A researcher gets to work at a Bio Farma research and development laboratory in Bandung, West Java. (Antara Photo/Fahrul Jayadiputra)

R&D Sells, but Who Should Be Buying?

BY :SUGENG TRIWIBOWO

JUNE 25, 2019

The welfare of a nation, in the long run, is determined by its capacity to produce goods and services for society.

That ability depends on what is called in economics "production factors": capital accumulation, labor and technological progress in the form of innovation, and improvement of applied science and knowledge to enhance the productivity and quality of those products.

In this knowledge-driven age and globally competitive economy, technological changes are pivotal to achieve sustainable economic growth, raise the standard of living and create welfare in the long run.

Underpinning these robust technological changes are research and development (R&D). This is why investment in R&D is obligatory for every government.

Research and development promote innovation which leads to the invention of better production techniques and more efficient processing methods that will eventually benefit the economy.

This frame of thinking should provide enough impetus for countries around the world to boost outlays on R&D.

Global expenditure on R&D has increased rapidly. It is estimated to reach 4.14 percent of world GDP in 2018, or around $2.1 trillion. This includes R&D spending by governments, businesses and academics.

If we look closer at the data, government spending on R&D has been in continuous decline, while the business sector's spending on R&D has been increasing.

From 2010, government support for R&D has decreased by 2.4 percent while business spending on it has increased by 2.5 percent. Overall business spending on R&D right now makes up around two-thirds of global R&D spending, a.k.a. Gross Expenditure on Research and Development (GERD).

Only a few countries have their R&D spending funded by public monies. Among G20 member countries, only Russia, India, Indonesia and Argentina have the majority of their GERD funded by taxpayers' money. 

Empirical evidence seems to suggest overwhelmingly that governments should not use too much public funding on R&D just to be able to compete with the private sector.

One reason is that excessive public funding for R&D may crowd out available resources. If there is too much demand from the government for R&D, costs of research will rise, discouraging the private sector from conducting its own R&D.

A 2008 study of 15 OECD countries by Wolff and Reinthaler suggested companies may have to fork out 20-30 percent more money to conduct R&D if governments keep increasing their R&D outlay.

Government-funded R&D may also supplant similar projects planned by private companies. This will discourage them from spending more on R&D, and the private sector will soon be heavily dependent on the government to do their R&D for them. It will also deter the private sector from competing in innovation. 

Funding R&D with taxpayers' money also means the government is inadvertently "picking winners and losers" in the market. Too much government support for specific sectors or companies will distort competition in a supposedly free market.

R&D should be targeted at projects that promise more social and economic returns. But the government usually (notoriously) has no idea which R&D projects are worth supporting. This inevitably leads to inefficient resource allocations.

Economists believe losers are better at picking a government than governments are at picking a winner. If good governance fails, loopholes will open up for rent-seeking practices.

The only reason why governments should intervene in R&D projects is when the market fails, i.e. if companies are becoming more and more reluctant to fund R&D that will benefit the public simply because it is not lucrative.

This is the reason why governments should only pay for basic research that promises good return and put more efforts on encouraging the private sector to take care of the development and innovation parts.

Rather than directly funding R&D projects, governments should introduce incentives to boost privately-funded R&D. These can be fiscal incentives (tax credit, tax allowance, tax deferrals etc.) rather than direct financial support for R&D projects.

Tax incentives are in general easier to manage – less bureaucracy and easier to decide who should be eligible for them. 

They also offer flexibility for companies to spend the money they save from paying less tax to fund R&D projects that promise better economic return. Studies have shown that tax incentives cause a rise in private expenditures on R&D.

Tax incentives will also prevent bureaucrats and potential fundees from settling a deal under the table.

Sugeng Triwibowo is an economic analyst at the Coordinating Ministry for Economic Affairs 

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