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Steven J. Markovich: Promoting Innovation Through R&D

By Steven J. Markovich November 14, 2012

In a post for the Council on Foreign Relations, Markovich investigates spending trends for research and development overseas and domestically, both private and public.

Experts agree that research and development (R&D) is the backbone of a globally competitive, knowledge-driven economy. R&D investment helps develop new products and services that drive growth, create jobs, and improve the national welfare. For decades the U.S. government and private sector have spent more than any other nation on R&D. But that advantage is eroding as other nations increase public and private R&D investments at faster rate, causing the global U.S. share of this critical investment to decline.

Government creates the policies that stimulate R&D activity in the private sector. At the moment, individual firms are often unable to harness all the benefits of innovation and, therefore, are underinvesting in R&D. Tax incentives like the Research and Experimentation tax credit are one tool to encourage investment, and experts say policymakers should do more to support U.S. innovation by aligning other relevant policies related to education, patent law, and immigration.

Why is R&D important?

R&D encompasses three activities: basic research, applied research, and development. Roughly two-thirds of all U.S. R&D is focused on development, with the remainder split between applied and basic research. Basic or pure research does not have an immediate commercial objective, but is rather focused on developing new principles and theories that explain the natural world.

“Modern economies are based on the command of knowledge and information,” economist Gary S. Becker wrote in November 2010. “Since knowledge is created by basic and applied research, the United States should increase the share of its GDP that is spent on R&D.” He added, “While most basic research projects fail, the successes often bring enormous benefits to society.”

These societal gains from basic research breakthroughs can have broad commercial applications down the road. For instance, basic research for the laser, a technology involved in some 55,000 U.S. patents, was funded by the U.S. Department of Defense. Government is heavily involved in basic research because it is better able to assume the risks and long investment periods associated with basic research–and ultimately more apt to reap the benefits. Basic research results are non-patentable, so while one firm cannot easily capture the benefits of basic research, the government will benefit if new insights ripple across the economy.

Without government intervention, “the private market would not adequately supply certain types of research,” Federal Reserve Chairman Ben Bernanke said at a conference on jobs and growth in May 2011. “The declining emphasis on basic research is somewhat concerning because fundamental research is ultimately the source of most innovation, albeit often with long lags.”

These lags exist because of the distance between basic research and human needs. Applied research helps bridge this gap by solving practical problems that benefit humanity with a commercial objective. While determining the structure of DNA was an exercise in basic research, efforts to determine a link between genetics and breast cancer would be applied research. Once that link is understood, the development phase of R&D puts the new knowledge into designing products and services. Creating a quick test for a genetic sequence linked to breast cancer would be development. Development is lower risk and yields patentable innovations with direct commercial objectives, so business R&D spending dominants in this phase. Notably, most government development funding is for defense.

Trends in Global R&D Spending

Over the first decade of the twenty-first century, total public and private U.S. R&D expenditures grew at just 5 percent a year, reaching $400 billion annually in 2009. Meanwhile, R&D spending has generally surged across Asia, with China and South Korea maintaining double digit growth rates. China became the second highest spender on R&D worldwide, with $154 billion in 2009, surpassing Japan. For that same period, the European Union averaged 5.8 percent R&D growth, reaching $300 billion.

Comparing R&D spending can be misleading, however, without accounting for the size of a nation’s population and economy. In 2009, the U.S. R&D to GDP ratio was 2.9 percent–a number last achieved in 1964, and near a record high. Nonetheless, eight nations had a higher ratio.

Global science and engineering (S&E) employment and R&D spending are closely related because personnel costs are the largest share of R&D expenditures in most economies. Between 1995 and 2007, the United States and the European Union both increased their total S&E employment from 1 to 1.4 million. Asia enjoyed more rapid growth over this period, particularly China (0.5 to 1.4 million) and South Korea (100,000 to 200,000).

Despite more rapid growth overseas, the United States is still a scientific powerhouse. U.S. researchers are responsible for more publications in top scientific journals than any other nation, and account for nearly half of the top 1 percent of the most cited scientific papers, while forty of the world’s top fifty research universities are in the United States. Still, there is a significant trend of internationalizing scientific research. In 2000, only a quarter of U.S. research articles had an international co-author, but today that number is one-third.

Federally Funded R&D

The federal government is the primary funder for basic research in the United States, the great majority of which is conducted at top colleges and universities. For decades, the U.S. government has spent more as a percent of GDP on directly funded R&D than other national governments. This is still true; in 2008 no other OECD nation had more direct government R&D funding as a percentage of GDP. But, this competitive advantage is eroding as growth of federal R&D investment wanes. From 1953 to 1987 the real annual growth rate in federal R&D spending was 4.9 percent, but from 1987 to 2008 federal R&Dexpenditures grew at just 0.3 percent.

The mix of federal R&D spending has changed as the priorities of the government have evolved. Over the past two decades, allocations for health research grew fastest to become a majority of non-defense R&D spending. However, more than half of federally funded research is still directed towards defense, even though this share is down from Cold War highs.

Military research has yielded innovations that have shaped modern life: jet propulsion, the Internet, GPS, nuclear power, microwave ovens, and communication satellites, just to name a few. Still, some experts believe that the flow of innovation may be slowing from the military to the broader economy, as military R&D is increasingly targeted to specialized needs. For instance, the commercial jet engine that enables modern air transportation has military roots, but decades of investment in stealth technology may have little potential outside of military applications.

