Government financing of business R&D and innovation

Rationale and objectives

Firms are major drivers of innovation but tend to underinvest in R&D. They engage in R&D to differentiate themselves from competitors, to be more successful in business and to increase profits. However, the costs and uncertainty of R&D, the time required to obtain returns on investment, and the possibility that competitors can capture knowledge spillovers – owing to the non-rival and non-excludable nature of R&D – often reduce their incentives to undertake R&D. The funding of innovative entrepreneurship raises further issues, addressed in the policy profile on “Financing innovative entrepreneurship”.

The effectiveness of public financing policies can be questioned on three main grounds (Guellec and van Pottelsberghe, 2000). First, government spending can crowd out private money, for example by increasing the demand for and cost of R&D through higher wages for researchers. Second, governments may support projects that would have been implemented anyway so that firms simply use public money instead of their own. Third, governments often allocate public funds less efficiently than market forces, thereby distorting competition and resource allocation. By trying to “pick winners”, they may end up supporting less promising research areas or favour incumbents and lobbying groups to the detriment of new and innovative firms.

Major aspects and instruments

Governments finance business R&D and innovation through a mix of direct and indirect instruments. Governments offer direct support through public procurement for R&D and a variety of grants, subsidies, loans or equity funding (Table 1) (OECD, 2014). They provide indirect support through fiscal incentives, such as R&D tax incentives. Direct funding allows governments to target specific R&D activities and steer business efforts towards new R&D areas or areas that offer high social returns but low prospects for profits, e.g. green technology and social innovation; direct funding instruments depend on discretionary decisions by governments. Tax incentives reduce the marginal cost of R&D and innovation spending; they are usually more neutral than direct support in terms of industry, region and firm characteristics, although this does not exclude some differentiation, most often by firm size (OECD, 2010b). While direct subsidies are more targeted towards long-term research, R&D tax schemes are more likely to encourage short-term applied research and boost incremental innovation rather than radical breakthroughs.

Direct financial support is offered through competitive grants and debt financing, such as loans for R&D projects. Risk-sharing mechanisms are widely used to provide lenders with insurance against the risk of default and improve firms’ access to credit. A loan guarantee implies that in the event of a loan default, the credit guarantee scheme will reimburse a pre-defined share of the outstanding loan to the lender.

Some direct support is also linked to public procurement (see policy profile “Stimulating demand for innovation”). In France and the United States, a large share of public support for R&D is provided to firms in the defence industry to develop military equipment and potentially civil applications. While governments retain the intellectual property (IP) of research results developed in the framework of public procurementprogrammes, the research results belong to R&D-performing firm(s) under other funding schemes (Guellec and van Pottelsberghe, 2000).

Many OECD countries have schemes and funds to access early-stage finance, particularly for equity. Support is provided to the venture capital industry, with some governments actively providing equity funding (OECD, 2011b; Wilson et al., 2013). A common approach is to facilitate the growth of venture funding through public venture capital funds, co-investment funds with private investments and “funds of funds” (see policy profile “Start-ups and innovative entrepreneurship”).

Technology extension services and extension programmes are often targeted to SMEs and aim to expand the diffusion of already existing technology, and to contribute to increasing the absorptive capacity of targeted firms. Technology extension services usually comprise a diagnostic phase when firm’s operations, practicesand strategic management are assessed, and an implementation phase when firms are given assistance to implement their development plan. Whereas governments of both developed and developing economieshave long used them, technology extension services are particularly important in low income countries where geographically dispersed firms operate far from international best practices in their industries.

Direct support for innovation, other than R&D-related schemes, includes measures to facilitate the commercialisation of innovation, support the development of networks, promote regional innovation hubs, and ease access to information, expertise and advice (OECD, 2011a). Innovation vouchers or technology consulting services and extension programmes are major policy instruments in this respect.

Tax incentives applicable to different tax arrangements, including corporate and personal income taxes, are also widely used to encourage private investments in R&D and the exploitation of IP assets, to attract business angels and leverage early-stage finance, and to attract foreign talent or foreign multinationals (see policy profiles “Tax incentives for R&D and innovation”, and “Start-ups and innovative entrepreneurship”).

Recent policy trends

Public funding of business R&D and innovation has increased significantly in most countries over recent years (Figure 1 and see chapter 4 on Recent trends in STI and policies). The policy mix used to finance business innovation has seen growing use of R&D tax incentives and a shift of emphasis in direct support towards new purposes (e.g. knowledge transfer or equity financing). There has also been more focus on evaluation (OECD, 2011a).

In most countries, 10% to 25% of business R&D expenditure is funded by public money (see Chapter 4, Figure 7). Belgium, France, Ireland, Korea and the Russian Federation are the most generous, with central government support to business R&D accounting for more than 0.35% of GDP (Figure 1). Overall public funding of business R&D and innovation increased between 2006 and 2014, both in real terms and as a percentage of GDP. The relative increase has been particularly marked in Belgium, Hungary and Ireland, where direct support and tax concessions to firms combined have more than doubled since 2006.

