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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 Index, UK=100 140 120 100 UK Germany France USA 80 60 40 20 0 Value added per worker Value added per hour worked Value added per person of working age Source: HM Treasury, Pre-Budget Report 2004 Service sectors account for an increasingly large part of the gap Share of UK-US Gap, 1990, 1995 and 2001 Mining/quarrying Electricity, gas, water Transport and storage Construction Post and telecom Hotels and restaurants Manufacturing (excl. mach+equip) Business services Machinery and equipment Financial intermediation Wholesale and retail Distribution of employment -5% 0 5% 10% 15% 20% 25% 1990 1995 2001 Source: authors' calculations using OECD data, US measured at f actor costs 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 R&D as a % of GDP UK R&D performance, 1981-2002 3.00 UK 2.50 USA France 2.00 Germany 1.50 1981 1984 1987 1990 1993 1996 1999 2002 Year Japan Who performs R&D in UK? (2002) £m % 13,100 67% Higher Education R&D (HERD) 4,400 22% Government R&D (GOVERD) 1,800 9% Business Enterprise R&D (BERD) Decline in BERD intensity, 1981-2002 BERD as a % of GDP 2.5 UK USA 2.0 France 1.5 Germany 1.0 1981 1984 1987 1990 1993 1996 1999 2002 Year Japan Increase in overseas R&D…? R&D level, rebased 200 150 R&D done by UK firms R&D done in the UK (BERD) 100 50 0 1992 1994 1996 Year 1998 2000 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) 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 to the firm’s R&D stock Estimate external r.o.r. from production function ln Yit L ln Lit K ln Kit R ln Rit E ln Rit eit 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) Ai R ln Ait 1 ln AFt 1 ln Y it 1 AF t 1 technology transfer Ai R 2 ln X it 1 uit Y it 1 AF t 1 absorptive capacity 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 <250 250+ <40m euros 40m+ euros Number of firms 4,500 1,000 Amount of R&D c. £0.5 bn c. £10 bn 50% 25% Corporation tax rate (B) 19% - 30% 30% Marginal effective tax credit (A*B) 9.5% - 15% 7.5% Yes (@24%) No Employment Turnover Rate of credit (A) Repayable? 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) User cost of R&D after credit = Where Ad is NPV of capital allowances before credit Ac is METC for R&D 1 Ad Ac ( ) 1 t is the firm’s real discount rate is the rate of economic depreciation of R&D t is rate of corporation tax 1 Ad 1 0.287 Change in price = ln ln 0.11 d c 1 0.287 0.075 1 A A 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 priceelasticity 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)?