Competition in the civilian market may spur a higher pace of innovation than the military demands; the rapid growth of the video game industry sped the development of virtual reality training systems for soldiers. Notably, no other developed nation allocates more than 30 percent of government R&D support to defense.

Increasing concerns about record high U.S. deficits and a rising national debt may make it difficult for Washington to allocate more funds to R&D. Aside from the $18.7 billion in R&D funds extraordinarily allocated by the American Recovery and Reinvestment Act of 2009, total federal R&D expenditures have been relatively flat under the Obama administration, with an average annual increase of 1 percent from FY2009 through FY2012.

The composition of spending has changed over this time period; military R&D declined by 3 percent, while health R&D grew by 9 percent. Non-defense and non-health R&D grew by 13 percent over the past four years, but this is far less than the pace set by the America Competes Reauthorization Act of 2010, which called for a doubling of allocations over ten years. Increased allocations for general science R&D have largely been directed at multiagency initiatives such as the National Nanotechnology Initiative.

Spurring Innovation with Tax Policy

The federal government also promotes R&D through its tax policy. An incentive known as the Research and Experimentation (R&E) tax credit encourages private sector R&D by allowing corporations to take unlimited deductions for qualified research spending. Many economists and businesses generally support the credit and its goal of raising private sector R&D investment to a more socially optimal level.

The R&E tax credit, however, has always been a temporary program–it has expired and been renewed thirteen times since 1981–and critics suggest this has weakened its effectiveness. Many experts note that businesses are reluctant to change their behavior given the historic uncertainty associated with the credit.

Today many countries have incentive programs far more generous than that of the United States. A recent study by the Washington-based Information Technology and Innovation Foundation ranked the United States twenty-seventh out of forty-two countries in R&D tax incentive generosity (assuming that the U.S. incentive is reauthorized.)

While the U.S. R&E tax credit is an incremental tax credit, other nations have used volume-based (e.g. Brazil, Canada, China, France, India) or hybrid systems (e.g. Japan, Korea) to calculate credits. Volume-based approaches reward firms for all R&D activities, so they are generous and expensive but simple to administer. The greater complexity of an incremental system like the United States’ creates costs for both companies and the tax authoritycosts that could be high enough to dissuade some firms from pursuing the credit.

While tax credits allow a direct deduction from taxes payable, some nations use enhanced tax allowances (e.g. Denmark, United Kingdom) that reduce the tax liability. The value of a tax allowance depends upon the corporate tax rate. Some nations tie R&D tax credits more explicitly to jobs with a payroll withholding tax credit for R&D wages (e.g Belgium, Netherlands), while others give more generous incentives to small businesses (e.g. Canada, Japan, Korea, United Kingdom).

One innovative policy gaining traction is the “patent box.” In 2013, the United Kingdom will follow the Netherlands, Belgium, Spain, and Luxembourg in adopting a patent box system that taxes firms at a lower rate on income related to domestically-developed patents.

The Business of R&D

In 2009, businesses funded 60 percent of total U.S. R&D–a ratio similar to other nations with intensive R&D activities, such as Japan, South Korea, Germany, and China–including nearly 60 percent of applied research and over 90 percent of development activities. While industry focuses most R&D on creating innovations with direct commercial applications, there are exceptions such as Bell Labs, the R&D arm of Alcatel-Lucent (previously a subsidiary of AT&T), whose researchers have amassed seven Nobel Prizes.

It’s also important to remember that a large established firm and a startup may prioritize R&D differently,” says James P. Dougherty, CFR Adjunct Senior Fellow for Business and Foreign Policy. “Large companies are generally doing deep and wide R&D. Start-ups are usually laser focused on the one (or very small number) of the specific things they are building or enhancing.”

Privately funded R&D in the United States is well diversified, with no industry accounting for more than a 23 percent share. In contrast, communication technology–including television equipment and semiconductors–is forty-five percent of business R&D spending in South Korea. The largest business sectors for U.S. R&D are: computer and electronic products, pharmaceuticals, software and computer services, R&D services, automobiles, and aerospace and defense.

U.S. multinationals continue to build R&D facilities overseas, but the majority of their investment is still targeted within the United States ($250 billion domestic vs. $61.5 billion offshore in 2008). R&D employment is also disproportionately domestic, particularly for manufacturing firms, which have roughly 40 percent of their total workforce overseas but only 25 percent of R&D jobs abroad. However, the recent trend indicates greater overseas R&D job growth. From 2004 to 2009, U.S. multinationals almost doubled their overseas R&D employment from 137,800 to 267,400, compared to creating only 22,300 new domestic R&D jobs.

Just as U.S.-based firms conduct research overseas, foreign multinationals invest in the United States, having funded $41 billion in U.S. R&D in 2008. The foreign share of business R&D spending has remained fairly consistent over the past decade, as foreign multinationals grew their R&D investments at approximately the same rate as U.S. businesses. Foreign multinationals added 16,800 U.S. R&D jobs between 2004 and 2009.

Steven J. Markovich’s original post for the Council on Foreign Relations, along with other contributions to the Renewing America project.