2 Tax Concessions

In OECD countries, R&D tax concessions are extensively used to stimulate business R&D expenditure R&D tax treatments includes immediate write-off of current R&D expenditure, depreciation allowances and various types of tax relief, such as tax credits or allowances against taxable income Generally, most of the OECD governments applied different R&D tax policies to large firms and SMEs (small and medium size enterprises) The figure 3 describes the tax subsidy rate in the 13 OECD countries in 2008

Figure3 Tax subsidy rate for USD 1 of R&D, large firms and SMEs, 2008

(Source: OECD Science, Technology and Industry Scoreboard 2009)

Note: The amount of tax subsidy for R&D is calculated as 1 minus the

B index (more details about B-index will be provide in Appendix A), which

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the B index is defined by Warda (1996) as the present value of before tax income necessary to cover the initial cost of R&D investment and to pay corporate income tax, so that it is profitable to perform research activities

In 2008, France and Spain provided the largest subsidies and made no distinction between large and small firms Japan, United Kingdom and the Netherlands appeared to be more generous for small firms Finland and Germany displayed negative tax subsidy rate1 both for large firms and SMEs (The value of tax subsidy rate for R&D in 2008 is provide in appendix B)

The tax subsidies for R&D to large firms increased significantly between 1999 and 2008 in France, and to a lesser extent in Italy, Portugal, United Kingdom, Belgium and Japan However, the OECD science, technology and industry scoreboard 2009 indicated that Italy had been experiencing the largest decreases in R&D tax subsidies for small and medium-sized enterprises

4.3 Changes of Government R&D Budget

For public research, government R&D budget data indicates the relative importance in public R&D spending of various socioeconomic objectives, such as defense, health and the environment The following figure displayed the government R&D budget changes in the 13 OECD countries over 1998-2008

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Citizens for tax justice (1996),”A negative tax rate indicates that rather than paying taxes, a corporation was able

to use excess deductions to get a refund for taxes paid in earlier years.”

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Figure4 Change in government R&D budgets, 1998-2008

(Source: OECD Science, Technology and Industry Scoreboard 2009)

As the figure 4 shows that except France, all of the rest 12 OECD countries’ government R&D has been experiencing increase over 1998-2008 For EU27 region, Growth of government R&D budget has been modest on average by 2.4% a year since 1998, compared to 2.9% in Japan and 4.2% in the United States In the OECD area between 2000 and 2006, government R&D budgets have grown on average by 3.8% a year (in real terms), and the growth rate for Ireland and Spain has exceeded 10% a year since 1998 France is the only OECD country whose government R&D budget experience decrease in the last decade, by around 0.4% a year The largest government R&D budgets as

France Netherlands Germany Finland EU27 (1998-2006)

Italy United Kingdom (2001-06)

Japan Belgium (1998-2007) Denmark (2001-08) OECD (2000-06) United States (2000-08)

Portugal Spain (1998-2007)

Ireland

%