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IFS
Productivity and
Government Policy Towards R&D
Laura Abramovsky
Institute for Fiscal Studies
Public Economics Lectures
London
19th March 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
© Institute for Fiscal Studies, 2007
The productivity gap
Labour productivity
140
Index, UK=100
120
100
UK
Germany
France
USA
80
60
40
20
0
GDP per worker
GDP per hour worked
Source: Office for National Statistics, International Comparisons of Productivity, year 2005
© Institute for Fiscal Studies, 2007
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
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UK R&D performance, 19812004
Gross expenditure
on R&D
asUKa %
USA
Germany
France
of GDP
GERD as % of GDP
2.9
2.7
2.5
2.3
2.1
1.9
1.7
1.5
1981
1984
1987
1990
1993
1996
Source: Main Science and Technology Indicators, OECD 2006
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1999
2002
Who performs R&D in UK?
(2004)
Business Enterprise R&D
(BERD)
Higher Education R&D
(HERD)
Government R&D
(GOVERD)
Total
£m
(cash
terms)
%
12,800
63%
4,800
23%
2,700
14%
20,300
100%
Source: Main Science and Technology Indicators, OECD 2006
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Decline in BERD intensity
BERD as % of GDP
Business Enterprise Expenditure
on
USA
Germany
France
UK
R&D
(BERD) as a % of GDP
2.2
2
1.8
1.6
1.4
1.2
1
1981
1984
1987
1990
1993
1996
Source: Main Science and Technology Indicators, OECD 2006
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1999
2002
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)
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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
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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)
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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)
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Augmented production function
approach (see Griliches, 1998)
Yit 
L K R
Ait Lit K it Rit
ln Yit   L ln Lit   K ln Kit   R ln Rit  eit
R
Yit
R
Rit
is the elasticity of output w.r.t. the firm’s R&D stock
is the (private) rate of return (r.o.r) to the firm’s R&D stock
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Estimate external r.o.r.
from production function
ln Yit   L ln Lit   K ln Kit   R ln Rit
  E ln Rit  eit
E
is the elasticity of output w.r.t. others’ R&D stock
© Institute for Fiscal Studies, 2007
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):
© Institute for Fiscal Studies, 2007
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
© Institute for Fiscal Studies, 2007
Estimates of the social rate of
return
et al
(2001a)
•Griffith
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
© Institute for Fiscal Studies, 2007
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
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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
© Institute for Fiscal Studies, 2007
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
© Institute for Fiscal Studies, 2007
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)
© Institute for Fiscal Studies, 2007
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?
© Institute for Fiscal Studies, 2007
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?
© Institute for Fiscal Studies, 2007
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%)
© Institute for Fiscal Studies, 2007
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
© Institute for Fiscal Studies, 2007
R&D tax credits in the UK:
volume-based
SMEs
Large firms
(employment (employment 250+
<250 &
& turnover 50m+
turnover < 50m
euros)
euros)
Number of firms (claims year
2005)
5,000
1,000
Amount of R&D (year 2005)
Rate of credit (A)
Corporation tax rate (B)
c. £0.5 bn
50%
19% - 30%
c. £12.5 bn
25%
30%
Marginal effective tax credit
(A*B)
Repayable (if no taxable
9.5% - 15%
7.5%
Yes
No
© Institute for Fiscal Studies, 2007
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
© Institute for Fiscal Studies, 2007
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)?
© Institute for Fiscal Studies, 2007
References
The UK productivity gap
Crafts, 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 performance
R. 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&D
Griliches (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 credits
Bloom, 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
© Institute for Fiscal Studies, 2007
The two faces of R&D
(Griffith et al, 2001a)
 Ai 
 R
 ln Ait  1     ln AFt  1 ln  
 Y it 1
 AF t 1
‘R&D
innovation effect’
‘non R&D-based technology transfer’
 Ai 
 R
  2   ln    X it 1  uit
 Y it 1  AF t 1
‘R&D-based technology transfer’
A: Technical efficiency or TFP
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Change in price of R&D
(see Griffith et al, 2001b)
User cost of R&D after credit =
Ad: NPV of capital allowances
before credit
Ac: Marginal Effective Tax
Credit for R&D
1  A d  Ac
(   )
1 t
: firm’s real discount rate
: rate of economic depreciation
of R&D
t : is rate of corporation tax
Proportional change in R&D user price (large firms) 
 1  Ad 
1  0.287


ln 

ln
 0.11
d
c


1  0.287  0.075 
1  A  A 
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UK R&D tax credits: additional
R&D
• and
Additional
R&D will
equal to:
its impact
onbeTFP
Eligible R&D * %Δprice * price-elasticity of demand
0.12 in the short run
0.11 for R&D
(see Griffith et al, 2001b)
0.86 in the long run
(see Bloom et al, 2002)
• 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)
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Increase in overseas R&D…?
R&D level, rebased
R&D done in the UK (BERD)
R&D done by UK firms (Scoreboard)
200
150
100
50
0
1996
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1998
2000
2002