Pulling teeth and assisting R&D

Methodology and what in disciplines other than economics is called ‘theory’ has always interested me – so long as it remains at the level that can be understood by my tiny brain and does not waft off into structuralism, deconstruction, critical theory or other strange activities. And what I think is most interesting, is not so much purely epistemological discussion about how disciplines know things. What I find interesting is to perform a kind of ‘psychoanalysis’ on professional practice. Why do some problems get tackled in certain ways, and does this make good sense? This question of course matters. It matters in what I call the ‘professional social sciences’ which are law and economics, those disciplines the thinking of which matters enormously to the way our policy makers, whether they’re in public or private bureaucracies make policies, and of course to the policies they make.

[As an aside many years after writing this, it occurs to me that I shouldn’t have been so implicitly dismissive of other social sciences. I should probably have called economics and law the “policy social sciences”. There are other candidates for “policy social sciences’ though somehow they don’t occupy as large a space in our collective minds – disciplines like town planning and criminology. I guess there are others. Meanwhile there are other social sciences of immense importance, like psychology. They can be of great importance in influencing things like personnel human resource management, and the practice of medicine, but they don’t typically bear as single mindedly on policy.]

Anyway here’s a simple exemplar in the genre in which I point to what I argue are some biases in the way the PC thinks about industry assistance and speculate as to their origins.

A shortened version of this article was published as “Don’t neglect innovation” in the AFR on 10th January 2011

Economic reform isn’t just about economics. It’s also a political project. Reform typically requires political leadership because electoral pain is inflicted now for benefits that can take many years – and more to the point, more than one electoral cycle – to materialise. Alongside the removal of dysfunctional economic institutions, reform also involves building new institutions. Just as we’ve removed industry assistance that wasn’t justified, we’ve increased assistance where the economic textbook said we should. Thus for instance, because others can see and copy others’ new knowledge, governments should assist research and development (R&D).

And politicians wouldn’t fund the billions that go into them without a long line of vice chancellors, researchers and businesspeople on their seasonal migrations to the lobbies of Canberra. If this looks like rent seeking, it is. It’s a dirty job. But someone’s got to do it. In contrast to most other rent seeking, it’s justified. However if keeping the rent seekers’ snouts out of the public trough is what gets you up in the morning – and it does if you’re an economic reformer, you’re bound to feel diffident about capitulating to the rent seekers – however justified their case might be.

And that’s a pity, because building a political economy focused on the future is every bit as much of a challenge as dismantling the culture of protecting the losers. The new must force its way into the world in a hostile environment. As thinkers since Adam Smith have observed, incumbent business interests are typically well represented in the political process whereas emerging possibilities can be fragile. They have minimal political visibility let alone support. That’s why in the last federal election the ALP scrapped its own policy to fund innovative government IT programs and the Libs junked the entire budget for e-health to fund spending on more familiar, (read: “more vote winning”) issues.

The Productivity Commission (PC) exemplifies reformers’ diffidence. It emphasises the importance of innovation and supports the textbook case for assisting R&D. Yet somehow it just can’t bring itself to propose increased assistance. The big calls in the PC’s 2007 mega-report on science and innovation amounted largely to hand wringing. “Australia’s public support of science and innovation is not in the ‘danger zone’ of demonstrable over or under-funding.” Yet its own research suggested that the economy wide rate of return to Australian business R&D was around 50 percent!

It’s possible that all the cherries have been picked – that the average return is 50 percent but the return of the next marginal project of the rank is below par. But how many industries do you know with an average return of 50% that aren’t expanding? But somehow the idea of increasing government support for R&D just didn’t rate. Indeed, the Commission couched some ideas for improving the efficiency of the R&D tax concession as opportunities for savings. But the tax concession it was proposing to economise on provided less than half the rate of assistance it did in 1996 when the Commission last reviewed it. Back then it said the rate was well . . . not in the danger zone of over or under funding.

When there are disparities of assistance – for instance industry funded agricultural R&D is usually funded at higher rates than business R&D – the PC has a problem. It can’t evaluate what level of assistance business R&D should receive (I can sympathise, we really don’t know enough to be at all precise). But it somehow it always seems to back levelling out assistance by lowering higher rates rather than raising lower rates.

The closest we ever got to a controlled experiment between the reformers’ inclinations towards the ‘positive’ and ‘negative’ aspects of reform occurred when the early Howard Government turned the clock back on reform to reduce the budget deficit. It introduced a temporary three percent revenue duty on duty free imports and permanently halved the (then) 150 percent R&D tax concession. On the backsliding from the ‘negative’ reform policies of cutting tariffs, the PC’s next Annual report was as critical as a government agency can be commenting on “perceptions of confusion and inconsistency in the approaches of governments to industry assistance” with the new import levy singled out as an instance. By contrast its reaction to the backsliding on the positive reform agenda – the reduction in the R&D tax concession was platitudinous, calling for greater continuity of innovation policy “notwithstanding a change of government”.

Now we have a chance to get some of this right. The Review into Australia’s Innovation System on which I sat, found that the 125 percent R&D tax concession was too small to influence firms’ decision making and also highly capricious in its incidence. R&D by profitable firms gets a little help (which varies depending on their ownership structure and dividend policies), whilst loss making start ups often get nothing. The review recommended substantially higher and more evenly distributed assistance together with some narrowing of eligibility to prevent ‘whole of mine’ claims where concessions go to the bulk of money spent building a huge mine in the face of novel geological challenges.

