Productivity and Government Policy Towards R&D

IFS

Productivity and Government Policy Towards R&D

Laura Abramovsky

Institute for Fiscal Studies

Public Economics Lectures

London

19th March 2007

© Institute for Fiscal Studies, 2007

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


The productivity gap Labour productivity

0

20

40

60

80

100

120

140

GDP per worker GDP per hour worked

Ind

ex,

UK

=10

0

UK

Germany

France

USA

Source: Office for National Statistics, International Comparisons of Productivity, year 2005


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


UK R&D performance, 1981-2004Gross expenditure on R&D as a % of GDP

1.5

1.7

1.9

2.1

2.3

2.5

2.7

2.9

1981 1984 1987 1990 1993 1996 1999 2002

GE

RD

as

% o

f G

DP

USA Germany France UK

Source: Main Science and Technology Indicators, OECD 2006


Who performs R&D in UK? (2004)

£m (cash terms)

%

Business Enterprise R&D (BERD)

12,800 63%

Higher Education R&D (HERD)

4,800 23%

Government R&D(GOVERD)

2,700 14%

Total 20,300 100%



Decline in BERD intensityBusiness Enterprise Expenditure on R&D (BERD) as a % of GDP

1

1.2

1.4

1.6

1.8

2

2.2

1981 1984 1987 1990 1993 1996 1999 2002

BE

RD

as

% o

f G

DP

USA Germany France UK



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)


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?


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


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)


Augmented production function approach (see Griliches, 1998)

ititRitKitLit eRKLY lnlnlnln

R is the elasticity of output w.r.t. the firm’s R&D stock

it

itR R

Y is the (private) rate of return (r.o.r) to the firm’s R&D stock

RKLititititit RKLAY


Estimate external r.o.r. from production function

ititE

itRitKitLit

eR

RKLY

ln

lnlnlnln

E is the elasticity of output w.r.t. others’ R&D stock


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%


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


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%


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


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…


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


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)


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?


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?


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%)


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


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

SMEs(employment

<250 & turnover < 50m

euros)

Large firms(employment 250+ & turnover 50m+

euros)

Number of firms (claims year 2005)

5,000 1,000

Amount of R&D (year 2005) c. £0.5 bn c. £12.5 bn

Rate of credit (A) 50% 25%

Corporation tax rate (B) 19% - 30% 30%

Marginal effective tax credit (A*B)

9.5% - 15% 7.5%

Repayable (if no taxable profits)?

Yes (@24%)

No


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


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)?


ReferencesThe UK productivity gapCrafts, 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 performanceR. 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&DGriliches (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 creditsBloom, 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


The two faces of R&D (Griffith et al, 2001a)

1

11

1 lnlnln

tF

iFt

itit A

AA

Y

RA

‘non R&D-based technology transfer’

‘R&D-based technology transfer’

itit

tF

i

it

uXA

A

Y

R

1

112 ln

A: Technical efficiency or TFP

‘R&D innovation effect’


Change in price of R&D (see Griffith et al, 2001b)

)(1

1 t

AA cd

User cost of R&D after credit =

Ad: NPV of capital allowances before credit

Ac: Marginal Effective Tax Credit for R&D

Proportional change in R&D user price (large firms)

11.0075.0287.01

287.01ln

1

1ln

cd

d

AA

A

: firm’s real discount rate

: rate of economic depreciation of R&D

t : is rate of corporation tax


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

0.11 (see Griffith et al, 2001b)

0.12 in the short run0.86 in the long run

(see Bloom et al, 2002)


Increase in overseas R&D…?

0

50

100

150

200

1996 1998 2000 2002

R&

D le

vel,

reba

sed

R&D done in the UK (BERD) R&D done by UK firms (Scoreboard)

Documents

Productivity and Government Policy Towards R&D