Productivity and Government Policy Towards

R&D

Rupert Harrison

Institute for Fiscal Studies

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

Value addedper worker

Value addedper hourworked

Value addedper person ofworking age

Ind

ex,

UK

=10

0

UK

Germany

France

USA

Source: HM Treasury, Pre-Budget Report 2004

Service sectors account for an increasingly large part of the gap

-5% 0 5% 10% 15% 20% 25%

Distribution of employment

Wholesale and retail

Financial intermediation

Machinery and equipment

Business services

Manufacturing (excl. mach+equip)

Hotels and restaurants

Post and telecom

Construction

Transport and storage

Electricity, gas, water

Mining/quarrying

Source: authors ' calculations using OECD data, US measured at f actor costs

Share of UK-US Gap, 1990, 1995 and 2001

1990 1995 2001

Source: Griffith, Harrison, Haskel and Sako (2003)

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, 1981-2002

1.50

2.00

2.50

3.00

1981 1984 1987 1990 1993 1996 1999 2002

Year

R&

D a

s a

% o

f G

DP

UK

USA

France

Germany

Japan

Who performs R&D in UK? (2002)

£m %

Business Enterprise R&D (BERD) 13,100 67%

Higher Education R&D (HERD) 4,400 22%

Government R&D

(GOVERD)1,800 9%

Decline in BERD intensity, 1981-2002

1.0

1.5

2.0

2.5

1981 1984 1987 1990 1993 1996 1999 2002

Year

BE

RD

as

a %

of

GD

P UK

USA

France

Germany

Japan

Increase in overseas R&D…?

0

50

100

150

200

1992 1994 1996 1998 2000

Year

R&

D le

vel,

reb

ased

R&D doneby UKfirms

R&D donein the UK(BERD)

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?

Why should government support 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

• 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 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?

• 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’

• 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

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

1

11

1 lnlnln

tF

iFt

itit A

AA

Y

RA

technology transfer

absorptive capacity

itit

tF

i

it

uXA

A

Y

R

1

112 ln

Estimates of the social rate of return Griffith et al (2001a)

• Innovation effect (1) 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 if 2<0

• Total effect (innovation + imitation/technology transfer)

1 - 2ln(Ai/AF)t-1 90% (3)

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

• 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 externality by bringing the marginal private return closer to the social return

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)

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

SMEs Large firms

Employment <250 250+

Turnover <40m euros 40m+ euros

Number of firms 4,500 1,000

Amount of R&D c. £0.5 bn c. £10 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? Yes (@24%) No

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

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

)(1

1 t

AA cdUser 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

Change in price = 11.0075.0287.01

287.01ln

1

1ln

cd

d

AA

A

is the firm’s real discount rate

is the rate of economic depreciation of R&D

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

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)

= (R/Y) * %(R/Y) * [1 - 2ln(Ai/AF)t-1 ]

= 0.04% in short run or 0.30% in long run

assuming 1 = 0.433, 2 = 1, and Ai/AF = 85% of frontier productivity

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 1 or 2 years

• Not going to narrow the ‘productivity gap’ on their own

Caveats

• If the 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

• There is some evidence that this happened in the US

• 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)?