With some of those rent-seekers lobbying for the legislation enabling the new scheme to pass and others wanting it stopped, the Australian Business Foundation has asked Lateral Economics to investigate and report on the best way forward, a report we’ll be delivering in March. We begin the project with an open mind about whether the new legislation truly reflects the Innovation Report’s recommendations and whether, even if it does, it can be improved.

And we also respect the importance of avoiding waste and poor design in assistance programs. In this regard, many of the PC’s proposals to redirect the energies of R&D programs often make a helpful contribution. But we also know that the economy of the future must push its way through the economy of the present. Improving competition in the economy is an important contributor to that vision. I salute the Commission’s vigilance on that score. But given the increasing importance of innovation in meeting the challenges we face – most particularly in climate change – and the declining importance of traditional assistance like tariffs, our current micro-economic priorities seem strangely inverted – somehow lacking in imagination and confidence.

Finding our way to a world in which firms focus on investing in the new knowledge necessary to address the problems we face is surely a bigger prize.

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13 Responses to Pulling teeth and assisting R&D

  1. Patrick says:

    I will look forward to your conclusions. There is a lot of support in resources in particular for flow-through shares which essentially enable the investors in a start-up to benefit directly from the tax benefits without losing limited liability and liquidity (by eg using a partnership).

    Maybe that is one answer to one of the problems you referred to.

  2. Nicholas Gruen says:

    Thanks Patrick,

    Would you care to elaborate a little?

  3. Patrick says:

    I was referring to the problem of start-up companies whose only real benefit from the current R&D tax concessions is a carried-forward tax loss (which they may then lose in any case).

    Typically, start-up companies do attract investors who can use tax losses (indeed, a proportion are set up by wealthy entrepreneurs who can use tax losses or as JVs between large companies). Very simply, flow-through shares are for all legal purposes shares but for tax purposes the entity’s tax losses ‘flow-through’ to the investors, which effectively tax-shelters investment in R&D-intensive or resources-focused start-ups and JVs.

    I believe that Canada uses them, and the US has effectively the same thing with its ‘check-the-box’ rules.

  4. derrida derider says:

    I’ve never agreed with the idea that a small country like Australia should invest heaps of scarce resources in basic research. Our optimal economic strategy is surely to freeload off others’ investment.

    Yes, GLOBALLY such research is way underdone because those who pay the cost don’t capture all the benefits. But we can only contribute globally insignificant resources, while being amongst those who can appropriate the benefits of others’ work. Putting lot of our resources into research is herefore altruistic, which is fine if everyone else was similarly altruistic. But they’re not.

  5. Nicholas Gruen says:

    DD, it’s a good theory, but how come when you try and measure it (admittedly a somewhat Herculean task) the research keeps saying that Oz research generates high social returns (for Australia). So the benefits to the world are just another one of those games of prisoners’ delight working itself out.

  6. phil says:

    An issue for practical implementation of support is identifying the genuine applicants. It’s incredibly labour-intensive to hand-hold through the various phases, simultaneously monitoring for genuine-ness (sorry!) and identifying the most suitable support mechanism. While all this is happenening you’re always suspecting that a better or more deserving candidate is down the street, you just don’t know about them yet.

    That’s why I guess the R&D tax concession has been a useful tool: easy to administer and fairly wide applicability. However like all broadly based schemes it tends to capture the less genuine applicants.

    An ongoing issue is the word ‘innovation’ that continues to scare deserving folks off. If they understood that process improvement is legitimate and they don’t need a white coat to qualify, the enthusiasm to pursue innovation and seek support where necessary would be more widespread.

    And contra DD, locally developed innovation can always be held up for the demonstration effect, particularly powerful in smaller communities.

  7. Patrick says:

    Well, an advantage of a tax concession is that it creates a small army of tax consultants out there to explain to people just what might qualify for the concession…. :)

  8. derrida derider says:

    [email protected], I think the calculations of social rates of return from research are often even more dodgy than the calculations of social rates of return from higher education. In particular, crude international comparisons associating living standards and research expenditure leave out all sorts of endogeneity questions.

    I’m no expert on the topic, but I have seen enough to be a bit sceptical of claims of high rates of social return coming from people seeking taxpayers’ money.

    On the question of tax deductions vs targeted grants, it’s the dilemma familiar to all who work in welfare policy – the more you target, the more worthy people miss out and the more skewed the incentives you present. Also the more intrusive and expensive your administration is. But then if you don’t target, you can waste a lot of money.

  9. Nicholas Gruen says:

    Agreed DD, but you measure what you can.

    I’m not sure the targeting thing is quite analogous to social security. You target welfare on need. Now in fact R&D is notionally targeted in the same way, with requirements not to give $ to people who would go ahead without them. But that’s very much honoured in the breach.

    So most R&D money goes to what the assessors think are the best bets.

  10. Tim Quilty says:

    Lets just make losses tradeable. Entities that incur tax losses can sell them to profitable entities to reduce tax payable. No need to muck around with new classes of shares.

  11. Nicholas Gruen says:

    Too expensive.

  12. Patrick says:

    Yes Tim, you’d be suprised how big some of the losses out there are. My guess is a few trillion extant at any given moment, a decent proportion of which have either low NPV to their current owner or will in fact never be used.

  13. Pingback: Club Troppo » What’s wrong with ‘Freshwater economics’? (Hint: it is absurd).

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