Small-minded R&D
Ottawa’s bias toward small business will hurt research
No doubt the top aim for the federal Minister of Finance is to improve long-term growth through innovation. “Supporting Entrepreneurs, Innovators and World Class Research” was the very first set of recommendations in the 2012 budget papers. You had to be a pretty slow innovator if you missed this one.
The crucial issue is whether the budget will spur Canadian business research efforts. Big companies get less and small companies generally get more support. But will this shift make Canada much more innovative in the future? I doubt it.
Certainly, past research and development programs have had little success in spurring business research that leads to new product developments or new methods of production. While Canada has one of the best records of investment in higher education R&D, it has one of the poorest performances of business R&D as a share of GDP: one half of the U.S. levels and two-thirds of the average in OECD countries. Given that Canada provides one of the greatest levels of tax support for business R&D in the world but far less grant support, obviously our system is not succeeding.
In this respect, the federal government is right to reform existing policies, whose effectiveness was earlier lampooned by Tom Jenkins’ report. Costing $8-billion, only two of the 80 or so programs are generally known. These are the Scientific Research and Experiential Development tax credit and the Industrial Research Assistance Program (IRAP) geared towards smaller businesses. The rest are a less-effective bundle of small and unconsolidated programs provided by various government departments, including Industry Canada, Natural Resources Canada, Environment Canada and National Defence.
In many past reports, Canadians have been looking for the Holy Grail of research commercialization, whereby discoveries taking place, such as in the university sector, can be turned into fast-growing global companies. And when we do have some success, such
as research-intensive Nortel and RIM, we just can’t seem to hang on to these gains. It is one thing to perform less well than a large country such as the United States that has several large innovators, such as Apple and IBM. It is another that Canada can’t do as well as some little countries such as Israel and Sweden.
In my view, the most important proposal is the introduction of “smart procurement,” whereby federal contracts would put some weight on innovation as part of the procurement process. Limited to small and medium-sized businesses, it is not clear why “smart procurement” is not also applied to larger companies in their contractual relationships with government agencies to encourage business innovation.
The budget also provides $400-million in seed funds for venture capital through private-sector funds. This proposal could do little if government is a last resort for entrepreneurs who think
Might make good politics but has questionable economics
they have a great idea but are unable to persuade a venture capitalist to solely put up its own funds in support. The details are to be worked out, but certainly it can do no worse than the current labour-sponsored venture capital credit, which has done more harm than good by encouraging too many poorly funded venture capital projects. That credit program should have been canned in the budget.
The largest set of changes result in a shift from tax to spending support. The R&D tax credit rate for large businesses is being dropped from 20% to 15%, the small business credit rate remains at 35% and capital will be excluded from the credit base (the latter is much more important for large companies). The government will be doubling IRAP by $110-million annually while shifting support toward internships and business-led research (including a different
focus for the National Research Council).
The significant shift in tax and grant support from large to small business research might make good politics but has questionable economics. The rationale for government intervention in business research is based on a classic market-failure argument: Businesses are unable to fully appropriate the returns on research investments since others can learn without cost. I can think of no study that supports that small business research has bigger spillover benefits than large business research, thereby suggesting greater tax support for small businesses. In fact, I suspect the opposite may be true.
If anything, the small business R&D tax credit of 35% is far too rich even relative to the additional compliance costs faced by small businesses in applying for the credit. And, if the small business grows, it loses many tax benefits, including the enhanced R&D credit. At least, the government could have reduced the small business credit by a quarter, to 26.25%, to reduce the differences between the large and small credit.
Further, by excluding capital from the R&D credit base, the new credit discriminates against capital-intensive research projects. While this matters little at the small business level (since capital is only 3% of their costs), it discourages larger, capital-intensive projects. Perhaps some compliance costs associated with the inclusion of capital is problematical for small businesses, but it is far from clear that this is good policy for large businesses.
As large businesses are responsible for the preponderance of business research, the tax credit changes will likely have a negative impact on research and development in the country. Certainly, small firms will get bigger support, but small firms have not been the greatest source of innovative capacity in the country. It is only when the small business grows that we get some success. So far, small business growth has far from been Canada’s strong point.