 

 

Several countries increased public spending for business R&D and innovation between 2014 and 2016. Most OECD countries and emerging economies ranked the support to business innovation and entrepreneurship among their top national STI policy priorities in 2016 (EC/OECD, forthcoming). A third of them also confirmed the stronger role of R&D tax incentives in the policy mix for business R&D and innovation while more than half see competitive grants and public procurement for innovation gaining importance (Figure 2, Panel 2).

Direct funding instruments, especially competitive grants, remain major levers of innovation policy (Figure 2, Panel 1). Direct support is provided through an increasing variety of tools for an increasing variety of purposes (e.g. to encourage knowledge transfer, growth of high-technology start-ups, venture capital activity, green innovation) (OECD, 2011a).

Direct funding instruments for business R&D and innovation have become more market friendly, encouraging competition-based selection and streamlining public support schemes. As part of its joint customer strategy for improving public service delivery; Finland created joint service packages for high-growth enterprises and implemented systematic exchanges of customer data between public services. The Finnish Funding Agency for Innovation, Tekes, also centralises all funding instruments for traditional, fast-growing, young or early-stage firms.

Public budgets for competitive R&D grants have been rising in Iceland, New Zealand and Norway. In addition, in Iceland the amount of tax revenues foregone through the recently implemented R&D tax credit has also increased. Australia’s Industry Growth Centres Initiative that was established in 2014 aims to drive innovation by concentrating government investment in the form of grants and subsidies on key industry sectors, such as advanced manufacturing, cyber security, or mining equipment.

A large number of countries have also adopted new governance arrangements, revised their legal frameworks and implemented new programmes for improving innovative public procurement (see the policy profile “Stimulating demand for innovation”). Belgium (Flanders) adopted a new Innovative Procurement Action Plan in 2015 and Sweden created the National Agency for Public Procurement. The Czech Republic set up a new Pre-commercial Public Procurement programme (2014-20). The Netherlands and Poland put the emphasis on green procurement.

Technology extension services and extension programmes, and to a lesser extent debt and equity financing, emerge as important and increasingly relevant policy instruments as well (Figure 2, Panel 1) (see the policy profile “Start-ups and innovative entrepreneurship”).

In the aftermath of the crisis, countries have increasingly emphasised debt and equity financing in their policy mix for innovation and entrepreneurship in order to compensate for limited private funding (OECD, 2014). The Netherlands has implemented several targeted financing facilities (fund of funds, regional development agencies, growth facility, pre-seed and early stage instrument, and the business angels co‑investment facility). France has introduced in 2016 a new Corporate Venture Programme that partially covers corporate losses through tax reduction. Additionally, the programme allows amortizing the stakes a corporate acquires in innovative SMEs and its shares of private equity funds over a period of five years. Iceland has been preparing a tax incentives initiative since 2016 to encourage individuals to purchase stocks in small growing companies. In Turkey, the Venture Capital Funding Programme (TUBITAK 1514) aims at providing grants to venture capital funds, which invest in potential start-ups in need of seed capital, in order to spur technology intensive R&D, as well as production and commercialization activities.

Austria has expanded its loan initiatives for innovative start-ups and SMEs in 2014, with programmes such as the Austrian Economic Development Bank (AWS) Pre-Seed and Seed Financing for high-technology companies and a Frontrunner Initiative for innovation and technology leaders. The government also adjusted its loan guarantee programmes (e.g. reduced guarantee fees) to EU financial instruments and increased its guarantees to SMEs with limited collateral. The United Kingdom have developed new types of financing tools, such as loans, to replace existing grants for a budget set to reach USD 235 million (GBP 165 million) by 2019-20. The United States continues to propose extensions of loan guarantees and other risk-sharing mechanisms to encourage business innovation, particularly in the clean-energy sector.

Use of innovation vouchers has spread across the OECD and emerging economies over the period 2012-14 (OECD, 2014) and less change can be observed since then (Figure 2, Panel 2). Estonia has allocated USD 18.6 million PPP (EUR 10 million) to its business innovation voucher programme, running from 2014 to 2020. Turkey and Sweden are running pilot voucher schemes. Australia and France have introduced innovation vouchers at the state and local level.

National tax policies for R&D have been relatively stable since 2012, as compared to other policy areas that experienced more substantial changes (Figure 3). They have however gone through more changes between 2014 and 2016 than during the previous period (see the policy profile “Tax incentives for R&D and innovation”). Countries with new tax initiatives include for example Ireland, Italy and Latvia. Ireland implemented in 2016 the first OECD-compliant Knowledge Development Box with a 6.25% tax rate on corporate income arising from eligible intellectual property assets. As from 2014 Italy’s Stability Law introduced fiscal incentives to promote R&I activities within enterprises, create stable jobs and reduce taxes. All incremental business investments on R&I made during the period 2015-19 will benefit from a 25% tax credit. Recent amendments to Latvia’s Corporate Income Tax Law allow applying tax incentive on staff costs, costs for research services and costs related to certification, testing and calibration.