On Public Financing of Innovation Bronwyn H. Hall UC Berkeley, NBER, and IFS

June 2005Worldbank Conf - Barcelona2 Outline Underinvestment? Underinvestment? Remedies Remedies –and what hasn’t worked A question A question

June 2005Worldbank Conf - Barcelona3 What needs fixing (in L.A.)? underinvestment (high rates of return) in business R&D due to underinvestment (high rates of return) in business R&D due to –financing problems –weak IP rights? –entry barriers (4 times Asian NICs as a share of GDP/capita) lower govt support for R&D lower govt support for R&D lower quality public sector research institutions and weak links to industry lower quality public sector research institutions and weak links to industry

June 2005Worldbank Conf - Barcelona4 Return or cost of R&D Level of R&D spending RCRC RSRS C S Social return Private return Optimal subsidy Determining the optimal subsidy Optimal competitive level of R Optimal social level of R cost

June 2005Worldbank Conf - Barcelona5 What’s wrong with this simple graph? Magnitude of the spillover gap varies Magnitude of the spillover gap varies –by country (openness, development) –by industry (appropriability) –by technology type (generic/specific) Project ordering varies depending on whether you use social or private returns to order Project ordering varies depending on whether you use social or private returns to order

June 2005Worldbank Conf - Barcelona6 Remedies for underinvestment – tax credits Features Features –Accelerated depreciation - usually 100% –Allowances – amounts that can be deducted from income for tax purposes (>100%) –Credits – amounts deducted from tax liability –Firm usually chooses projects Drawbacks for developing countries Drawbacks for developing countries –expensive unless incremental –enforcement? –size of corporate tax burden

June 2005Worldbank Conf - Barcelona7 Why an incremental credit? Rate of Return or Cost of R&D Amount of R&D  R0R0 R1R1 Tax revenue loss for incremental credit Tax revenue loss for ordinary credit Effective cost of capital Firm increasing R&D from R 0 to R 1

June 2005Worldbank Conf - Barcelona8 Remedies for underinvestment - subsidies Public subsidies (cost-sharing) Public subsidies (cost-sharing) –Government usually chooses projects (although firms propose them –Sometimes targeted to collaborative research (univ-ind, govt-ind, etc) In developing countries In developing countries –successful in Finland, Israel, and some other countries (mostly more developed) –early stages of development no technology restrictions no technology restrictions other innovation expenditures (diffusion) other innovation expenditures (diffusion)

June 2005Worldbank Conf - Barcelona9 Remedies for weak institutions/links Successful in US development: Successful in US development: –extension services associated with universities (funded by govt) Taiwanese model of public research organizations (ITRI, ESRO) Taiwanese model of public research organizations (ITRI, ESRO) –with 50% cost-shared spin-offs of successful projects and engineers –downside job insurance encourages risk- taking

June 2005Worldbank Conf - Barcelona10 Some policies that seem not to have worked well trying to create a VC industry trying to create a VC industry –with insufficient private demand for capital (Chile) –with excessive govt intervention, mainly financial goals, and with downside insurance instead of upside payoff (Israel’s Inbal) encouraging FDI via low taxes/duties/trade zones with no provision for transfer activities encouraging FDI via low taxes/duties/trade zones with no provision for transfer activities –Costa Rica – low links with rest of economy, most skilled labor moving from one foreign firm to another, little local R&D or tech transfer –Mexico – as local content requirements reduced, foreign firms closed R&D activities

June 2005Worldbank Conf - Barcelona11 Intellectual property policy Asian NICs developed in an environment without a lot of patent use Asian NICs developed in an environment without a lot of patent use –now patent aggressively, partly due to changes in the ICT sector Many (not all) infant industries did the same Many (not all) infant industries did the same –Cornish pumping engine –chemicals in Germany/UK in 19C –early semiconductors/software Does TRIPS foreclose this avenue of technology development/transfer? Does TRIPS foreclose this avenue of technology development/transfer?